COHA Academic Report

8/2/2019 COHA Academic Report

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An Economic Analysis ofthe Role of Foreign

Investments in BrazilAcademic Report

This report was prepared by Gustavo de Lima Palhares, Research Associate at the

Council on Hemispheric Affairs and a graduate student at Fundao Getulio Vargas

GV Law, along with Guest Contributor Higor Uzzun Sales, a Master in Business

Administration from Harvard University.

4/18/2012


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Index

Introduction 3

1 Investments in Brazil by Non-residents 5

1.1 Types and Regulation 5

1.2 Direct Foreign Investments 6

1.3 Portfolio Investments 9

1.3.1 Private Equity as an Alternative Investment for Foreign Investors 12

1.4 Intercompany Loans 14

2 Recent Government Measures Regarding International Investments 16

2.1 Taxation and Stock Market Measures 16

2.2 Fiscal Consolidation and Growth 18

Conclusion 21


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Introduction

Since its discovery on the 22nd of April, 1500, Brazil has been a country of evolving,

if elusive, prosperity and natural wealth. However, only after the passing of many

centuries has it taken the shape of today: a prospective world power with a top-rated

world economy.

With a broad spectrum of unique resources, vast amounts of territory, and a behemoth

population, it is becoming increasingly clear that after becoming politically stable and

establishing sound economic fundamentals, it is well within the realm of possibility that

Brazil will become one of the most serviceable economies in the world. This scenario

began to reveal itself as a likely reality after the rapid recovery showed by the country

during the 2008 world crisis and the one that fell so decisively on Europe in 2011.

The development plan that was being implemented throughout this period allowed the

country to become a major destination for foreign investment; but along with its

newfound prominence, new challenges also have appeared. With all this new

internationally sourced capital entering the country, certain questions arise: (i) are

existing regulations effective?; (ii) how essential is the current complex of foreign

investment for Brazils economic health?; (iii) how dependent is the country on

international investments?; (iii) is the present administration driving Brazil in the right

direction, considering the aforementioned investment policy?; and (iv) in light of the

countrys existing modernization policy, will Brazil be able to live up to an array of

successful forecasts coming from the most unlikely of corners.


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Despite the optimism that has been a consistent part of the stories that have been

circulating in the media over the past seven years concerning the ongoing investment

strategy, only an economic and legal analysis of the countrys recent past and present

can accurately answer these enquiries.

Thus, this report is divided into three main parts. The first section has an informative tilt

to it, and is focused on the regulatory and legal implications of the Brazilian legal

system, exploring the matter of international investments as its introductory section.

Also in this section, the text provides a number of legal definitions pertaining to

different types of possible transactions, along with a guide to how the investments are

actually made. Giving a broad view along with a game plan of the countrys pertinent

regulations, this section makes it possible to assess the efficiency of the Brazilian rules

regarding the international transactions now being undertaken.

The second part of this report will attempt to analyze the measures taken by the

government so as to determine how effective they actually are. Also, the importance of

the full spectrum ofinternational investments on Brazils economic success is detailed,

based on real-time statistics, making it possible to raise issues related to government

policy and suggest possible alternatives.

The third and last section of this report gives a wide-based conclusion of all the analyses

provided, relying on an extensive research project based on many public documents

issued by major international institutions, as well as the most current information that

has been released by the Brazilian government and the private sector.


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It can be said in advance that the government has done a fairly good job in taking the

right measures at the right time, though a few concerns do still remain. Nevertheless,

with the same strategies and philosophy taken by the authorities during the recent world

crises, Brazil can at least identify all the challenges seen ahead.

1. Investments in Brazil by Non-residents

1.1.Types and Regulation

The main ways to mobilize foreign investment in Brazil are through foreign direct

investments (FDI), portfolio investments (PI), and inter-company loans. These

investments are aimed at various segments of the domestic market, but it is important to

note that according to the Brazilian Constitution, some sectors can only be financed and

developed by national capital. This includes the: (i) development of nuclear energy

activities; (ii) health services; (iii) mailing services; and (iv) the aerospace industry.

There are also a few restrictions on the acquisition of rural and borderland financial

institutions.

The general rules regarding the entry of foreign capital are regulated by Law # 4.131dated as of September 3rd, 1962 (Law 4.131), but its registration rules are guided by

specific rulings issued by the regulatory body in charge of supervising these operations.

Authorization by the Brazilian Central Bank (BCB) or the Brazilian government is

not required, according to the Article 3 of the law, however, any such foreign capital

must be registered. Also, Article 5 of Law 4.313 requires that the aforementioned

registration be complete within 30 days from the time the funds enter the country. This


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rule is applicable to any foreign capital entering the Brazilian market, and Article 58 of

the law stipulates a R$ 100,000 fine can be levied by the BCB in cases where the

registry process does not respect the deadline. Enforcement of this fine is rare, but the

procedure is essential for the transfer of profits abroad (as a result of overseas profits

secured in FDI) and for re-nationalization of capital.

All incoming foreign capital must be registered through the BCBs system called

Sisbacen utilizing its IED mode for FDI, PORTIFOLIO mode for portfolio

investments and ROF mode forintercompany loans. After the registration takes place,

a number connecting the investor and the receptor is issued (RDE -

IED/PORTFLIO/ROF), which will then remake future registrations, changes and

other transactions.

In 2010, the total amount of foreign capital that had been accumulated came to represent

30.8 percent of Brazils GDP, a total sum of$660.5USD (BCB 2011 Census), showing

the significance of the international investors and the importance of a efficiently

regulated market to the countrys economic success. [1]

1.2.Direct Foreign Investments

For procedural regulation purposes, the BCB considers FDI as all corporate capital

participation acquired or paid-up by corporate shareholders or individual residents

abroad, except shares acquired in the financial or stock market (vide article 2o of the

Ruling # 2997, issued by the BCB).


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As mentioned in the previous section, Brazilian law requires all foreign capital to be

registered, including FDI. The person responsible for this registration is the receptor

(the company that will receive the investment) and the investor represented by its

Brazilian representative1, according to the Ruling # 2997, article 3o, Paragraph 2o.

In order for the transaction to be executed, international investors are also expected to

have a Tax Payer Registry, called CPF (for individuals) and CNPJ (for corporations), as

required by the Normative Rulings issued by the Federal Revenue Office # 461/2004

and 748/2007.

Although wider, the definition provided by the BCB differs from the one applied by

major international institutions, like the Organization for Economic Co-operation and

Development (OCDE) and the World Bank, which define FDI as the net inflows of

investment to acquire a lasting management interest (10 percent or more of voting

stock) in an enterprise operating in an economy other than that of the investor. [2]

One of the reasons that can explain the difference of concepts and the creation of a

wider definition of FDI is the need to include every international capital flow under

BCB regulation.

1 Normative Ruling DNRC # 76, issued in 28 th of December, 1998, requires all foreign shareholders to

appoint a Brazilian representative to act on his behalf, with powers to resolve any issues and receiveservice of process in Brazil.


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Therefore, despite the dissimilarity at stake, the BCBs definition of FDI must be taken

into consideration when it comes to the domestic rules regarding the investment

procedures which were set up in consideration of the BCB concept. On the other hand,

in order to adequately illustrate the Brazilian economic scenario, the statistics presented

in this study take the internationalized concept of FDI into account.

According to the World Bank, in 2007 Brazil received an amount of US$ 34.6 billion of

FDI. This number has increased approximately 16.7%, reaching US$ 48.5 in 2010 [3].

Also, recently the BCB stated that in 2011, from January to November, a net inflow of

US$ 60.1 billion was registered of FDI entering the country, representing an increase of

81,6% compared to the same period in 2010 [4]. Authorities claim that a new record

will be broken when they close out the total amount for the entire year of 2011.

Regarding the destination of FDI flow, research shows that FDI has been well

distributed in the Brazilian market (2010 data). The number one destination is the

Telecom industry (11,4%), followed by the food sector in second place (10.7%) and in

third, two areas, other industries and Metal Works (10.2%). Also, accounting for a

prominent position are the oil and gas industries (8.8%) and mining (4.6%).

These numbers have demonstrated a sharp rise in the amount of investment in Brazil,

compared to other nations, due to its political stability and enviable economic position.

In addition, unlike other Latin American countries which receive appreciable FDI to be

invested in one specific commodity, FDI in Brazil is fairly uniformly distributed. This

indicates greater stability and entails a lower risk of suffering from any market

meltdown.


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If from one perspective FDI is an important source of capital and economic

development, it also indicates a large reliance on foreign capital and may cause

concerns about the eventual impact on the countrys currency. Another concern is the

term of the investments, which make a large difference for Brazils long-term plan for

development the most valuable foreign direct investment is a long term one. These

issues are shared by Brazilian authorities and justify some of the recent measures taken

by them, as we shall see in Chapter 2.

Regarding the origin of FDI, according to the International Monetary Fund (IMF),

most of the inflows come from Europe. Therefore, even though FDI amount has a

tendency to increase, an aggravation of the European crisis could result in a reduction of

investments in Brazil.

1.3.Portfolio Investments

The BCB and the Brazilian Securities Commission (CVM) consider PI to be all

investment executed by non-residents on the Brazilian stock or financial market (i.e.

stock exchange, future market, private equity funds etc2), which is regulated by the

Resolutions #2689 and 2687, issued by the National Monetary Council (Conselho

Monetario Nacional) on January 26th, 2000.

2

The Brazilian Law assures that all foreign investors have access to the same products available toResidents.


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The aforementioned regulation dictates that in order for the investments to be executed,

three main prerequisites must be made of: a) there must be a representative in Brazil, b)

the operation and the investor must register with the Brazilian Securities Commission,

and c) register the operation before the Brazilian Central Bank, through the Sisbacen

system, using the RDE-PORTIFOLIO mode. The investor must also contract a receiver

financial institution (i.e. bank) to wire the capital. The currency will be closed in the

moment of the transaction, when the financial institution and the stock exchange will be

in contact in order to execute the transaction.

Regarding the representative mentioned under letter a) above, he or she is the investors

contact for all Brazilian Central Bank and Brazilian Securities Commission issues

related to the operations. Although not required, the representative is usually the same

person responsible for all tax matters.

According to Normative Ruling #419, issued by the Brazilian Securities Commission in

2005, the foreign investor can benefit from a simpler registry process, which consists of

transferring the registration procedures to a Brazilian broker. However, a few pre-

requisites must be met: a) engagement with a foreign intermediate institution, and being

already registered under its home country laws and regulations, b) the intermediateinstitution must undertake the responsibility to present any information regarding the

investor, whenever solicited by the Brazilian Securities Commission or any by any

governmental agency, and c) an agreement must have been signed between the

Brazilian Government and the securities commission of the country where the investor

resides.


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Nevertheless, it is important to note that the intermediate institution chosen by the

investor cannot be contracted if it is considered to be from a nation which is rated as a

high risk country in terms of money laundering and terrorism financing, and must not be

cavalierly assessed as a non-cooperative country by some international organizations, as

regards to such putative illegal acts.

The 2008 subprime crisis, followed by the Lehman Brothers collapse, set every major

stock exchange on a downhill course. Consequently, the Brazilian Stock Market

registered one of its worse indices. However, after a short period, Brazil surprisingly

showed a never yet seen economic recovery and sturdy financial system, bringing back

investors to its market, as demonstrated by the equity and debt securities table below.

*Source: IMF

Even though the amount of portfolio investments has increased between 2008 and 2010,

following the same tendency seen with the FDI, recent data indicates that PI flows have

decreased approximately 12 percent in 2011.

Many reasons may account for this decrease, but the main reason was the expected low

performance presented by the Brazilian stock market in 2011, due to Europes finance

crisis, which affected all major stock markets around the world. In addition, a few tax

Origin and Amount (millions of USD) of Portfolio Investments in Brazil (equity and debt securities)

2007 2008 2009 2010

AllCountries

18,366 100% AllCountries



37,630 100%

Korea 4,026 22% U.S.A. 2,585 19% U.S.A. 4,218 24% U.S.A. 18,552 49%Bermuda 3,177 17% Austria 2,118 15% Bermuda 2,813 16% Spain 3,715 10%

Austria 2,819 15% Korea 1,558 11% Cayman 1,810 10% Bermuda 3,112 8%

Spain 2,158 12% Spain 1,473 11% Denmark 1,759 10% Denmark 2,544 7%

U.S.A. 2,024 11% Bahamas 1,172 8% Spain 1,205 7% Cayman 2,098 6%


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measures taken by the government in 2010, which will be detailed further on Chapter

2.1, kept some portfolio investors away from the Brazilian market in 2011.

Still, after the European situation was stabilized and the Brazilian government removed

the 2 percent Tax on Financial Transactions (IOF) on PI in December, 2011 PI in the

first months of 2012 has shown a recovery and should keep increasing in 2012.

1.3.1. Private Equity as an Alternative Investment for Foreign Investors

One particular class of PI that has shown strong growth in the last years is the private

equity industry. Private equity investments are long term investments, executed by

funds, usually with five to ten years horizon, that for the most part focuses on acquiring

participation in companies with growth potential or efficiency opportunities with the

objective of exiting them once these objectives are achieved, with a return hopefully

better than the average.

The private equity industry is of extreme importance as it has a direct relation with the

causes of increase, of PI, FDI and intercompany loans. This kind of investment

generates market growth, injecting capital into projects and business, thus, creating new

companies that will also attract foreign capital, through FDI or intercompany loans.

The attractiveness of Brazil to private equity investments results from the strong

fundamentals in the economy and long-term growth perspective that boosts the

investments in FDI and, to a lesser extent the investments in intercompany loans. At the


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same time, most of the returns expected by private equity firms will result from a strong

merger and acquisition (M&A) environment and a solid financial and stock market,

which are exactly the main factors that boosted PI in the country recently.

To put the various components into perspective, the interest of foreign capital in this

investment class, here we should note that the total of capital invested in private equity

in Latin America during the year of 2011 was US$10.3 billion, and Brazil represented

US$8.1 billion of this value, according to Private Equity International magazine. [5]

It should be highlighted that these statistics represent a significant amount compared

with other countries in the region. However, Brazil is still at significantly lower levels

when compared to China and India. Below are two charts with the evolution of

committed capital in the private equity industry in Brazil, as well the penetration of this

industry in Brazil as compared to other countries.


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*Souce: FGV Cepe

*Souce: Empea IMF

1.4.Intercompany Loans

The intercompany loan is a form of foreign investment that is executed by transferring

money from a foreign company to its Brazilian subsidiary, by way of a loan. Much like

FDI, intercompany loans became a common transaction as due to current legislation it is

more difficult for a foreign company to establish an outside branch in Brazil.

Once the transaction is made from a foreign company to its Brazilian subsidiary,

intercompany loans take place after a previous FDI has successfully been made. Thus, a

representative will already have been appointed when the loan happens and will also be

the representative of this matter.


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According to a recent Inflation Report issued by the BCB, US$ 12 billion in

intercompany loans were registered in 2011, showing an increase of US$3.7 billion

compared to the year 2010.

Despite the increase, this scenario could change in 2012, as the amount of short-term

intercompany loans is expected to decrease due to a 6% tax imposed by the government

for loans shorter than 3 years.

Nevertheless, considering the power and value the Real has accumulated in recent years,

a decrease of short-term foreign capital in the country should benefit the economy,

reducing the value of the countrys currency. Additionally, long-term investments

would be attracted; generating more jobs and prosperity in the long run, and exporters

would have the added advantage of gaining access to a low cost product when shipped

abroad.

2. Recent Government Measures Regarding International Investments

As a country rich in natural resources, attractive demographics and a large and growing

consumer market, added to its solid strength when it comes to financial, monetary and

fiscal tools, Brazils economic success should not come as a surprise. However, in order

for progress to come faster and confirm the countrys status as a world power, a few

measures should be taken, especially regarding its taxation.


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Recently the government has taken actions seeking to strengthen the Brazilian market

on a medium to long-term plan, taking into account currency issues and taxation

problems.

2.1.Taxation and Stock Market Measures

One of the most useful tools of government interference in the currency exchange rate

and control the amount of foreign investments in the country is the aforementioned IOF,

which applies to exchange and PI operations.

Over the past years ,the IOF percentage has faced many changes implemented regarding

the countrys situation at the time, which reflected on the currency rate and amount of

PI entering Brazil, as illustrated in the timeline below:

It is important to highlight that the measures taken in March and April 2011 had a larger

impact on the flow of intercompany loans, pressuring the companies to execute long-

term investments in the country. This strategy is a smart move, as it creates incentives

History of Capital Controls in Brazil

Mar-08 IOF of 1.5% introduced on foreign portfolio.

Oct-08 Following Lehmans bankruptcy and resulting BRL depreciation, the government suspended the

1.5% IOF tax on foreign fixed-income investments.

Oct-09 As the BRL appreciated again, the government re-introduced the IOF on foreign portfolioinvestments, at a higher rate of 2%.

Oct-10 The government raised the IOF on foreign fixed-income investments to 4% and then to 6% two

weeks later (the tax on equity investments remained 2%).

Jan-11 The BCB introduced a new reserve requirement of 60% of banks short USD position in the spot

market above USD3bn (lowered to USD1bn as of July 2011.

Mar-11 The government imposed a 6% IOF on external bonds and loans shorter than 360 days.

Apr-11 The 6% IOF on external bonds and loans was extended to maturities shorter than 720 days.

Dec-11 The government removed the 2% IOF on foreign portfolio investments in equities.

Mar-12 The 6% IOF on external bonds and loans was extended to maturities shorter than 3 years.


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for investors to actually contribute to a countrys economy and social condition,

generating long-lasting jobs and projects, since the investor will be charged a 6% IOF if

the loan lasts less than the period stated. With that in mind, the government extended

the IOF to loans shorter than 3 years in March, 2012.

The removal of the 2% IOF on PI (equities), should increase the PI inflows.

Consequently, the companies negotiated with stocks and bonds will benefit as PI is an

important source of capital to these companies. Another consequence is an indirect

boost of the market sector that these businesses run.

In addition to the changes at stake, monetary stabilization and the conversion of

Brazilian real interest rates to international readings are a strong incentive to various

regime stock markets. Investors tend to shift investments in government bonds (titles of

debt) to long term investment in equity markets, for example.

The actions taken by the government lately are in general positive. However, the way

the currency has been handled and the uncertainty of how much the authorities will keep

devaluing, has to remain a concern. If a pattern is not established foreign investors may

hesitate to invest.

2.2.Fiscal consolidation and growth

Despite the two recent world credit crises, one originated in the subprime mortgage

industry in the U.S.A. and the other in the sovereign credit default risk pool in Europe,

the government was able to achieve its primary surplus during the recent past years, at a


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time when the sharp manifestation of the financial crisis took place. Though the

government was able to adopt several incentives, involving decreased industrial tax

rates during the crisis, in order to restore growth, Brazil was able to perform better than

other nations. Besides other facts stated above, the timely elimination of these tax

incentives (implemented at the time of the crises) can also be explain by the rapid

restoration of the country growth, since it helped to maintain the fiscal balance creating

a healthy tax position. Below is a chart with the evolution of the primary surplus in the

last years:

*Source BCB

This fiscal consolidation was also perceived by the international market. The market

perception of the fiscal position in the country is reflected by its sovereign risk,

measured by the cost of credit default swaps (CDS). These instruments are contracts

that insure against the default of sovereign debt. Therefore, when the CDS cost is low, it

indicates that the country risk is also low. Below is a graphic comparing Brazilian CDS


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pricing with other countries. Note that it had a positive evolution from 2008, before the

crisis, to 2011, thus decreasing its activity by approximately half.

*Source Bloomberg

Regarding foreign investments, the maintenance of healthy fiscal accounts generates

two main streams of impacts. The first one, which is more direct and easier to measure,

is the lowering of capital costs in the country. The second impact results in the

improvement of the expectations and confidence of the market when it comes to the

Brazilian economy.

For a long time the Brazilian economy has struggled, having short cycles of euphoria

and crisis, which inhibited long term investment planning. These events generated an

environment of prudence and caution as shown by the international market, decreasing


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the investors expectations and confidence, which was not necessarily beneficial for

solid economic development. No one can deny that there were many reasons for that to

happen if the countrys recent past is brought up. Brazil experimented with five

different currencies in a period of eight years, from 1986 to 1994, declared a

moratorium on US$67 billion of debt in 1987, as well as did its largest neighbors -

Mexico in 1982 and Argentina in 2001 - and faced crises such as the 1997 Asian

financial crisis and 1998 Russia devaluation and defaulting on its debt.

More recently, the efforts taken by the government seeking economic stability have

positively impacted the human emotion that drives investors, and consequently, the

market, increasing investor confidence. This sentiment has been labeled by John

Maynard Keynes as the "animal spirits", in his classic The General Theory of

Employment, Interest, and Money.

.

Conclusion

Regarding the current regulation for international investments, Brazil has met the

requirement of international parameters encompassing every form of investment

requiring registration for all aspects of the economy. Nevertheless, the weak

enforcement of a significant fine in case of violation of the demanded registration must

be remedied. Registration provides government control and also increases tax revenue.

Furthermore, we suggest a consolidation of all regulation issued by the BCB, CMN and

CVM. This would provide investors with easier access to the rules regarding their

investments, thus showing more transparency and speeding up the procedures.


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Overall, the recent, all the economic and fiscal measures taken by the government have

been fairly effective. Besides a possible dependence on foreign investors, particularlythose originating in Europe, authorities have established mechanisms seeking to

increase long-term capital, as these types of investments contribute to the governments

plan of growth and stability, while generating new long-lasting enterprises and jobs.

Still, despite this positive outlook, there are three main concerns that should be taken

into consideration by the authorities, as they have the capacity to affect the local

economy growth, and the foreign investments associated with them: (i) the uncertainty

regarding government measures, considering the countrys volatile currency rate; (ii)

the increasing dependence of the economy on China and the relevant imports of raw

material; (iii) the growing gap in the countrys balance of payments due to low savings

rates (a credit crunch with a large gap, could generate a domino effect on the existing

flows of capital).

It is clear that Brazil has yet to face many different challenges. Yet, with its historical

flexibility and various economic tools in hand, all of the aforementioned adversities can

be overcome. If the will and mentality that has been used for the past years is preserved,

maintaining rates and fiscal measures, it is likely that the countrys development will

exceed expectations in the years to come.


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Works Cited:

[1]

http://www.bcb.gov.br/Rex/Censo2010/port/Resultados_preliminares_Censo_2011.pdf

[2]

http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD

[3]

http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD

[4]

http://www.bcb.gov.br/htms/relinf/port/2011/12/ri201112c5p.pdf

[5]

Private Equity International Magazine, March 2012
http://www.bcb.gov.br/Rex/Censo2010/port/Resultados_preliminares_Censo_2011.pdfhttp://www.bcb.gov.br/Rex/Censo2010/port/Resultados_preliminares_Censo_2011.pdfhttp://data.worldbank.org/indicator/BX.KLT.DINV.CD.WDhttp://data.worldbank.org/indicator/BX.KLT.DINV.CD.WDhttp://data.worldbank.org/indicator/BX.KLT.DINV.CD.WDhttp://data.worldbank.org/indicator/BX.KLT.DINV.CD.WDhttp://www.bcb.gov.br/htms/relinf/port/2011/12/ri201112c5p.pdfhttp://www.bcb.gov.br/htms/relinf/port/2011/12/ri201112c5p.pdfhttp://www.bcb.gov.br/htms/relinf/port/2011/12/ri201112c5p.pdfhttp://data.worldbank.org/indicator/BX.KLT.DINV.CD.WDhttp://data.worldbank.org/indicator/BX.KLT.DINV.CD.WDhttp://www.bcb.gov.br/Rex/Censo2010/port/Resultados_preliminares_Censo_2011.pdf

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