Brazil Gets a Little Nutty: Investment Survival in Emerging Markets

Brazil made news late Monday by imposing a capital inflow tax of 2% in an effort to try and put the breaks on the rapid ascent of the real, the country's currency.

In reaction to the news, the Bovespa dropped 2.88%, the iShares Brazil ETF (EWZ) was down 3.82% and the currency, as measured by the WisdomTree Brazilian Real ETF (BZF) dropped 2.12%. YTD those three are up 65%, 120% and 35% respectively. My core holding for Brazil has been Vale (VALE) for several years and it is up about the same as EWZ.

A 35% move for a currency is huge to the point of distorting the economic functioning of the country. It was a very big deal when the dollar dropped to 2.00 reals last May. It is now at 1.70 (meaning the greenback is dropping against the Brazilian currency) in only four months.

This has been a good thing for U.S.-based investors, and that is the reason why EWZ is up so much more than the actual Bovespa Index. In addition to making trade with the U.S. expensive (for Americans), it also makes trade expensive for the Chinese. Remember, the yuan is (sort of) pegged to the green back so if the real is up a lot against the the dollar it is also up a lot again the yuan.

The decision to impose the tax will either work as they hope or it won't, but clearly the action took the markets by surprise. The reasons for the moves up in the currency and the equity market are all still intact. If you have been involved with emerging markets for any length of time then you know that pullbacks of varying magnitudes come along for varying reasons. The one yesterday may or may not be anything more than the one day, I don't know. But I do know it will not be the last time an emerging market gets hit by news that seems out of the blue or goes down for no reason.

Occasionally these things are serious, like with Russia during the bear market, but they do happen. If emerging markets in general all correct then you won't really have any place to hide, but for the occasional country event the consequence can be mitigated by having a small weighting. For most countries I have had 2-3% weightings and have started to inch that up in a couple of instances (with more to come) to 4-6% which I am quite certain would be my max.

As the subject of country weightings has come up before, people ask why I invest so little if I really like a country. Stuff like the news from Brazil this week is exactly the reason. One of the risks to investing in certain market segments is events that cannot reasonably be analyzed. The obvious way to mitigate this type of risk is to avoid too much exposure.

For long-time readers this will be consistent with how I have been managing country exposure for years having written most extensively about Norway and China in addition to Brazil.

Comments

[TradingHelp...:]

2% on capital inflows? Brazil's gone nuts.

Oct 21 10:38 AM

[Brian P Shr...:]

Roger:
This may be a sore subject, but what do you think about Iceland now? How can a retail investor invest?
Thanks,
Brian

Oct 21 11:47 AM

[NormK:]

I've done very well with two Brazil staples: CZZ (largest sugar cane producer) and BTM (Brazil Telecom) over the past year, which I attribute to both recovery from overall market crash and of course the currency play as you mentioned. I was actually hoping for a larger dip before buying in to BZF since, as you mentioned it has gone up so much as well. Do you think there's a little more fallout to help it go down even more or has the whole inflow tax already played itself out in the market?

Oct 21 12:19 PM

[Angel Martin:]

A timely warning to those that think that the US is poor place to invest compared to emerging markets.

The best predictor of the future is past behavior. There is just a lot of political risk when one invests in the "bananna republics".
Look for

Oct 21 12:20 PM

[NormK:]

re: Angel, What is tempting about Brazil compared to other emerging markets is that it is so rich in natural resources, and I'm not just talking about oil. As long as they have a means to sell to the rest of the world, they will continue to grow. But I get your point.

Oct 21 01:02 PM

[Roger Nusbaum:]

nothing sore about the subject, i was wrong about the intermediate term of course but i was lucky enough to sell my Kaupthing shares long before the final meltdown.

for now i do not know of a way in. i would want to look at the fishing industry (a big building block upon which the mismanaged good times were built) where there every to be access for US based investors or one of the utilities (geothermal).


On Oct 21 11:47 AM Brian P Shriver wrote:

> Roger:
> This may be a sore subject, but what do you think about Iceland now?
> How can a retail investor invest?
> Thanks,
> Brian

Oct 21 01:05 PM

[ynwestor:]

Roger,
The yuan being pegged to usd, making the real more expensive in yuan terms is a Chinese problem only to the extent China sells more to Brazil than it buys from them, right? But Brazil must be selling a lot of raw materials to China, no?
The pegged currencies to usd, also raise the issue of what happened to the 'efficient market'? With usd seriously falling against most currencies, PGD, the black swan etf is attracting NO buyers. WHAT GIVES?

Oct 21 01:39 PM

[optionsgirl:]

Here's bloomberg's update:

bloomberg.com/apps...

Oct 22 08:43 AM

[ECONOMICS 101:]

Brian Semkiw believes Brazil is a juggernaut and must be watched very closely.
"They have a big economy that will only get bigger and are learning from the mistakes of others' says Brian Semkiw.

Oct 22 09:39 AM

[fran:]

please list the criteria for "banana republic" qualification. then see if any country in N. America comes close. please share your analysis here on SA.


On Oct 21 12:20 PM Angel Martin wrote:

> A timely warning to those that think that the US is poor place to
> invest compared to emerging markets.
>
> The best predictor of the future is past behavior. There is just
> a lot of political risk when one invests in the "bananna republics".
>
> Look for

Oct 22 09:49 AM

[Soldalma:]

I just arrived in Rio and was told that there were many more dead after the 14 (including 3 policemen in a crashed helicopter) that were reported in the international press a few days ago. So it's business as usual.

But I am in the unusual position of having to praise the Brazilian government for something it did. The tax was a prudent measure that will raise some money and function as a signal. With the real at 1.70 exporters were struggling. Lex had some comments on the issue in today's FT.

The only problem is the tax will not stop the real from appreciating. Calls on BZF just after the news were a rare opportunity, with unreasonably low implied vols. With domestic small cap mutual funds up 160% YTD and even blue chips up more than 100% who cares about 2%?

Oct 22 03:21 PM

[Soldalma:]

Somebody mentioned criteria for being classified as a "banana republic." High on the list would be having unsustainable public sector and current account deficits. Brazil does not qualify on those grounds, the US does.

In fact, if the US had taken measures to prevent its currency from appreciating a few years ago things could be much better nowadays in the Land of the Brave. Now the dollar is depreciating but a bit too late.

Oct 22 03:24 PM

[whooper1:]

The 2% tax won't have any effect on investors already in Brazil. The dip in equities and foreign exchange will be short lived and forgotten. Ironically, it will hurt small and medium sized Brazilian companies looking for foreign capital to expand, particularly those selling debt instruments denominated in the rapidly sinking dollar.

Oct 22 08:07 PM

[Angel Martin:]

Re: who is a banana republic.

The banana republic is exposed when the economy is doing poorly. If Brazil is creating a 2 tier exchange rate when times are good, what will they do to foreign investors when things are bad?

Oct 22 11:04 PM

[Jake2:]

"The best predictor of the future is past behavior." But past performance is no guarrantee of future returns. Or, as Jeff Skilling and/or Bernie Madoff would say. "Let me out of this place."

Oct 23 01:25 AM