Can Portfolio Flows Play a Dual Role in Brazil in 2013?

Brazil’s current account remained relatively stable in 2012, with a deficit of around 2.4% of GDP, slightly higher than the 2011 deficit of 2.1% of GDP. The CAD was fully funded by FDI, which summed US$68 billion (3% of GDP), while portfolio flows remained anemic at 0.4% of GDP. These dynamics prevailed throughout 2012, so far helping dismiss concerns regarding the external balances: The deficit is small and manageable; the trade balance remains in surplus; the bulk of imports are related to semi-manufactured and capital goods; and long-term financing flows (FDI) have been generous. Looking into 2013, however, the government may need to address the performance of portfolio flows, which saw a dramatic decrease in 2012 following punitive macroprudential regulations first implemented in late 2010. Although many of these measures were derogated or amended as market pressures changed, other factors—weaker macroeconomic fundamentals, lower interest rate differentials and most likely increased uncertainty regarding policy implementation (the risk of further punitive measures or government intervention as soon as things become uncomfortable for the government)—have deterred short-term capital flows from returning to Brazil.

Figure 1: Current Account Deficit Comfortably Financed by FDI, for Now

Source: BCB, RGE

Portfolio flows in 2012 totaled $8.2 billion and averaged barely US$690 million per month, well shy of the $5 billion average during 2010 and the 2011 average of $3 billion. However, Brazil may need increased portfolio flows in the next few years to help finance its current account deficit, as external accounts are affected by the deceleration of the Chinese economy—the chief consequence of which will be lower demand for metals, such as iron ore—and increased imports as investment accelerates ahead of the World Cup and Olympics.

Figure 2: Private-Sector Credit Deceleration Highly Correlated with Portfolio Flows (left axis: $, millions; right axis: y/y)

Source: BCB, RGE

Interestingly, there is a strong correlation between portfolio flows and private-sector credit growth in Brazil, which was particularly strong for the 2006-09 period, and somewhat weaker postcrisis. If we accept the premise that portfolio flows, to some extent, affect domestic credit, and embrace the idea that that credit is a key growth driver in Brazil (as we believe it is), it is unsurprising that 2012 saw dramatic drops in portfolio flows, private-sector lending and economic activity (bearing in mind, of course, the many other challenges faced by Brazil in 2012). Significantly, credit growth levels before the crisis were a cause for concern, arguing for a more stable equilibrium. The relationship between capital flows and the credit boom brought forward a set of vulnerabilities at the time, which seem to have been contained in the postcrisis years.

Still, credit growth is necessary for domestic expansion; hence, perhaps, a healthier Brazil requires higher portfolio flows to help drive credit growth aimed at infrastructure investment, as the current account widens due to higher imports of capital goods and lower export revenues. But such credit expansion needs to be better channeled toward productive investment rather than to continue feeding already over-leveraged household consumption. In fact, clear game rules, prudent macroeconomic management and proper incentives for private capital would generate the proper conditions for foreign capital to fund local investment projects directly through debt and equity channels. There is no doubt that the bulk of the financing for the current account deficit needs to come from FDI rather than portfolio flows. However, FDI has already broken records in Brazil and other Latin American countries and, as current account deficits widen, further financing may be required. In particular, a deceleration in China risks deterring FDI destined for sectors like commodities or other tradable goods, leading to greater concern about the future financing of current accounts. Could it be possible then that portfolio flows deliver a dual role of providing extra financing for the current account while feeding domestic credit? And, more importantly, can such credit be aimed at productive investment rather than short-term consumption?

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