3. High share of subsidized lending: The third key factor that is contributing to pressure on interest rates is the large share of earmarked and subsidized credit in Brazil. This takes place through government-backed financial institutions, especially the state development bank BNDES. BNDES’ lending represents roughly 20% of total credit in the economy, while total earmarked lending (including rural and housing credit) stands at about 35% (see chart below). Much of the earmarked lending is tied to the “long term interest rate” (TJLP), which generally does not change when the central bank moves the policy rate (the SELIC target rate). The TJLP was last raised in 2003 and has since been cut in half (from 12% to 6%). The lack of response to market rates weakens the transmission of monetary policy. Since a substantial share of credit does not react to the policy rate (or market interest rates), the central bank has to compensate by keeping rates higher for non-subsidized credit in order to achieve the same tightening effect. The end result is a higher level of market interest rates.
Despite the large gradual decline over the past 10 years, local interest rates in Brazil still remain exceptionally high compared to other EM countries (see chart below).
Here are the three main factors that explain why rates have been particularly high in Brazil:
(1) the recent history of hyperinflation,
(2) the structurally low savings rate, and
(3) the high share of subsidized and directed lending in the economy.
1. History of hyperinflation: Brazil’s inflation rate averaged well over 100% annually during the 1980s and exceeded 1000% annually during the first half of the 1990s. Only in the second half of the 1990s—after a currency reform that introduced the Brazilian Real (BRL)—were policy makers finally able to stabilize inflation in the single digits. We believe the relatively fresh memory of extraordinarily high inflation rates still has a profound impact on economic behavior in Brazil. In particular, we believe there is a tendency in Brazil to overestimate medium-term inflation risk. As a result, the central bank has to be particularly vigilant (both in terms of the level of policy rates as well as the timing of rate hikes) in order to keep inflation expectations contained. Overestimating inflation risks also fosters the tendency to borrow even at very high nominal rates and the reluctance to invest at fixed nominal rates, as upward inflation shocks benefit borrowers and hurt lenders.
2. Low savings rate: Brazil’s national savings rate is very low compared to most advanced and emerging economies (see chart below). In 2010 it was just 16%. Among other EM peers only Turkey had a lower savings rate at about 12.5%. Brazil’s Latin American peers have savings rates at or above 20% and most Asian economies have rates around 30% (and as high as 50% in China). A low savings rate in a country with substantial investment needs causes upward pressure on interest rates, as there is a shortage of savings to finance investment at “normal” interest rates. Another way of looking at this is through domestic demand. The flip side of a low savings rate is a high consumption rate, which means—when combined with significant investment demand—that domestic demand is too high and needs to be curbed through higher interest rates in order to avoid overheating.
And the last two reasons are:
4. Inefficient court system (hence, precarious laws to reinforce creditor protection)
5. The huge (and inefficient) government spending
We will discuss these last two items in another article.
Source: Bloomberg, Steffen Reichold
“Brazilian Bubble” provides the investment community with an unbiased perspective on Brazil and other Emerging Markets. We share investment ideas, market reports and economy analysis with our readers that the mainstream media and analysts leave largely unnoticed. We don’t care for the bull side or the bear side – only the right side. If you would like to contact us, please write to contact [at] brazilianbubble [dot] com