September 13, 2019 / 2:57 PM / a month ago

The key to strengthening Brazil's fragile economic recovery? Brazilians

BRASILIA (Reuters) - Brazilian investors have kept faith in their financial markets this year while foreigners have steered clear, but if their confidence fades, so too might the nascent recovery in Latin America’s largest economy.

FILE PHOTO: People are seen in front of an electronic board showing the graph of the recent fluctuations of market indices on the floor of Brazil's B3 Stock Exchange in Sao Paulo, Brazil, July 25, 2019. REUTERS/Amanda Perobelli/File Photo

Brazil appears to be turning a corner after its $1.8 trillion economy went into reverse earlier this year, despite the mounting global strains caused by U.S. President Donald Trump’s intensifying trade war with China.

That is because the channels of contagion for Brazil’s economy - economist-speak for its weak spots - are not through trade, which accounts for a small share of economic activity.

Yet the contagion could soon be felt via local financial conditions and markets, as well as business and investor confidence - all of which could soon flash red if the U.S.-China trade war intensifies, world growth slows, and neighboring Argentina fails to emerge from yet another financial crisis.

“You have this battle going on now - negative global factors against positive local factors,” said Tony Volpon, chief economist for Brazil at UBS. “Brazil’s vulnerability will depend on local investors.”

Below the surface of weak headline growth, Brazil’s economic foundations are strengthening, analysts say, pointing to the government’s reform agenda overhauling costly pension and complex tax systems, and implementing an ambitious privatization program.

In addition, official interest rates are the lowest in history at 6.00% and set to be reduced further, possibly as low as 5.00% by year-end, according to consensus market estimates.

August was instructive for Brazil. The domestic macroeconomic picture seemed relatively benign - on balance, economic activity and survey data improved. Economy Ministry officials said the worst is over for Brazil’s economy, the eighth largest in the world.

Yet financial market stress intensified as emerging markets came under pressure.

Foreign investors accelerated the withdrawal of funds from Brazilian stocks, meaning the 22 billion reais ($5.3 billion) outflow in the first eight months of the year was the biggest since 1996.

Yet compared to other emerging markets, Brazilian stocks have held up well and are still near their highs in local currency terms. Selling from foreigners has been met with buying from locals, who averted a steeper slide in prices.

Foreigners also sold Brazil’s currency heavily in August, according to U.S. futures market positioning data and anecdotal evidence from traders who say overseas investors did so to limit the damage to their portfolios from the crash in Argentina.

The real BRBY fell 8% against the dollar in August - its biggest monthly fall in four years - to within sight of its record low of 4.25 per dollar and prompted the central bank to sell dollars outright for the first time in over a decade.

According to Deutsche Bank, the real was the second-worst performing emerging currency in August only behind Argentina’s peso. Brazilian local currency debt also posted the second-biggest losses on an unhedged basis, again only behind Argentina.

“While Brazil stands out as a closed economy ... the importance of the rest of the world to local growth dynamics is undeniable,” said Cassiana Fernandez, Brazil economist at JP Morgan in Sao Paulo.

“Channels of contagion go far beyond trade, and the indirect impact on local financial conditions and business confidence stand out in particular,” Fernandez said.

INSULAR BRAZIL

Brazil’s relative insularity to global trade partially shields it in times of slowing global growth, but also limits the positive impact on exports and growth from a weak exchange rate.

Brazil’s trade openness -¬†exports plus imports, as a percentage of GDP - is just 23%, according to the World Bank, lower than 76% in Mexico, 50% in Chile, 28% in Colombia and 25% in Argentina.

That security blanket is also frayed by the recent explosion in Brazil’s trade with China, economists say. China is now Brazil’s largest export market, taking 27% of all Brazil’s sales of goods and services overseas last year, much of that one-off purchases of Brazilian soy.

China’s growth is already its lowest in decades and heading below 6.0%, while its currency is its weakest against the dollar since 2007 and likely to depreciate further if Beijing loosens fiscal and monetary policy to counter the slowdown.

None of that is particularly encouraging for Brazil. Its two largest markets, China and the United States, are locked in an intensifying trade war and face growing economic headwinds, and its third largest, Argentina, is mired in economic crisis.

Some economists dismiss the spillover from Argentina, where the currency and bond markets have collapsed, the government has imposed capital controls and a sovereign debt default looms.

But last month was a wake-up.

“The risk of contagion from Argentina to other Latin American countries, except Brazil, via trade or banking links is limited,” wrote Bertrand Delgado, strategist at Societe Generale, in a research note this week.

“However, portfolio contagion could become an issue if conditions in Argentina take a turn for the worst,” he warned.

Reporting by Jamie McGeever; Editing by Marguerita Choy

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