The Politics Behind Brazil's Investment Tax

By Carl Delfeld of Chartwell ETF & Emerging Markets Alpha

Brazil’s (EWZ, BZF)  stocks and currency fell sharply on Tuesday after the government announced a 2% tax on foreign portfolio investments in an effort to stem the rapid rise of its exchange

The move, announced shortly before local markets closed on Monday, followed steady gains in Brazil’s currency, the real, which has advanced 36 percent against the US dollar already this year, reducing the competitiveness of Brazilian exports against many competitors such as China which has re-established a peg to the US dollar.

What was behind this sudden move and how should investors weigh these and other  political and regulatory risks that go along with international, and especially, emerging market investing.

Malaysia (EWM), blaming foreign speculation for destabilizing its economy, imposed capital controls to prevent a run on its currency in 1998 during the Asian financial crisis. Chile (ECH), one of the most successful Latin American economies though still referred to by some as a frontier market, maintained controls on capital inflows for many years but has now suspended them. Chinese mandarins seeking to boost the Shanghai market, sometimes lower the tax on stock transactions to give its market a shot in the arm.

To understand Brazil’s move, you need to take a look at the politics behind it.

On September 29th Henrique Meirelles, the governor of the Central Bank, announced that he was joining the Party of the Brazilian Democratic Movement, a coalition of regional barons that is the country’s largest political outfit. In a general election next October he is expected to run for governor of his home state of Goiás, although he may reach as high as the vice-presidency.

Mr Meirelles, a former chief of BankBoston, had been elected to congress for an opposition party before being selected to head the Central Bank in 2002 by President Luiz Inácio Lula da Silva who believed his banking credentials would help sooth the anxiety of international investors worried about his left-wing reputation. Mr. Meirelles turned into a Mr. Volcker and promptly raised interest rates to painful levels to tame inflation. These measures in part led to the extraordinary economic boom bring Brazil’s GDP to almost $2 trillion, tenth in the world.

In the wake of the global financial crisis, the Central Bank brought interest rates down and the economy is likely to have returned to an annualized growth rate of 5% or so in the third quarter. This resilient growth is creating other political and economic issues.

The real has strengthened against the dollar 36% this year alone. Brazil’s current-account deficit is widening again and many analysts expect the Central Bank to have to raise interest rates again.

Meanwhile, exporters and manufacturers complain vociferously about the impact of a strong real. With an election coming next year and recognizing that a strong real provides benefits such as keeping inflation low and lowering the price of imports of capital goods, the government believed it had to do something: hence, the 2% tax seen as reasonable and not revolutionary.

Likewise, my guess is that smaller measures like the 2% levy are hoped to replace the stronger step of raising the central bank’s benchmark rate of 8.75% which is currently at a record low.

It is usually not good politics to raise interest rates in the midst of an election cycle. On a relative valuation basis, Brazil still seems cheap relative to its BRIC partners India and China. I prefer coupling the top-heavy iShares Brazil ETF (EWZ) with its small cap brother (BRF) which has a significantly higher allocation to Brazil’s fast-growing consumer goods and service sector.

Investor’s should expect some surprises and join Chartwell ETF to follow the politics of emerging market investing closely.