Economic Research Low isn t necessarily bad

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1 a Brazil Outlook January 2009 Ana Esteves ana.esteves@itaueuropa.pt Registered with CMVM María Insausti maria.insausti@itaueuropa.pt Registered with CMVM Bruno Baptista bruno.baptista@itaueuropa.pt Pending Registration with CMVM Economic Research Low isn t necessarily bad 2009 will certainly be a more challenging year than 2008 as credit restrictions, risk aversion and low economic growth worldwide continue to feed through to the Brazilian economy. While domestic demand has been resilient up until the third quarter of 2008, lower confidence, lower access to credit and lower exports should progressively slow down domestic demand, particularly investment, and contribute to further decelerate economic growth. With low commodity prices and weak demand from US, exports should fall more than imports, and the trade balance should continue to shrink as terms of trade worsen and Brazil outgrows key trading partners. The trade balance is one important component of the current account; but is not the only one. The equity deepening has made dividend payments its second most important conditioner and in 2009 dividend outflows could fall largely because of a weaker currency and a lower payout ratio. The current account should present a deficit in International investment in Brazil will likely slow down from the levels registered in most recent years. Firms are less prone to invest on weak demand prospects and financial investors have fewer funds available and a higher opportunity cost, after developed market equities and credit spreads having fallen/widened substantially, particularly when bearing in mind risk differences between countries. In this environment, the Brazilian currency should remain under pressure. On one hand, foreign direct investment, contrary to 2008, won t be enough to cover the current account deficit, and on the other hand, with economic activity weakening and consequently inflation pressures easing, the central bank, should follow most of the monetary authorities worldwide and cut rates during We expect the selic to end the year at 10.75% and the BRL/USD at Reserve accumulation due to previous current account surpluses, foreign direct investment inflows, financial inflows and a prudent debt management by the Treasury have contributed to improve Brazil s resilience to external shocks. Brazil currently holds a net external cash position; therefore, the depreciation of the BRL now reduces the net debt/gdp ratio, improving the solvency of the country. Challenges are high for everyone, but Brazil could remain among the countries suffering less from this whole mess. Trade represents a small part of GDP, exports are diversified at least geographically, the country has low dependence on external financing, reserve accumulation in the last years has provided an important buffer to external shocks, which the government has been using to fight the crisis, credit penetration in the economy is still low, the financial system as a whole seems sound with low dependence on open market funding and foreign direct investment represents a small share of GDP (around 2% of GDP against 4-5% of LatAm peers). Index: What Will be 2009? 2 Risks and Opportunities in Review 8 Conclusion 12 Of course, important risks exist. The build-up of a current account deficit not compensated by foreign direct investment could contribute to increase currency volatility given financial flows are normally a more uncertain source of funds, even if being a positive influence. A more volatile currency could raise concerns about inflation pressures ahead, limiting room for monetary policy actions, while contributing to deteriorate agents confidence and delay consumption and investment decisions. In fact, low investment could be a key weakness for the country, due to its linkage to commodities as low commodity prices, delay or deter investments both from international and local investors. In this environment a stable currency and higher commodity prices are crucial for Brazil. Please see the last page of this report for important disclosures.

2 Brazil Economic Outlook 1. What Will be 2009? Globalization is a strong barrier for decoupling, specially in the longer-term Commodity prices were key to change opinions about Brazil and it took a year for such a change to happen Emerging markets in general and Brazil in particular, weren t immune to sustained credit restrictions in the developed world. Nevertheless, the fact that concerns with many developing economies health only arose deep in 2008, well after the credit crisis started in the summer of 2007, is a sign that these economies are healthier than in the past, being more protected from external shocks. The decoupling story held-up well for a year but globalization would end up showing its influence anyway in case developed markets turmoil proved less temporary than initially though. That s precisely what happened. Brazilian financial markets performance proved to be mostly a commodity story, contrary to other emerging market peers such as China. Graph 1 shows that equity markets in China started to recede as soon as credit restrictions and financial market volatility started in the summer of 2007 and perception about high risk in the international financial system aggravated, here measured by the Ted spread. In Brazil, the Bovespa and the currency only started to give in when more adverse economic conditions pulled back commodity prices in June Selected Indices since 2006 (Graph 1) Selected Indices since Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-09 Bovespa (left) Oil (left) BRL (left) Ted spread (right) CSI 300 (right) Equities, currency and commodity in base 100 since Jan 2006, Ted spread in bps. External vulnerability decreased but international events are affecting confidence This reflects several issues. On one hand, it was needed important changes on worldwide economic fundamentals, for Brazilian financial markets to start to be affected by a more adverse international environment. Such a time lag supports the idea that Brazil external vulnerability remains low when compared with other emerging market peers and that investors have perceived it. However, because in economics everything has to do with everything, Brazil sound fundamentals have been progressively affected by perception about the long length and depth of liquidity and solvability problems leading to recession in the developed world and very low growth in the developing. Such a scenario wasn t consensus a year ago, but now following IMF s expectations, in 2009 the world could grow a meagre 0.5%, with the US contracting 1.6%, the Euro zone contracting 2%, Brazil growing 1.8%, Russia contracting 0.7%, India growing 5.1% and China growing 6.7% (BRIC). Lower confidence, credit and exports should progressively slow down domestic demand 2009 will certainly be a more challenging year as credit restrictions, risk aversion and low economic growth worldwide continue to feed through to the domestic economy. While domestic demand has been resilient up until the 3Q08, lower confidence, lower access to credit and lower exports should progressively slow down domestic demand, particularly investment, and contribute to lower economic growth (Picture 1)

3 The international crisis was transmitted to Brazil via the credit channel, as USD credit lines vanished and spreads for both corporate and individual clients climbed consistently. Current spreads should eventually recede, but confidence will gradually be undermined and a slowdown is inevitable, with a resulting (favourable) impact on inflation. International Crisis Contagion Lines (Picture 1) International credit restrictions Lower confidence Lower exports Financial market volatility Local credit restrictions Lower consumption Source: Banco Itaú Europa. Lower investment: int./ external FX volatility Inflation Lower imports The trade balance should shrink but a deficit will likely be avoided We expect a sharper slowdown in the external component of GDP growth than in pure domestic demand. Areas more dependent on credit are likely to suffer more leading to a sharper deceleration of investment than consumption. While we expect GDP growth to stand at 1.5% in 2009, domestic demand (ex- exports and imports) should grow 2%. Accordingly, with low commodity prices and weak demand from the US, exports should fall more than imports, and the trade balance will likely continue to shrink. Although Brazil has a diversified export profile, the problem is that weak to no growth is expected almost everywhere in emerging economies, while a recession in the developed world is the most likely scenario, as a consequence of the maintenance of credit restrictions for over 1.5 years now. In addition, Brazilian exports enjoy a relevant degree of diversification by geographic region (Graph 2), but commodity-linked products stand for around half of the total and their prices are more volatile that those of final goods, therefore having fallen more sharply that the prices of the products imported. This situation could be aggravated if the currency remains weak or even depreciates further. Brazilian Exports Profile (Graph 2) Brazilian Exports by Destination Brazilian Exports by Product Other operations 3% Basic 37% Middle East 5% US 15% Africa 4% Asia 20% Australia 1% Manufact. 46% Semi manufact. 14% LatAm 26% Europe 29% Source: Banco Itaú Europa, Brazil Central Bank

4 Brazilian imports hugely depend on domestic growth. Our calculations show that, within twelve months past a shock, imports are three times more sensitive to domestic demand than to the real foreign exchange rate (Graph 3). Moreover, the BRL has been depreciating and a weak currency turns import prices more expensive, increasing the value of imports despite creating incentives for agents to substitute imported goods for local products. Domestic Demand and Import Volumes (Graph 3) Source: Itaú Coretora de Valores SA. Domestic GDP excluding trade balance. Negative current account pressuring the currency Foreign investment should slowdown maintaining the BRL under pressure As the terms of trade (i.e., ratio of export to import prices) worsen and Brazil outgrows key trading partners, the trade surplus should come down: we project a 10.3 bn USD trade surplus in 2009 (2008: bn USD). For subsequent years, the BRL adjustment, the commodity recovery and the global pickup should pave the way for a sharp trade balance rebound. That will materially reduce the current account gap in subsequent years. What is more, although the trade balance is one important component of the current account, it is not the only one. We project current account deficit at -31 bn USD (-2.4% GDP) in The equity deepening has made dividend payments the second most important conditioner of the current account. For 2009, we project net dividend outflows down to 21bn USD (2008: 34bn USD), largely because of a weaker currency and a lower payout ratio. As a percentage of GDP, however, the decline in dividend remittances will be compensated by a declining USD-value of Brazil GDP and relatively strong corporate profits in Still, a trade balance turnaround and easier external credit conditions suggest Brazil will have little trouble financing a small current account deficit between 1 and 2% of GDP after the storm is gone. Needless to say that international investment in Brazil will likely slow down from the levels registered in most recent years. Firms are less prone to invest on weak demand prospects. Financial investors have fewer funds available and a higher opportunity cost, after developed market equities and credit spreads having fallen/widened substantially, particularly when bearing in mind risk differences between countries. We forecast net financial inflows totalling 60bn USD in Interestingly, the tally is half as large as the 124bn USD net inflow registered in the golden year of We break 2009 inflows down in: 25bn USD in foreign direct investment, 19bn USD in stocks & long-term debt, and 16bn USD in commercial & other loans. Note that the decline in foreign direct investment during 2009, estimated at around 42% YoY, is sharper compared to other financial inflows because of the lagged response to a changing economic environment. The other categories will have adjusted mostly in In this environment, the currency should remain under pressure. On one hand, foreign direct investment, contrary to 2008, won t be enough to cover the current account deficit, and on the other hand, with economic activity weakening and consequently inflation pressures easing, the central bank, should follow most of the monetary authorities worldwide and cut rates during We expect the selic to end the year at 10.75% and the BRL/USD at

5 Inflation should recede on lower economic activity, but a weak currency is a risk to price stability A weaker currency bears the adverse effect of fuelling imported inflation, which limits the scope to use monetary policy more aggressively, despite lower commodity prices acting to some extent, as a hedge of currency risk. In addition, lower flexibility of the Brazilian economy than that of more developed peers, could also be a restriction to a more pronounced decrease in inflation as government controlled prices, indexed to previous year inflation, continue to rise at a high pace, reflecting the last year of bonanza (Graph 4). Inflation and Monetary Policy (Graph 4) 12% 10% 8% 6% 4% 2% 0% E 2010E 14.0% 13.5% 13.0% 12.5% 12.0% 11.5% 11.0% 10.5% IPCA (left) Non-food market prices (left) Selic - central bank rate (right) Food prices (left) Gov-controlled prices (left) Source: Itaú Coretora de Valores SA. Fiscal stimulus is important External reserves accumulation should be a buffer for the crisis The possibility of lacking scope for monetary policy to act if a weak currency turns out to be a dominant pressure on inflation, or of a more pronounced economic deceleration, should open the way to some sort of fiscal stimulus, expected to be announced anytime soon. Lower growth, lower tax revenues and the fact that the government intends to preserve public investment from budget cuts, could put pressure on the fiscal balance, although preserving comfortable primary surpluses at around 2.5% in 2009 and 3.3% in 2010 and beyond. Reserve accumulations due to previous current account surpluses, foreign direct investment inflows, financial inflows and a prudent debt management have contributed to improve Brazil s resilience to external shocks. Although gross debt levels have been rising, reserve accumulation fuelled a reduction in overall net debt. Prudent debt management has been focusing on increasing the maturity profile while improving debt composition reducing exposure to floating rate and foreign currency linked by fixed rate and inflation linked bonds. Brazil currently holds a net external cash position, both at public and private sector levels. Accordingly, the depreciation of the BRL now reduces the net debt/gdp ratio, improving the solvency of the Treasury. With external vulnerabilities largely reduced and foreign exchange volatility lower than in the past, Brazil is not isolated from international events but it is certainly more protected

6 Economic Estimates (Table 1) Brazil Annual Macroeconomic Forecasts 2008F 2009F 2010F 2011F 2012F Real GDP growth 5.4% 1.5% 4.9% 4.3% 4.4% Domestic demand 8.1% 2.0% 3.5% 3.7% 6.8% Unemployment 7.90% 9.2% 9.8% 9.9% 9.3% Investment/GDP 19.5% 19.6% 19.3% 20.2% 21.2% IPCA 5.90% 4.80% 4.90% 4.20% 3.80% Selic rate, end of the period 13.75% 10.75% 10.75% 9.25% 8.00% Primary fiscal surplus - % GDP 4.1% 2.5% 3.3% 3.3% 3.3% Public sector net debt - % GDP 36.0% 34.2% 29.9% 25.7% 24.0% BRL/USD, end of the period Current account balance - bn USD Foreign reserves - bn USD Trade balance - bn USD Foreign direct investment - bn USD Source: Itau Corretora de Valores SA. Lower than expected global growth could leverage the negative consequences of our scenario Risk aversion could further delay investments, deplete international reserves, maintain a weaker currency for longer and continue to erode agents confidence affecting domestic demand 2. Risks and Opportunities Risk 1. Larger than expected global growth deceleration or eventually recession The main risk we see ahead is if global growth is much lower than the 0.5% the IMF expects for In such an environment, domestic demand and exports would suffer even more, narrowing the trade balance substantially. Foreign investment would drop further and as a result of these forces, the BRL/USD would weaken markedly in 2009, probably breaching the 3.00 barrier against the USD. GDP growth would most likely be negative. The outlook for inflation wouldn t change much. On one hand rigidities pointed out previously reduce its volatility and on the other hand, most of the inflation impact of the currency shock is offset by cheaper commodities and domestic growth slowdown. Inflation risk remains low even in this very negative scenario. However, in a stress situation, the central bank would probably still care about inflation and because of higher inflation even if only slightly, there could be less room for rate cuts in Risk 2. High risk aversion and financial market volatility Another potential risk Brazil could face in 2009 is if the IMF worldwide growth scenario in fact materializes or fails by being too conservative, but risk aversion remains high preventing direct and financial investments in emerging markets, particularly Brazil. The most important consequence would be a delay in foreign direct investment and portfolio investment, maintaining the currency under pressure for longer. If the central bank pursues an active policy of stabilizing the currency, that would affect international reserves and consequently perception about the country risk internationally. Brazilian credit spreads are still low, bearing in mind rating differences and high correlation between the local equity market and commodity prices (Graph 1). We expect commodity prices to fall at least in the first half of 2009 and that could pose more challenges to the economy than many parties might anticipate. Markets seem to be pricing geographies rather than fundamentals as credit spreads are more similar among the same geographic area than among the same rating. Exposure and dependence on the US economy is also taken as an important factor affecting risk perception of investors (Graph 5)

7 Credit Spreads by Rating 5 Years (Graph 5) /01/ /03/ /05/ /07/ /09/ /11/ /01/ /03/ /05/ /07/ /09/ /11/ /01/ /03/ /05/ /07/ /09/ /11/ /01/2009 (bps) Brazil (BBB-) Peru (BBB-) Mexico (BBB+) China (A+) EUR BBB EUR AA US IG In the last couple of years foreign exchange flows were mostly explained by more permanent trade flows instead of financial investment flows, but in 2008 high risk aversion caused financial outflows, which added to a substantial rise in imports and consequently lower trade inflows, contributed to depreciate the BRL currency. (Graph 6). Foreign Exchange Flows (Graph 6) 100 (bn USD) Trade Financial Source: Brazil Central Bank, Banco Itaú Europa. Volatile financial markets, and particularly a volatile currency, affect agents confidence and consequently their proneness to consume and invest. By itself uncertainty contributes to delay their decisions and therefore the recovery of economic growth to trend. Opportunity 1: Fiscal spending The fiscal stimulus should be an opportunity Similarly to most countries in the world, in Brazil a fiscal stimulus to the economy is also under discussion, although nothing definitive has been decided yet. In December 2008, the government announced an 8.4 bn BRL of fiscal reductions on income tax, financial transactions tax and industrial products tax, or 0.2% of GDP. Although meagre, if more measures on the fiscal front are implemented, there could be some good news to the Brazilian economy. Although fiscal stimulus could be perceived as lax management of public accounts, if economic activity recedes more than we expect in Brazil, failure to take measures would probably be badly seen by most of the economic agents, especially in a context where worldwide policies are being loosened up

8 in Review Consumption: Strong consumption growth probably decelerated in the fourth quarter Consumption rose consistently above 6% until the end of the third quarter of Although data regarding the fourth quarter of the year is still scarce, retail sales fell 0.7% MoM and rose 5.1% YoY in November, well below previous readings, as credit restrictions intensified. Items more linked to credit conditions presented a deceleration that month, with vehicle sales falling 20.3% YoY and construction materials falling 6.2% YoY. Industrial production data also shows a YoY fall of durable consumer goods production of 20.4%. Consumption stands for around 60% of GDP. (% ) Jan-07 Retail Sales and Consumption Growth Apr-07 Jul-07 Oct-07 Retail sales Investment: Strong investment growth probably decelerated in the fourth quarter Investment in Brazil rose at double digit pace until the end of September, reflecting a friendly economic environment and lower interest rates both nominal and real. Similarly to consumption, industrial production and business confidence indices suggest the trend cooled off in the fourth quarter. Weakness in industrial production was felt all across the board, with durable goods falling 4% MoM in November. Investment represents nearly 20% of GDP Consumption Industrial Production and Investment Growth Feb-08 Investment May-08 Jun-08 Aug-08 Industrial production Government spending and budget balance: High and rising with comfortable surplus Government spending presented stable growth at around 5% until the third quarter, while real revenues helped to maintain the primary surplus on an upward trend the whole year. A more challenging growth environment in 2009 will likely decrease government revenues but an active fiscal policy, to compensate adverse macroeconomic conditions, should maintain the contribution of the public sector to GDP growth high, although leading to a lower primary surplus, especially when factoring in investments. On top of a rising primary surplus, lower interest payments also contributed to decrease the nominal deficit in Government spending represents around 18% of GDP Mar-07 Trade balance: Domestic demand reduced the trade surplus The trade balance contribution to GDP growth has been decreasing as real imports growth outpaced exports. Weaker external demand and stronger domestic demand explained the outcome leading the annual trade balance surplus down from 40 bn USD in 2007 to 25 bn USD in Real exports represent 14% of GDP and real imports subtract 12%. Jun-07 Sep-07 Gov spending growth Nom. deficit % GDP Public Sector Data Dec Mar-07 Jun-07 External Sector Sep-07 Exports' growth (left) 12M trade balance (right) Dec-07 Jun-08 Nov-08 Primary surplus % GDP Jun-08 Imports' growth (left) (bn USD) - 8 -

9 Trade balance: Dominant price effect In 2008, the drivers of export and import growth in nominal terms have been different from the past. While until the end of 2007 exports rose on the back of positive price and volume effects, in 2008 only the price effect was positive. For imports both price and volume effects remained positive until 2008, however while quantities growth largely outpaced prices, in 2008 the later caught up What's Driving Trade? Price Volume Price Volume Price Volume Imports Exports Source: Bloomberg, Funcex, Itaú Corretora de Valores SA. Current account, foreign direct investment and reserves: Weaker and falling In 2008, and for the first time since 2002 the current account balance became negative due to a lower trade surplus and higher services payments reflecting more profits and remittances abroad. However, foreign direct investment remained high, serving as an important factor to support the value of the currency most of the year and proceed with international reserve accumulation, even as financial investments registered outflows. Foreign direct investment stands for around 2% of GDP, low when compared with other Latin American peers. It is diversified by country of origin with the US standing for 18% of the total. 40% of it targeted commodity related sectors and the other 40% were invested in financial services and real estate. (bn USD) External Sector Current account Foreign direct investment International reserves Inflation and monetary policy: Central Bank committed to fight inflation Domestic demand and rising commodity prices exerted inflation pressures during the first half of the year. In the second half, worldwide credit restrictions and financial market instability appeared more strongly in economic activity in emerging markets, contributing to ease and in some cases to fade inflation and inherent concerns. On a YoY basis, consumer price indices in Brazil stood above the central bank s mid point of the inflation target range 4.5%, leading the monetary authority to raise benchmark rates until July and remaining on hold the rest of the year Feb-08 Inflation May-08 IPCA tradable MoM (left) IPCA MoM (left) Jun-08 Aug-08 Nov-08 Dec IPCA non-tradable MoM (left) IPCA YoY (right) Selic: Jan Mar Apr Jun Jul Sep Oct Dec % Source: Brazil Central Bank, Bloomberg, Banco Itaú Europa

10 Budget balance and public debt: Improved profile The Brazilian public sector profile improved in On top of a rising primary surplus, lower interest payments also contributed to decrease the nominal deficit. Total domestic and external debt increased in 2008, but reserve accumulation reinforced the net external public cash position. The maturity profile of public debt continued to rise, reaching 3.3 years for public offered securities. The debt composition also improved with a rising share of inflation linked and fixed rate bonds while reducing USD linked bonds and floating rates. The primary surplus target remained 3.8% Private sector debt: Low private debt and external vulnerability The Brazilian economy has low leverage. Latest data available show that the saving rate of the economy as a whole reached 18% (savings as a % available income) and 7.6% at family level. Dependence on external financing is also low, because in 2008 the Brazilian economy became a net external creditor. Public Debt % GDP Net debt Net external debt Net domestic debt Source: Brazil Central Bank, Bloomberg, Banco Itaú Europa. (bn USD) Q07 Brazil Total External Debt 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 Agents confidence: Receded the whole year Confidence in Brazil has been receding since the beginning of Despite positive domestic momentum during the first half, a volatile and unstable environment in financial markets worldwide, feed through to consumers and especially more sensitive and aware business managers. Total Net Source: Brazil Central Bank, Bloomberg, Banco Itaú Europa. (Points) Jan-07 Apr-07 Jul-07 Confidence Indices Oct Consumer (left) Business (right) Source: FGV, Bloomberg, Banco Itaú Europa. Unemployment: Downward trend Unemployment in Brazil maintained a downward trend in 2008, even in the second half of the year, when the economic environment became more challenging. The fact that real income and therefore living standards have improved, are two important factors underlying consumption dynamics. However such trends could be changing as Caged registry of formal jobs showed a sharp rise in joblessness in December, twice the usual for such a month Jan-07 Apr-07 Jul-07 Unemployment Oct

11 Lending: Decelerated on the back of higher domestic rates and aggravated credit restrictions In 2008 lending continued to grow at double digit pace, although maintaining a decelerating trend at first explained by a tighter monetary policy by the Central Bank as inflation concerns where high in the 1H08 and secondly by tighter credit conditions in the third/fourth quarter of the year both in international and domestic markets. Mortgage loans decelerated too, although maintaining a strong growth pace. Mortgage loans represent slightly less that 2% of total loans. New loans fell in the fourth quarter of the year, by more than 7% in November, after falling 6.2% in October YoY. Financial system s health: Sound The Brazilian financial system as a whole remained liquid and capitalized in Although in the fourth quarter was felt an increase in the pace of deposit redemptions, the largest banks maintained low dependence on open market based funding and a large deposit base when compared to lending. Credit quality was on an improving trend until November 2008, despite adverse financial conditions. The minimum BIS ratio admissible in Brazil is 11% although among the 10 largest banks by assets, they all stand well above the requirement. Real estate market: Sound Construction activity remained strong in 2008 despite more adverse access to credit. In the region of São Paulo houses offered and housing starts continued to rise at double digit pace. In the second half of the year, more adverse conditions drove prices down on a YoY basis Lending Growth Feb-08 May-08 Jun-08 Aug-08 Nov-08 Dec Mortgage (right) Lending (left) Selic (left) Ratio Lending/deposits 81.9% Deposits/liabilities 48.0% Open market/(liabilities+equity) 20.3% ST deposits/deposits 12.7% USD based funding total credit 20-30% Source: BCB, Banco Itaú Europa Feb-08 Housing Growth May-08 Jun-08 Aug Prices (left) Houses offered (right) Financial markets: Equities, credit risk and the currency expressed risk aversion Risk aversion was well present in the second half of the year as Brazilian equities and the currency against the USD plunged while credit spreads widened to a four year high. Bovespa has evidenced high and positive correlation with commodity prices, which is justified on fundamental grounds, as products exported are mostly commodity linked and Petrobras and CVRD stand for 36% of the Bovespa index, followed by CSN and Usiminas with 4.1% and 3.9% each. (points) Feb-08 Feb-08 Markets May-08 May-08 Jun-08 Aug-08 Aug-08 Nov-08 Dec-08 Dec-08 Jan-09 Jan Bovespa (left) BRL/USD (left) 5yrCDS (right) (bps)

12 Local rates: Pricing in monetary policy The local interest rate benchmark curve reflected both monetary policy and risk aversion dynamics. In the first half of the year expectations about a tight monetary policy and risk aversion pushed the local curve up. However, in the second half, as credit conditions tightened and the economy deteriorated, a loose monetary policy was progressively priced in, moving the local interest rate curve down Local Interest Rates Feb-09 Feb-11 Feb-13 Feb-15 Feb-17 Feb-19 Feb-21 15/01/ /12/ /06/ /01/ /01/2007 Brazil seems more protected than peers from the global turmoil Rating: Upgrade to investment grade Brazil reached investment grade status in 2008 and currently is rated Ba1/BBB-/BBB- by Moody s, S&P and Fitch. All outlooks are stable. Measures to fight the crisis: Monetary and fiscal The Central Bank has been actively stimulating liquidity in foreign currency markets by selling USD in repurchase agreement auctions, reducing reserve requirements for banks acquiring USD with repurchase agreement, selling currency swap contracts, selling USD in spot market, collateralizing loans, aimed at financing exports, eliminating tax (IOF) on fixed-income capital inflows; engaging in currency swap transactions with other central banks and using international reserves to finance companies with foreign currency debt. The Central Bank has been actively stimulating liquidity in local markets through increasing exemption limits, reducing the rate and/or postponing several modalities of reserve requirements, committing to eliminate reserve requirements on time deposits, on deposits by leasing companies and additional requirements (100 bn BRL), reducing reserve requirements on time deposits for banks that buy assets from other institutions; buying certain assets from banks, authorizing public banks (Banco do Brasil and Caixa) to acquire stakes or control in other institutions, increasing lending requirements to the rural sector, building special lines to homebuilders, allowing Fundo Garantidor de Crédito to buy loans from smaller banks and substantially increasing amounts BNDES can use to finance exporters (100 bn BRL in 2009 or near 3% GDP). On the fiscal front a full package is under discussion, due to be released anytime soon. 4. Conclusion Brazil isn t immune to the global turmoil, but it certainly seems more protected than peer economies such as Russia, India and China. Although economic activity decelerated more strongly in the second half of the year, the deceleration has proved softer in Brazil than anywhere else (Table 2). Nominal growth of monthly exports on a year-on-year basis decelerated among most of these countries, but the slowdown was softer in Brazil. From the imports performance one can conclude that domestic demand remained more robust in Brazil than in most of its peers. In this environment, although industrial production fell in the fourth quarter, on average yearly growth remains robust, when compared to peers. Financial markets performance reflected precisely that with equities falling less and CDS having an acceptable performance considering the risk differences implicit in the sovereign ratings

13 Key Growth Rates in 2008 (Table 2) Confidence and commodity prices are key going forward Brazil Russia India China Exports 23.15% 42.97% 17.88% 17.82% Imports 44.76% 36.32% 36.32% 20.07% Industrial production 4.68% 3.87% 4.81% 12.65% Equities % % % % 5 Year CDS (bps change) Rating Ba1/BBB-/BBB- Baa1/BBB/BBB+ Baa2/BBB-/BBB- A1/A+/A+ Currency vs USD 30.7% 19.3% 23.8% -6.5% India CDS - Rep. Bank of India. Positive values in currencies mean depreciation against the USD. Yearly averages. Yet Brazilian consumer confidence is eroding faster than in other countries, such as China, and that may aggravate the domestic situation. (Graph 7) Consumer Confidence (Graph 7) Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Brazil China Going forward, the environment is challenging for everyone, but Brazil could remain among the countries suffering less from this whole mess. As we have seen previously, trade represents a small part of GDP, exports are diversified at least geographically, the country has low dependence on external financing bearing a public external net cash position, reserve accumulation in the last years has provided an important buffer to external shocks, which the government has been using to fight the crisis, credit penetration in the economy is still low, representing only 40% of GDP, below the 80% in developed countries, the financial system as a whole seems sound with low dependence on open market funding and foreign direct investment represents a small share of GDP (around 2% of GDP against 4-5% of its LatAm peers). We are not the only ones thinking that Brazil could be less affected than other countries by the international turmoil. In November, when the international turmoil aggravated further, the IMF revised down its projections for growth worldwide in 2009, made earlier in October. Brazil was among the least penalized. Such happening occurred again in January 2009 (Graph 8)

14 IMF Expectations for 2009 Growth Rate: October Revision (Graph 8) 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% -4.5% -5.0% Em. markets Italy Spain Brazil France Source: IMF, Banco Itaú Europa. Asia India Middle East Eurozone Japan Africa Asean-5 World US Germany China Canada Central and Eastern Europe Mexico Other advanced UK Russia CW Indep. states and Russia CW ex-russia IMF Expectations for 2009 Growth Rate: January 2009 Revision (Graph 8) 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% -4.5% US Spain Brazil India Mexico CW ex-russia France Middle East Africa Italy Eurozone Asean-5 Canada UK Asia World Germany Em. markets China Japan Central and Eastern Europe CW Indep. states and Russia Other advanced Russia Source: IMF, Banco Itaú Europa. Nevertheless, the build-up of a current account deficit not compensated by foreign direct investment could contribute to increase the currency volatility given financial flows are normally a more uncertain source of funds, even if being a positive influence. A more volatile currency could raise concerns about inflation pressures ahead, limiting room for monetary policy to act, while contributing to deteriorate agents confidence and delay consumption and investment decisions. In fact, low investment could be a key weakness for the country, due to its linkage to commodities. Low commodity prices delay or deter investment decisions both from international and local investors. In this environment a stable currency and higher commodity prices are crucial for Brazil

15 IMPORTANT GENERAL DISCLOSURES The information herein is believed to be reliable but Banco Itaú Europa S.A. does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Banco Itaú Europa S.A. may have a position in these financial instruments from time to time. This report is prepared by Banco Itaú Europa S.A. and this material is for our European Clients ONLY. This information is NOT intended or distributed to U.S. clients by Banco Itaú Europa S.A. However, if a U.S. investor receives this information via a third party it must be understood that any U.S. persons interested in any securities mentioned herein must call a representative of Itaú Securities, Inc. ("Itaú Securities") in New York, MEMBER: NASD/SIPC, not any of the non-u.s. affiliates. Any Financial Products related to this report may or may not be provided by Itaú Securities to U.S. investors. Banco Itaú Europa S.A. is wholly owned by Itausa Portugal SGPS which has become the European Platform of the Itausa Group, a Brazilian conglomerate. Banco Itaú Europa S.A. is credit rated by S&P and Moodys as a separate bank from Banco Itaú S.A. Portuguese banking regulation prohibits BIE from lending to its Brazilian parent group of companies for over 10% of its own equity. Banco Itaú Europa S.A. structure has been designed to create regulatory and geographic barriers to Brazilian transfer risk. Banco Itaú Europa S.A. headquarters is located in Lisbon, Portugal and is supervised and regulated by Banco de Portugal. Banco Itaú Europa London Branch is authorized by the Banco de Portugal and regulated by the Financial Services Authority for designated investment business in the UK. Banco Itaú Europa S.A., capital markets area has a strong relationship with Banco Itaú Financial Holding Company in Brazil. Itaú Securities is a wholly owned subsidiary of Itaú Corretora de Valores S.A, a subsidiary of Banco Itaú S.A. 1. This report has been produced by Banco Itaú Europa S.A., and/or by one of its branches or subsidiaries (together, referred to as Banco Itaú Europa ). This report is being distributed (i) in the United States by Itaú Securities Inc., an NASD member firm; (ii) in the United Kingdom and Europe by Banco Itaú Europa S.A., London Branch, authorized by Banco de Portugal and regulated by the Financial Services Authority; (iii) in Brazil by Itaú Corretora de Valores S.A., authorized by the Central Bank of Brazil and approved by the Securities and Exchange Commission of Brazil; and (iv) in Hong Kong by Itaú Asia Limited, licensed with the Securities and Futures Commission. 2. 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Opinions, estimates, and projections expressed herein constitute the current judgment of the analyst responsible for the substance of the report as of the date in which this report was issued and are therefore subject to change without notice. Prices and availability of financial instruments are indicative only and subject to change without notice. Banco Itaú Europa S.A. has no obligation to update, modify or amend this report and inform the reader of this report accordingly, except when terminating coverage of the issuer of the securities discussed in this report. 3. The analyst responsible for the production of this report hereby certifies that the views expressed in this report accurately and exclusively reflect his or her personal views and opinions about any and all of the subject issuers or securities and were prepared independently and autonomously, including from Banco Itaú Europa S.A. Because the personal views of analysts may differ from one another, Banco Itaú Europa S.A., its subsidiaries and affiliates may have issued or may issue other reports that are inconsistent with, and/or reach different conclusions from, the information presented herein. 4. An analyst s compensation is determined based upon total revenues of Banco Itaú Europa S.A., a portion of which is generated through investment banking activities. Like all employees of Banco Itaú Europa S.A., its subsidiaries and affiliates, analysts receive compensation that is impacted by overall profitability. For this reason, analyst s compensation can be considered to be indirectly related to this report. However, the analyst responsible for the production of this report hereby certifies that no part of his or her compensation was, is, or will be directly or indirectly related to any specific recommendation or views contained in the report. 5. 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