by Claudio Prado and Murilo Aragão
Some strange rumors involving Fernando Collor de Mello’s brother Pedro circulated the week of May 18. These rumors said that the President’s brother had recorded an extensive interview for Veja (a major Brazilian magazine) disclosing a scandalous financial link between the president and his former campaign treasurer, Paulo César Ferias (aka PC), then a wealthy entrepreneur and consultant.
Leakage of some details of the interview caused the São Paulo stock exchange index, Bovespa, to drop 6% and 2% on May 21 and 22, respectively. Despite the anxiety, most market participants thought this would be just another small political crisis not uncommon in Brazil.
Veja’s edition finally hit the stands on Sunday, May 24 with the shocking interview of Pedro Collor, who accused PC of being the president’s front man in an influence peddling network, and of paying most of the president’s personal expenses. The following Monday and Tuesday, a startled stock market shed 9%. A moderate recovery ensued as some players still believed in a dilution of the crisis and as the pending Earth Summit in Rio de Janeiro temporarily diverted the media’s attention. However, after June 1, a huge plunge occurred and resulted in a loss of 34% in only two weeks. The preference shares of Telebrás, the state-owned telephone utility, plummeted to $13.6/1000 on June 16—down from a peak of $38/1000 in April.
This period was exactly when a congressional committee started its investigations into PC and into his alleged links with the president. This 22-member commission was formed by congressmen from the government and opposition parties, notably Partido da Frente Liberal (PFL), Partido do Movimento Democrático Brasileiro (PMDB) and Partido dos Trabalhadores (PT). The appointment of Benito Gama from the PFL as president of the commission was seen as favorable to Collor since the party had been the government’s main support in the months leading up to the crisis.
Gama’s original strategy was to maintain a majority in the commission so that he could control the course of the investigation. However, the government lost not only its numerical control of the committee, but also the loyalty of some politicians who started to become more devoted to the investigations.
At this point, the possibility of Collor being impeached stopped looking farfetched, although most political analysts thought it was unlikely due to: uncertainties in the impeachment process itself, which would complicate its continuation; the “play tough” stance adopted by the president (which did not surprise anyone who knows him), who refused—and still does—to resign; and the perception that his vice president, Itamar Franco, was against the modernization process initiated by Collor and was not capable of assuming the government of Brazil.
The press continued to play a fundamental role in the process. On Sunday, June 28, Isto É, another weekly publication, came out with the news that signified a coup de grace in Collor’s fight to stay in power. It featured an interview, this time with one of his drivers, showing in great detail the president’s relationship with PC.
That following Monday, the Bovespa dropped an amazing 17%. A consensus was emerging that the impeachment process was irreversible. A spectacular, short-lived rebound occurred a few days later.
In the middle of the whole crisis, the Bovespa rose 38% between July 3rd and July 14. That resulted from the increasingly widespread perception that the most important person in the government was Economy Minister Marcilio Moreira, who always opposed any shock reforms and maintained a tight fiscal and monetary policy. The idea was that even if Collor was forced out, Marcilio would stay.
The São Paulo business community emphasized their support for Marcilio through a dinner offered in his honor on July 8, further tranquilizing financial market and helping the rebound However, probably as a result of intense profit-taking and the continuation of the congressional investigations, the rally ended and the market plummeted again.
An important event happened on August 19. The Bovespa went up 6.5% on the rumor that Collor would resign (H). This meant that by that time, the market had concluded that the ousting of Collor would be positive for the country. This rationale would persist in the following weeks and influence market movements.
The short rally on August 24 was triggered by the formation of a pact between the most important ministers, whereby they pledged not to resign before a conclusion to the crisis was reached.
The slump on August 31 was a Monday market reaction to Color’s Sunday speech in which he dismissed any possibility of resignation and openly attacked the Congress. This once again demonstrated how investors were hoping for a quick end to the crisis through the president’s resignation.
Finally, the rally on September 24 was caused by the Supreme Court decision that the Lower House vote on impeachment would be done through an open call, thereby making congressmen publicly responsible for their position.
The historic voting occurred on September 29. Collor was ousted for a 180-day period and is still awaiting the Senate’s final decision on his impeachment. Since, Franco has delivered several nationalistic speeches.
The Lagging DFA
As can be seen in Figure 2, the DFA market, which until then had shown a surprising resilience to the crisis, started to crash on June 17 when prices plunged from the 39 level to 35. Enormous intra-day volatility marked trading on June 18th, with deals done at 36 and 30. Over the next few days, DFA prices recovered to 35 as a result of the impending Brazilian Brady Deal, which was agreed on July 7. This rally peaked at roughly 37 on July 14, followed by a dramatic slump. The DFA hit 26.5 on August 18, and an ensuing recovery placed DFA levels in the low 30s.
Figure 3 depicts the 20-day historical correlation between the Bovespa and DFA. Not surprisingly, until July 24, this correlation was positive but low—around 0.2. A few days later, it jumped to 0.4 and eventually reached 0.8 in September, when the Bovespa and DFA moved almost side by side. But why did the correlation between these two markets behave in such a way?
The answer may be that under normal circumstances, Bovespa and DFA correlation is positive, but not necessarily high. During the first two months of the Collor scandal, the DFA was “debt driven”. In other words, traders, lenders and other players were focusing more on the pending Brady Deal and its technical aspects and not as much on the political scene. The firm reassurance by Marcilio Moreira that all previous economic policies would be maintained and the strong rally in Argentina’s GRA following its own Brady agreement were perhaps also responsible for the delayed reaction.
After a certain point, probably around July 24, the DFA market started trading on the daily political developments in Brazil, which were sharply mirrored by the Bovespa and correlation between both reached 0.82.
Franco’s First Weeks
Collor was ousted for 180 days according to the Lower House vote in favor of his impeachment on September 29th. The process itself will have to be formalized through a proceeding in the Senate, but it is extremely unlikely that he will be returned to power. Confirmation could come in January.
Vice president Itamar Franco became the acting president. All ministers resigned and were substituted with people appointed directly by Itamar Franco and his closest friends. The new cabinet is very heterogeneous, and some of its members were perceived to have nationalistic views on economic policies. That, coupled with some declarations by Franco against the stock market, triggered another huge slump in the Bovespa, ending its pre-impeachment rally. Indeed, this 30% slump threw the index to its lowest level in 1992.
On the privatization issue for example, the new Government said it would maintain the current list intact, but also stated that “strategic” companies such as the oil group Petrobrás, Telebrás and the mining giant Companhia Vale do Rio Doce, would not be sold. What is interesting to observe is that even if Collor were in power, the privatization of these companies would still have to be ratified in Congress through an amendment to the constitution.
The latest significant movement in the Bovespa at the time of this writing was a rebound caused mainly by the issuance of a Sponsored Level 1 ADR on Telebrás preferred shares. This will transfer to New York some of the trading that until now occurred in São Paulo and Rio.
What’s next? The Bovespa will certainly continue to be volatile, with volatility now around 70%, but could recover more since most companies’ shares cost less than 30% of book value and other cheap ratios could lure investors. The correlation between DFA and Bovespa has already decreased to 0.3 and will go up again only on the evolution of another major crisis.
DFA will go through a long winter between the signing of the term sheet and implementation of the Brady deal. Despite positive aspects of the Brazilian economy, such as the large industrial sector, surging exports, large amounts in reserves ($23 billion), the small size of foreign and domestic debt when compared to a GDP of $450 billion, the IMF agreement is necessary for the Brady deal and its maintenance is questionable.
But again, since we are talking about Brazil, many things could happen which are completely contrary to the predictions made here. Key requirements, such as fiscal reform and the continuation of the privatization process, could be carried through faster than we anticipate and the trued restructuring that Brazil so desperately needs may finally become a reality. LF
Claudio Prado is a vice president at MG Emerging Markets and Murillo Aragão is a political consultant in Brasília