Brazil and fiscal dominance

A few days ago I was reading an article in the Economist about structural problems in Brazil, caused by a combination of many years of wildly imprudent fiscal policy and the collapse of the oil and iron ore boom (soybeans, too) that had been preventing legislative craziness from having immediate bad consequences.

Those consequences have since arrived, in the form of deep recession, high inflation and a collapsing currency.  The policy situation in Brazil is grim enough to be described as one of fiscal dominance, a term that has slipped into the economic lexicon without my noticing it (by the way, the Bundesbank has an interesting discussion of its relevance in the EU).

What does fiscal dominance mean?

It’s a situation where a country’s finances are so unstable—high, and rising, government deficit + large outstanding, and also increasing, government debt–that any attempt to raise interest rates runs the risk of driving the government into default.  Investors quickly figure out the extra interest expense that will be needed to roll over existing debt and issue new bonds to fund the continuing deficit.  They know the point where the government will simply be unable to pay.  They don’t wait for that point, of course.  They run for the hills as soon as they reckon this is a real possibility.

As a result, in a fiscal dominance situation money policy can play no role in either stabilizing the currency or fighting inflation.  Fiscal policy, which in Brazil’s case has caused the parlous circumstances it now finds itself in, is the only policy tool available.





investing in stocks outside your own country: the Vale example

Still at spring training. So far, the Mets have beaten the Braves (five Atlanta errors) and lost to the Cardinals.

Investing in a foreign country

In my experience, one of the most difficult (and expensive) things to learn about investing outside your home country is that what you consider to be self-evidently and commonsensically true about the characteristics of good investments there isn’t necessarily so in someone else’s market. Instead, the rules that govern each market are the product of that nation’s legal framework, its shared social norms and the risk preferences of the dominant investors there (be they local or foreign), as well as the objective characteristics of the companies that are publicly listed.

The situation is made more difficult because we’re all, at least initially, not consciously aware of our deepest presuppositions about our own market. We don’t think to ask anyone in a new market what the rules of the game are, either, because we assume they’re the same as ours. And the people in the new market that we might ask are, like ourselves, probably not consciously aware of the assumptions they share with their fellow local investors.

Take the US and UK markets, for example. Superficially, the two are very similar. They have the same general language, same general legal system, same general accounting conventions. One is the former colony of the other. They are political allies. Everyone talks about Anglo-American capitalism as being different from the Japanese or continental European varieties.

Yet the two markets are quite different.

For example:

–Americans “know” that debt is a cheaper form of capital than equity; British investors “know” the reverse.

–The letter of the law is paramount in the US. In the UK the spirit of the law is more important. If some one can figure out a way to exploit imprecise wording in a contract to achieve an advantage, he’s likely lionized in the US. In the UK, he’s vilified.

–UK investors prefer to own the stocks of mature companies that generate free cash flow, pay rising dividends and have low price-earnings multiples. US investors are pretty evenly split between such value investors and growth advocates, who prefer younger, faster-growing firms that are cash flow users, not generators, and pay no dividends. US individual investors are prepared to pay very high PEs for stocks in the latter class.

How does one learn these rules? Mostly through experience—and through being aware that it’s important to be on the lookout for them speeds up the process immensely.

At the present time, there’s an interesting instance of “local ground rules” in progress, one that will go a long way toward fleshing out the rules of investing in Brazil, a potentially important emerging market. Here it is:

Vale, a large, publicly listed company in Brazil, is one of the world’s most important miners and exporters of iron ore. Iron ore is the main raw material used to create blast-furnace steel, the type of steel used to make automobiles. Vale’s most important customer is the steel industry in China.

Although Vale is happy to remain a miner/exporter, the current Brazilian government isn’t content with the current state of affairs. According to a recent Financial Times article, it wants Vale to integrate forward by investing in steel mills in Brazil and so it can produce steel for export in its home country. Vale is refusing.

The government’s response? …to force the current Vale CEO out of office, in the hope of replacing him with someone willing to adhere to the government’s wishes. As I see it, the government’s reasoning for its action is not that becoming a producer of steel, in direct competition with its largest iron ore customer, will be good for Vale or its shareholders. The rationale is that it will be good for Brazil.

It isn’t clear yet whether the government will get its wish.  I suspect that if I knew more (read: anything) about the Brazilian legal system, I’d have found tha there’s a deep-seated belief that natural resources really belong to the citizenry as a whole, that private companies don’t own natural resource deposits in the same way they do other assets.  And that idea is the basis for the government’s request.  If so, this might imply other industries might be immune from these tactics.

But every country has investment issues like this.  In Korea, for example, if a company is seen to be making “too much” money, it has been asked to make a “voluntary” contribution to some government-sponsored research project.  In Japan, the banks were never intended to make money; they were intended to gather national savings to make cheap loans to export-oriented companies.  Recently, we’ve learned that yoghurt-production is a key b in France, and thus not subject to foreign takeover.  For a decade or so, US oil companies were legally barred from charging market prices for the oil they brought to the surface.  And the US has massively protected/subsidized the domestic auto industry for as long as I’ve been a professional investor.

My private belief is that these quirks end up being bad for the capital markets anyplace they’re enforced.  They result in inefficient allocation of capital.  And that results in lowe price earnings multiples for stocks in the affected industries.

In a practical sense, however, there’s nothing any single investor can do about the local house rules  …other than to be aware they exist, lurking under the surface, everywhere–and take appropriate protective measures.