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Demand growth in Brazil driven partly by a one-off pop in household credit [ClearOnMoney]
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Demand growth in Brazil driven partly by a one-off pop in household credit

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Commentary

Demand growth in Brazil driven partly by a one-off pop in household credit

26 Nov 2011 by Jim Fickett.

Brazilian consumers have recently discovered credit: credit outstanding to individuals grew from 5% to 15% of GDP in just a few years. However there are good reasons to think the most rapid growth is over – the cost of credit, at 20-25% in real terms, is very high, and defaults are rising. The main take-home lesson for investors is that when Brazilian or global companies point to rapid growth in sales to Brazilian households, one should remain a little skeptical – that growth may well slow significantly.

Everyone knows that growth in emerging markets is much better than in developed ones, and that this situation will continue for a long time. But what Mr Everyone knows is always far too simple, and sometimes completely wrong, so let's look at some facts.

Very often, when one sees unusually good growth, or impressive returns, the biggest driver is merely one more credit bubble. This was the case with real estate during 2003-2007 in the US and in the great bubble in Japan; it is very likely the case with infrastructure in China currently; and we will make the case that a surge in household credit is at least partly responsible for strong recent growth in Brazilian consumer demand.

The basic facts

Credit to individuals in Brazil grew from 5% of GDP in early 2003 to 15% of GDP in late 2009.

(Data and graph from the Banco Central do Brasil; click for larger image.)

By way of comparison, US consumer credit, which grew strongly in absolute terms from early 2003 to the middle of 2008 (after which it began to fall), was a constant 18% of GDP during that period. This shows that

  1. Credit growth in Brazil has been quite extraordinary
  2. The current level of consumer credit in Brazil is nevertheless, in absolute terms, not extreme

Occasionally you see claims that total credit to the household sector is, comparatively speaking, very low in Brazil. This is true but misleading. The fact is that Brazilian households have very low mortgage debt, compared to other OECD countries, but have a normal level of consumer credit. This graph from Bradesco, one of the main Brazilian banks, tells the story:

Credit growth is slowing

Although the absolute level of consumer credit in Brazil is not particularly high, the cost of carrying that credit is: real interest rates are running at 20-25%. Debt service is running at about 25% of income, compared, for example, to 11% currently in the US.

Not surprisingly, then,

  1. It is apparent in the first graph above that the growth rate seems to have slowed in the last couple years

The banks are probably not at risk

Credit bubbles often lead to financial crises, however in this case the main danger is not to the banks. With a 20-25% real interest rate, many defaults can be absorbed. Further, the average maturity of consumer loans is only 18 months, so if the economy turns down, or loan quality begins to seriously degrade for some other reason, consumers and banks can adjust quite quickly.

The danger is to consumer demand growth

Since credit to the household sector has risen so rapidly, a significant fraction of recent growth in demand has likely been due to the run-up in credit. Or, to put it in plainer terms, a large fraction of the lower and middle class has recently discovered credit cards, and started running up big bills; but this introduction to credit is a one-time event.

It is very common to see investment advisers very excited about rising demand from the middle class in emerging markets. For example, Obelisk International wrote recently about Brazil,

Brazil now has 40 million new consumers whose big spending is, in turn, driving the economy forward.

The recent Christmas shopping period was reportedly the best ever throughout Brazil and consumer spending is expected to continue to rise over the next few years with an increase of 4% forecast for this year. Domestic appliances and telecommunications are experiencing huge increases in sales - mobile telephone ownership has gone up by nearly 500% since 2002 and internet connections by over 340%.

But the new consumers also aspire to bigger purchases. Top of the new middle class wish list is a home. Property investment in Brazil has increased dramatically over the last few years and is set to do even further this year as more and more Brazilian families get a foot on the property ladder.

Next on the wish list are cars with 45% of the new middle class keen to buy a vehicle. Car manufacturing has grown by 88% since 2002, but there is still plenty of room for growth in this key sector, a favourite for investment in Brazil. This year, several large car manufacturers such as Fiat, Ford and Volkswagen have earmarked large investment sums for their factories at locations throughout Brazil.

Yes, the middle class has been growing and yes, they have greatly increased consumption. But since much of that increase in consumption is due to a one-off rise in credit, from near zero to a typical OECD level, the growth in consumption is going to slow. When you see a pitch like this, or are evaluating a company that hopes to grow revenues in emerging markets, you need to either get some hard numbers on how much of the growth is dependent on rising credit, or you need to be very skeptical about future growth rates.

I'm not predicting a crash in Brazil, or even claiming that the economy is unhealthy. In fact, natural resources are a huge plus, the population is relatively young, and the government is fairly reasonable. I am, in fact, optimistic about Brazil. I'm just saying one must take projections of growth in consumer demand with a grain of salt.

[For further background see the new Reference page Brazil household credit.]