December 2011

FIXED INCOME: Return of the hot money?

Brazilian flagThousands of protestors pouring into the streets of Brazil not surprisingly overshadowed news that a fixed income tax had been repealed. Andrew Short asks what markets can expect next. When protesters filled streets up and down Brazil on June 13, international investors probably failed to notice that the scrapping of the IOF tax officially came into effect the same day. The 6% tax was levied on all fixed income investment from foreigners to prevent the Brazilian real overheating and halt short-term money flowing into and out of the market. When Brazil introduced the IOF tax – or financial operations tax – in 2010, the country was riding the crest of a commodities boom. Things have shifted since those golden days, and the protests underscore what investors from overseas may have missed in their haste to find returns. One of the primary issues of the protesters was the fairly mundane rise in bus fares in São Paulo from 3 Brazilian reales ($1.3) to 3.30 Brazilian reales – not a significant hike but, in a country where the minimum wage is 674.96 Brazilian reales, this would certainly hurt commuters in the long term. As the protest continued for days, it became apparent the grievances were not as modest as first thought; those on the streets were taking aim at deeper structural issues. Brazil is experiencing a widespread collapse in infrastructure, problems with ports, airports, public transport, health care and education. The protesters are annoyed also with the fact that Brazil has a poor population but taxes are exceptionally high. Seen through the lens of an overly sensitive and critical media abroad, these protests will no doubt be making investors ponder their allocations to the region. The status Brazil enjoyed is slipping and it is quickly becoming a place to avoid for risk-averse investors. Seen in this light, the scrapping of the IOF tax comes at an interesting time for the country. Does the move by the finance minister Guido Mantega mean capital for fixed income investment will come flocking back? Or is it another sign the government is scrambling around for ideas about how to reignite growth in Brazil? It is hard to give a definitive answer, but there are other signs that Brazil is not the destination it once was. DOWGRADING
The lack of confidence is being underpinned by the ratings agencies – it looks as though Brazil’s sovereign credit rating is going to be downgraded from its current S&P rating of BBB to BBB – at some point. The only positive is that it will remain investment grade. This was underscored by Barclays in a research note suggesting that Brazil will most certainly be downgraded a notch by the beginning of 2014, unless there is a credible and material change in the course of fiscal policy. They add: “Fiscal deterioration is almost unavoidable, which, along with the weak economic performance, should trigger a negative ratings move (S&P recently placed Brazil on negative watch for these same reasons).” Even with the bad news piling up and the sentiment on Brazil becoming overly negative, the house view at Bradesco Asset Management is that the protests will not have much of an effect on investor perception and the scrapping of the IOF will have a positive outcome. Joaquim Levy, the chief executive officer, says there will be no major change in flows into Brazil. “I don’t think the IOF was a major deterrent; volatility in the global market will be more of a determining factor about investments into Brazil.” He does think that certain products will become more attractive because when the tax was in place the majority of investors allocated to hard-currency funds that did not have pay tax. “Hard currency was an easy way for investors to get exposure to Brazil. However, with the scrapping of this tax, I think our domestic funds will get a lift,” he adds. This point is echoed by Citi Brazil Securities and Fund Services head, Marcio Veronese, who believes there will be a substantial increase in flows. “After a couple of weeks [since the repeal] of the IOF tax, we can say we have perceived a substantial increase in volumes towards fixed income. Many international investors who were somehow exposed to Brazil via offshore instruments decided to purchase directly government bonds in the country,” he says. Veronese adds that considering the vast majority of investors doing business in Brazil seem to focus long term, it is more likely that volumes of future inflows will be sustained at the new higher level achieved in the last couple of weeks. For managers outside Brazil the move is also seen as a positive thing and the protests are having little effect on their long-term thinking. Jan Dehn, head of research at Ashmore Brazil, says the removal of the upfront cost is a great move because more flows will come into the market. But he caveats this point with the observation that money will flow into Brazil but not just because of the scrapping of the IOF tax. “Bond yields have recently increased sharply due mainly to a big risk aversion in the global market place,” he says. “The move higher in bond yields have been excessive; the Brazilian curve is pricing in 300 bps of hikes. This is more hikes than will happen; Brazil has one of the highest real yields in the world. So investors are being compensated for the elevated rate of inflation.” POSITIVE STEP
One of the world’s largest global bond investors, Pimco, views the move as a positive step as well. Co-head of emerging markets, Michael Gomez, says that it signals a decreased official sector intervention in determining the level and term structure of local Brazilian interest rates. “With an inflation-fighting central bank, and the highest nominal and real interest rates of any major global bond market, Brazil local bonds are attractive. Removal of the IOF has made them more so.” These comments have been backed up in the short term by an uptick of inflows into Brazil – foreign fixed income investments reached $4.91 billion in June. This is an increase from the $4.17 billion fixed income investments the country received between January and May this year. According to Tulio Maciel, Brazil’s Central Bank Economics Department head, investors seem to be migrating from stocks to fixed income assets due to the scrapping of the tax. “It is possible investors are departing from shares and entering fixed income. In some ways the IOF removal is helping that flow,” he says. QUANTATIVE EASING
However, Carlos Eduardo Toro, KPMG director for international taxes at Brazil, says there is another factor at play in the rise in fixed income investments which runs contrary to the government’s view.
The uptick in fixed income investment in June  “is not only due to the IOF, which certainly creates an incentive, but it is also the perspective of an increased government interest rate”, he says. At the end of May, the Brazilian Central Bank unanimously decided to lift the Selic, the country’s benchmark interest rate, by 0.50% to 8%, in order to curb inflation. While fixed income saw positive figures, the balance between entry and flight of dollars in the country’s financial market was negative for Brazil, coming in at $209 million so far in June, according to information from the Central Bank. Not every asset manager is optimistic about what the scrapping of the tax will herald. In a report published by Natixis recently, the fund manager expressed this move would not make much difference and that flows will be lower than expected because of lower growth prospects and weaker fundamentals. They also point to a bigger trend at work: there has been an emerging market sell-off as the fed has signalled it will start to scale back its asset purchases programme, or quantitative easing (QE).
After strong non-farm payrolls data in the first week of July, it appears the US economy is getting stronger and this could have more effects on the Brazilian economy and flows. This is leading investors to readjust their portfolios, thus limiting the flows towards Brazilian assets. As QE begins to be tapered off by the Fed the perception of Brazil by foreign investors may change dramatically. It will become apparent if the scrapping of the IOF has done its job or if Brazil has become unappealing in light of protests and poor fundamentals. ©2013 funds europe

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