SAO PAULO, Jan 23 (Reuters) - Pacific Investment Management Co, the world's largest bond fund, urged Brazil to rethink its current economic policies and restore credibility on public finances, the latest sign that foreign investors are growing worried over the outlook for Latin America's largest economy.
Policymakers in Brazil need to work on a plan to lure investment, revive confidence and spur growth with moderate inflation, Michael Gomez, co-head of emerging markets, said in a letter to investors published on the fund's website on Thursday. Pimco, as the Newport Beach, California-based bond giant is known, oversees about $1.97 trillion in assets.
The letter marks the most radical change of tone from Pimco since at least 2002, when Mohamed El-Erian, who back then managed $15 billion in emerging markets bonds for Pimco, said the election of former union leader Luiz Inácio Lula da Silva as president would not trigger a crisis in the country. On Tuesday, El-Erian resigned as Pimco's chief executive and co-chief investment officer.
Gomez said the investing climate in the country last year was characterized "by anything but order and progress," in reference to the motto emblazoned on Brazil's flag. Standard and Poor's decision to put Brazil's ratings on negative outlook for a downgrade raised alarm bells over the state of the government's finances, he added.
"Brazil needs to anchor economic policy around a stringent and credible primary surplus target rather than run the current mix of loose fiscal policy, subsidized public credit and ever tighter monetary policy," Gomez said in the letter. "Yet, things could improve from here, if policymakers rethink their remedies for Brazil's challenges."
His remarks come as higher borrowing costs and a presidential election, alongside the removal of monetary stimulus in the United States, are making investors skittish about Brazil. Some $12.3 billion left the country last year, the biggest outflow since 2002 - when global turmoil and a tense presidential ballot fanned fears of a debt default.
Pimco and banks including HSBC Securities and Citigroup Global Markets Inc are concerned that last year's market decline in Brazil could extend into 2014 if macroeconomic imbalances deepen, political noise on the way to elections increase and global market turmoil rattles investor confidence.
In 2013, the potential withdrawal of monetary stimulus in the United States and a deterioration in Brazil's fiscal position hurt markets. The October vote, in which President Dilma Rousseff is expected to run for re-election, is a worry to investors. Polls showed that she would beat any challenger if the elections were held now.
Over the past decade, and encouraged by El-Erian's successful bet on Brazil, investors poured hundreds of billions of dollars into the country. But many of them are now leaving.
Under Rousseff, some investors say, policy implementation was erratic, imbalances in the country's external sectors worsened, and state meddling in the private economy triggered steep investment losses.
"The policy mix that has eroded confidence, distorted the local interest rate market, undermined the currency and injected credit risk premium into sovereign assets is readily fixable," Gomez wrote.
Faced with a changing and tougher external backdrop led by a cooling Chinese economy, weak commodity prices and a potential rise in global borrowing costs, policymakers in Brazil failed to appropriately adjust their policies to restore confidence and lure sufficient investment, Gomez said.
Yields on local government notes surged an average 3.6 percentage points last year, while the benchmark Bovespa stock index, calculated in U.S. dollars, shed 30 percent in the past 12 months.
"Valuations are attractive, but unless an effective policy mix is restored, the outlook for order in Brazil's financial markets is less certain," Gomez noted.
Gomez said, however, that Brazil has a number of attributes - including a healthy demographic profile and abundant natural resources wealth - that support "the potential to generate strong economic growth and lower inflation."
Low foreign currency-denominated debt and large foreign reserves, as well as a floating exchange rate, should act as insurance for the country, Pimco said.