Views from the Floor

In this weekly publication, we talk about why Brazil is the EM country with the potential to trigger systemic stress.

Brazil: The EM Country With the Potential to Trigger Systemic Stress

According to our estimates, debt/GDP in Brazil is growing at an unsustainable pace that would require an adjustment of the social security regime and further additional fiscal consolidation to stabilise it. We believe it would be difficult for a President, even with a strong determination, to get these reforms in place. Given the evolution of the polling, it is becoming increasingly unlikely, in our view, that whoever gets elected as president in October will be able to push through the reforms needed, unless substantial additional market pressure is imposed.

If the reforms outlined above do not take place, we believe that Brazil will be forced to consider some form of restructuring of its local debt, which is large and responsible for the majority of annual interest bill that amounts to approximately one third of all of tax collection.1

Given the size of Brazil’s economy and the exposure held by both dedicated emerging-market and cross-over investors, we think the Latin American country has the potential to generate systemic ripples much more than Turkey.

The potential silver lining is that Brazil does have significant room to adjust if the political system is willing, or forced, to implement the adjustment. At this point, we believe it could become an attractive investment opportunity.

Exhibit 1. Brazil’s Gross Debt-to-GDP Ratio

Source:; Banco Central do Brasil, as of 31.12.2017

Exhibit 2. Brazil’s Interest Bill as a % of Tax Revenue Collected

Source: The World Bank, as of 31.12.2016

Turkey Contagion: Spain Most at Risk

As the Turkey crisis persists and investors worry about the contagion in the rest of the emerging markets (EM), we believe the European banking system generally, and Spain especially, could be at risk.

Let’s look at the numbers: Spanish banks were owed USD 82.3 billion by Turkish borrowers as of the first quarter of 2018, the FT reported, quoting data by the Bank of International Settlements.2 This compared with USD 38.4 billion owed to French banks and $17 billion owed to Italian lenders.

Indeed, Spain’s exposure to foreign claims from the most vulnerable EM economies is an eye opening 170% of total country bank equity, according to a report by BCA research. (BCA counts Argentina, Turkey, Brazil, Colombia, Mexico, Chile, South Africa and Indonesia as the most vulnerable EM economies.) Overall, about 30% of the euro area’s banking capital and reserves were exposed to these EM countries.

Exhibit 3. Amount owed to Eurozone banks by Turkish borrowers ($bn)

Source: FT, BIS, as of 31.12.2017

Exhibit 4. Spain’s Outsized Exposure to Weak EM Countries

Foreign claims in most vulnerable* countries (as a percent of total country bank equity). Source: BCA Research, BIS data; as of 20.08.2018. Notes – 1:* Includes Argentina, Turkey, Brazil, Colombia, Mexico, Chile, South Africa and Indonesia, as per overall vulnerability index. 2:** Sum of Germany, France, Italy and Spain.

Keep an Eye on Italy…

We believe that Italy is headed on a collision course with the EU as the two meet to discuss Italy’s budget in September.

The bickering has already started: Italian Deputy Premier Matteo Salvini and his populist ally Luigi Di Maio of the Five Star Movement have said that they want the EU to bend its rules on deficit targets to allow them to boost spending and cut taxes.

In addition, government officials have used the collapse of the Genoa bridge to question whether Italy should respect EU budget ceiling of 3%. (Never mind that Italy will receive 2.5 billion euros in EU funds for roads and rail over the 2014-20 EU budget period.3) The current 2019 deficit goal, inherited from the previous center-left government, is 0.8% of GDP, down from a targeted 1.6% this year.4

With contribution from: Pierre-Henri Flamand (Man GLG, CIO) and Guillermo Osses (Man GLG, Head of Emerging Market Debt Strategies).