AMRAE Seminar on Brazilian Insurance Market

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Atelier C10 Brésil : risques et solutions Brazil : risks and solutions

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Intervenants

Modérateur

Patrizia MASTRAPASQUA Relationship Management Director – Lockton Brazil

Cristiane ALVES Risk Manager Latin America President of ABGR - Associaçao Brasileira de Gerência de Riscos

Angelo COLOMBO Property & Casualty Director – Allianz Seguros

Nadine BARRERE-COUCHON Senior Insurance Advisor – Global Gas & LNG

Brazil Workshop C10

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Brazil presentation and key figures Insurance / reinsurance market Regulation Insurers / Reinsurers

Brokers Role and specificities in Brazil

Risk Management – Pirelli experience Main risks Insurance Group programmes implementation Evolution of risk management in Brazil

Associaçao Brasileira de Gerência de Riscos

Brazil Workshop – C10

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Brazil in a snapshot 1/3

Brazilian economy to overtake France 'before 2015‘ ? “After overtaking the UK economy to become the world's sixth-largest,

Brazil's Finance Minister predicts it will take fifth spot from France before 2015”

Brazil country risk rated A4 by Coface Stable and fast growing economy

Internationally active country G20 leader in 2008 and 2014 World Cup & 2016 Olympic Games

USD 2440 bn

in 2011 Key data comparison Brazil France

GDP (2010) in USD Bn 2 120 2 677

GDP per capita (2010) in USD 11 289 34 092

Est. Growth (2011) 3,5% 1,7%

Inflation (2011) 6,5% 1,4%

Trade balance (2010) in USD Bn + 20,27 - 71,16

Insurance penetration (2010) as % of GDP 3,1% 10,5%

Public deficit (2010) 2,2% 7,5%

?

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• Very well structured banking system

• BNDES – National bank for social and economic development 2008 Credit volume of USD 40 bn (World Bank USD 13.4 bn)

• BM&F Bovespa 11th world largest stock exchange

• 5th largest market capitalization

Brazil - Bovespa

Nov 2011 in USD bn

Petrobras 167,3

Vale 120,3

AmBev Bolsa 93,5

ItauUnibanco 74,9

Bradesco 57,5

France - CAC 40

Sept. 2011 in USD bn

Total 103,8

Sanofi-Aventis 88,4

LVMH 79,0

GDF SUEZ 64,5

L'Oréal 61,0

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• Fast growing middle class

• Health system • 75.9% of population part of Unified Health System (S.U.S.) • 24.1% benefits from Supplementary System (private health plans)

• Abundant natural resources and diversified economy

• Large agricultural producer and powerful industry player • 2010 exportations: USD 202 bn minerals, oil and fuels, transport equipment, soy products, sugar and ethanol

• Good Brazilian / French political and economical relationship

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Catastrophic loss exposure: • No major exposure to earthquakes or hurricanes • Drought / crop failure • Flood, mass movements • Fire (notably wildfires)

Environmental risk exposure: • Deforestation in the Amazon, desertification in the Northeast • Soil erosion and pollution (soy and cattle ranching) • Air and water pollution (urban or industry intensive areas) • National Environmental Law, Administrative liability, Criminal liability

Political and social and other risk exposure: • Medium-Low risk • Security, Strike, Riot, Civil Commotion and Terrorism • Legal and regulatory

• Complex federal Structure • Need for structural reforms (tax system) • Insufficient education system

Specific risks

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Role of direct insurers • fronting arrangements • policy issuance • small risk retention

Role of IRB • only reinsurer authorized to operate in Brazil • use of retrocessionaires to enhance cession limits • in charge of reinsurance regulation and governance

Main problems related to international programs • impossibility to control the amount of risk ceded abroad • constraints to implement new policy wordings • delays to transfer premium to external reinsurers and captives • claims control for losses over USD2 million • process full of subjectivities

Regulation – Before market opening

10

Regulation – Before market opening

Reinsurance Brokers

(optional)

Reinsurance Brokers

(optional)

Insured clients

Brokerage

(compulsory)

Insurance Companies

IRB

State Owned Reinsurer

Global Reinsurance Market

(including captives)

Retrocession flow until Oct/2008

Note: despite the new

legislation signoff by

government in December

2007, changes were

actually implemented as

from October 2008.

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Date • Announced in December 2007, to become effective after October 2008

Reasons • Brazilian companies demanding state of art reinsurance solutions • Compromise assumed by Brazilian government with WTO

Changes implemented • Three types of reinsurers were created: Local, Admitted, Occasional • Locals were granted right of first refusal for 40% of all Brazilian facultative risks and treaties • Reinsurance governance and regulation transfered to Superintendence

Consequences • By end 2010 there were 90 new reinsurers registered in Brazil • New products became available • International programs became feasible as elsewhere • IRB reduced its market share from 100% to 40%

Regulation – First market opening

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Local Admitted Occasional

Minimum Capital USD 34m USD5m none

Right of first

refusal

40% of treaties

and facultative

none none

Retrocession to

markets other

than Admitted

and Occasional

No Yes Yes

Max book

Retrocession

50% No limitations No limitations

Restriction to

insurers

None None Cession limited to

10% of reinsured

portfolio, except

surety

Credit rating Locally

established

Mirrors head

office

Mirrors head

office

Reinsurance Market – Types of reinsurers

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Regulation – First Market Opening

Reinsurance Brokers

(optional)

Reinsurance Brokers

(optional)

Insured clients

Brokerage

(compulsory)

Insurance Companies

Brazilian Reinsurers

(Local, Admitted, Occasional)



Retrocession flow from 2008 to 2011

Right of first refusal

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Effective as from March 31st 2011 1. What has changed? • Limitation of intra group reinsurance to 20% of premium of any transaction • Initial “Right of first refusal” replaced by a mandatory 40% participation of Local Reinsurers. Terms and conditions, premium and deductible can be changed • Treaties in force were given 12 months to be amended and reflect new rule. Due on March 31st 2012

2. Why? • Strenghten local market • Control the amount of premium leaving the country

Regulation – Latest news

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Effective as from March 31st 2011

3. What impact ?

Pros: • Brazilian reinsurance market to become stronger, a strong candidate for a hub within Latin America • Higher local market capital to withstand economic crises or currency volatility

Cons: •Risk of reinsurance capacity shortage • Impossibility to naturally spread risk over markets, one of the most important foundations of reinsurance industry

4. Why general disagreement ? • Instability generated by constant change of rules • Changes made without previous market consultation

Regulation – Latest news

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Regulation – Latest News

Reinsurance Brokers

(optional)

Reinsurance Brokers

(optional)

Insured clients

Brokerage

(compulsory)

Insurance Companies

Brazilian Reinsurers

(Local, Admitted, Occasional)



Retrocession flow as from 2011

40% compulsory placement

If Locals refuse a risk under any

terms and conditions, this can

be placed elsewhere

Latest changes

20% Intragroup premium

restrictions

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Brazilian Insurance Market

•Source:Susep (via Siscorp) (oct/2011) •P&C without motor

13,5 15,3 17,3 19,9

12,5 14,9 13,6 14,8

10,0 11,2 12,6 13,8

10,6 12,1 13,7 15,7

2007 2008 2009 2010

LIFE

HEALTH

P&C

MOTOR

21,7 24,4 27,1 29,8

17,4 19,7 22,2 24,8

16,5 18,1 19,7 21,4

18,7 20,9 23,1 25,1

2011P 2012P 2013P 2014P

LIFE

HEALTH

P&C

MOTOR

GWP Market Performance – R$ Billion GWP Market Projection – R$ Billion

CAGR 07/10 CAGR 11/14 11% 11%

CAGR 07/10 Mix 2010

10% 11% 9%

13%

life motor health P&C

14% 14% 11%

6%

life motor health P&C

31%

23% 22%

24% 29%

25% 21%

25%

CAGR 11/14 Mix 2014

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Reinsurance Market overview

AGCS IRB

Line of

Business

EURm EURm

Property 300 153

Liability 150 23

Construction 200 107

Cargo 200 122

Reinsurance Capacity French Reinsurers in Brazil Company Status

Scor Admitted

Axa Corporate Occasional

Axa Vie Occasional

Caisse Centrale Occasional

Coface Occasional

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11 Local Reinsurers already licensed

Local Reinsurer Business Focus Headoffice

IRB Life/Non Life Brazil

J Maluceli Re Non Life Brazil

Terra Brasis Non Life Brazil

Austral Re Non Life Brazil

Munich Re Life/Non Life Germany

Mapfre Re Life/Non Life Spain

Alterra Non Life Bermuda

Zurich Re Life/Non Life Switzerland

ACE Re Life/Non Life Bermuda

XL Re Non Life Switzerland

Chartis Re Life/Non Life United States

AGCS (Allianz) Non Life Germany

Swiss Re Life Non Life Switzerland

License in

2012

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AGCS Brazil Value proposition to Multinational clients

• Maximize cession of Brazilian share in international programs up to 100% to AGCS International Branches or captives

• Capabilities in Property, Marine, Liability, D&O, Aviation, Engineering and Energy

• Expertise in wording translation and adaptation to local legal requirements and approval with superintendence

• Service offer to clients aligned to international standards – GPS System

• Adherence to Claims SLAs (service level agreements) as agreed with risk managers

• Enhanced premium collection to fulfill global allocation needs or PPW clauses

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Allianz in Brazil

Ranking GWP

total Motor P&C Health Life Total

Total mkt

share

ITAÚ / PORTO 5,4 3,7 0,7 2,7 12,5 24%

BRADESCO 2,8 0,8 5,9 2,7 12,2 24%

SUL AMÉRICA 2,1 0,4 5,2 0,4 8,1 16%

MAPFRE / BB 3 2,2 0 2,8 8 15%

ALLIANZ 1 1 0,4 0,1 2,5 5%

CAIXA 0,2 1,1 0 0,7 1,9 4%

LIBERTY 1,5 0,2 0 0,1 1,8 3%

SANTANDER - 0,3 0 1,4 1,7 3%

TOKIO MARINE 0,6 0,5 0 0,5 1,6 3%

HDI 1,3 0,2 0 0 1,4 3%

TOTAL Top 10 17,9 10,4 12,2 11,3 51,7 100%

Top 10 / Market 90% 71% 88% 73% 79%

GWP Top 10 2010 – R$ Billion

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Insurance Market - Brokers

LEGISLATION

INSURANCE BROKERS

• Introduced through the Decree Law No. 73/66 ruling on insurance and reinsurance operations in Brazil;

• Supervised by SUSEP responding to the Ministry of Finance;

• Brokerage is compulsory;

• Not allowed to collect premium payments;

• Not allowed to issue insurance certificates;

• No obligation in having an E&O policy in force.

REINSURANCE BROKERS

• Introduced by Law no. 126 and Resolution 173/07;

• Supervised by SUSEP responding to the Ministry of Finance;

• The use of a Reinsurance brokerage for reinsurance operations is not compulsory by Law but insurance companies tend to use them especially on treaties and complex facultative placements;

• Collect reinsurance premiums;

• Must issue bilingual insurance slips;

• Must keep E&O policy in force 10MM per claim/20MM in the aggregate– ded lower BRL 100K.

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OVERVIEW

INSURANCE BROKERS

• Over 70.000 insurance brokers in Brazil between individuals and structured companies;

• Reducing to 20.000 those focused on life and non-life, half based in São Paulo State;

• Very few Brokers operating at a national level;

• Few brokers operating on more sophisticated insurance lines;

• Some of the largest brokers in Brazil operate as captive brokers of large industrial or construction groups or are specialized in niche products.

REINSURANCE BROKERS

• Around 30 registered companies, most of them operating since 2008;

• The majority focused exclusively on facultative placements;

• Around 1/3 also involved with Treaties;

• All international retail brokers have their reinsurance arm;

• Presence of a number of international reinsurance brokers with no retail activity;

• Domestic retail brokers setting up their reinsurance arm for portfolio protection.

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INSURANCE BROKERS

CLOSED MARKET

• Used to tariff market and standard policy forms;

• Familiarity with a restricted range of insurance products according to the IRB standards;

• Reduced competitiveness due to same reinsurance support;

• No major difficulty in completing placements for hazardous or large capacity risks;

• Strong Commercial approach with insurance companies;

• Insurance companies used to give more technical support to brokers.

OPEN MARKET

• Having to be familiarized with different insurers´s tariff and wordings;

• Having to deal with a number of new insurance solutions;

• Market security and selection critical to reliable solution;

• Deep knowledge of the market trends and criativeness makes a difference;

• Assist the client with the improvement of their risk is essential;

• Improve their technical team – specialization approach;

• Increased responsibilities.

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REINSURANCE BROKERS

CLOSED MARKET

• Around 10 companies registered by the IRB ;

• Operating as commercial offices of foreign brokerage firms;

• Used to work as negotiators facilitators between the IRB and the international market;

• No formal responsibility in the Country;

• No local bank account;

• Reactive approach.

OPEN MARKET

• Duly registered with Susep with formal responsibilities in the Country;

• Having to deal with multiple reinsurers (10 local – 30 admitted – 60 occasional);

• Responsibility in choosing the reinsurers - market security;

• Proactive approach:

Find solutions not available in the Country;

Bring innovation to the local market;

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CHALLENGES WITH THE NEW REGULATIONS

• Because of the obligation of placing 40% of the risk with local reinsurers and no more than 20% intercompany, as an immediate reaction, a number of international carriers had to set up or are setting up a local reinsurance company;

• With the publication of resolution 225 at the end of December 2010, the market has worked with a certain level of difficulty as Susep did not issue any instruction on how the market should have proceeded in case of declinatures by all Local reinsurers;

• Ultimately cedants had to ask the local reinsurers to act as a retrocessionaires, with relevant overrider costs involved, in order to allow the completion of their reinsurance placements;

• Recent Resolution CNSP 241/2011 , finally clarifies the situation establishing that , in case of lack of capacity of the local reinsurance market, cession of risks in percentages lower than the mandatory 40% are authorized. If no local reinsurance market is available cedants are free to place either with admitted/occasional or even not registered reinsurers..For this purpose all local reinsurers must be approached , having 5 business days to respond in case of facultative cessions and 10 in case of treaty.

• Local reinsurers might apply conditions on their retention different from the ones offered by admitted or occasional reinsuers.


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SOME NEW COVERS AND POLICY FORMS EXAMPLES

PROPERTY • Broader Property policy forms even for smaller risks, in the past only Jumbo risk would

benefit from that; • Increased use of ALOP and DSU;

LIABILITY • Introduction of All Risks policy forms; • Wider interpretation of « Pain & suffering » • Environmental Liability • Product Recall: development of specific policy wordings

FINANCIAL LINES

• Introduction of wider D&O policy wordings; • Improvement of E&O scope, development of taylor made policy wordings for specific

activities; • CRIME and EPL policies are now available


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LOCKTON BRAZIL EXPERIENCE – CASE 1 – 2008/2009

THE RISK MANAGER OF A LARGE INTERNATIONAL ENERGY COMPANY 3 MONTHS BEFORE RENEWAL ASKED OUR ASSISTANCE TO MEET THE FOLLOWING GOALS:

1.Leave the minimum possible retention to local insurers and reinsurers;

2.Issue a policy with one single carrier (no coinsurance) to have easier control over premium payment;

3.Have a unique policy wording as close as possible to the programme one.

SOLUTION

• We arranged meetings with local insurers and reinsurers;

• We could find companies prepared to accept a fronting arrangement but would only be able to accept coinsurance due to the high credit risk involved (over 1bn USD policy limit).;

• We managed to arrange a scheme with a company that is present in Brazil both as insurer, admitted and local reinsurer;

• We helped the client with the selection of a lawyer specialized in insurance so that they translated the foreign policy wording into Portuguese and adjusted the wording to local legislation;

• The insurance company then applied to SUSEP to approve the issuance of the policy as a singular process;

• All the goals were met within the set timeframe

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LOCKTON BRAZIL EXPERIENCE – CASE 2 – 2011/2012

THE RISK MANAGER OF A LARGE FOREIGN WIND POWER COMPANY WANTED US TO USE AN EXISTING FACILITY PLACED IN THE INTERNATIONAL MARKET TO COVER ALL BRAZILIAN ERECTION PROJECTS. THE MAIN GOAL WAS:

1. Grant that the local projects would have access to the same rating level;

2. Enable to have the same broadness of cover;

3. Export as much risk and premium as possible in order to « feed » the facility thus having more negotiation power with the underwriters.

SOLUTION

• We identified possible fronting markets both on the retail and reinsurance sides;

• We could only find two insurers prepared to issue as fronting companies and managed to find a local reinsurer prepared to front their 40% of their share without applying any change to the original terms quoted by the international market;

• Policy wordings were followed as close as possible to the original, however some local adaptations were needed to comply with the local legislation;

• In this case, it was not needed to involve law firms as the companies standard policy wordings were used as a basis, complemented by special clauses;

• Around 99,5% of the risk was exported but the client had to pay an overrider to the local reinsurer.

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WHAT THESE TWO CASES HAVE IN COMMON • Both risk managers had a clear objective in mind;

• They traveled to Brazil to meet in person all the key people in the process:

The local management, sharing their ideas and asking for their support; The local broker, asking feasibility of their plan and support with the

implementation; The local insurers, in order see who could offer the best solution;

• They set up an action plan with all parties involved;

• They followed-up.


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PREPARATION OF YOUR STRATEGY- 3 MONTHS BEFORE EXPIRY

• Define your strategy with your central broker choosing the carrier and defining local conditions. International carriers are increasingly structured to give solutions to multinational companies;

INVOLVEMENT OF YOUR LOCAL BROKER – 2 MONTHS BEFORE EXPIRY

• Instruct your local broker so that he is fully aware of your strategy ; • He will make sure that the local carrier´s representative implements what has been

negotiated at a corporate level; • Note that pure allocated premium may be an issue, if the cost is not aligned with the local

practice ratings. POLICY ISSUANCE

• Policy wording would normally be best local standard with possibility of including some special

conditions; • If there are any particular clauses that you want to be properly addressed locally it is

important to involve both the local broker and the local insurer, with a certain anticipation .

Timeline - Treaty

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PREPARATION OF YOUR STRATEGY – 4/5 MONTHS BEFORE EXPIRY

• Define your strategy with your central broker - you need to have your market and conditions sorted out;

• Define your goal for your local policy: Conditions as close as possible to your programme? Fronting arrangement? Best local rates? Singular Process – taylor made policy wording?

INVOLVEMENT OF YOUR LOCAL INSURANCE AND/OR REINSURANCE BROKER – 3 MONTHS BEFORE EXPIRY

• You will have to submit to your local reinsurance broker a slip with the negotiated terms for

Brazil; • The local reinsurance broker will have to approach the local reinsurance market which:

Can decide to retain up to 40% of the risk following your conditions; Can decide to retain up to 40% of the risk at their terms; Can be prepared to write 40% of the risk and retrocede back to the selected

international market by charging a fronting fee ; ./..

Timeline - Facultative Basis

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ACTIVITY OF YOUR LOCAL INSURANCE AND /OR REINSURANCE BROKER - 3 MONTHS BEFORE EXPIRY UNTIL POLICY ISSUANCE • Before defining the local reinsurance company, the local reinsurance broker will have to open

negotiations with each local reinsurer to make sure that your strategy is met (rates – conditions – retrocession – wording – fronting fees);

• In case you are looking at a fronting arrangement, the local broker will also have to open discussions with the local insurance market that might have restrictions in working with the selected reinsurance market (either admitted or local);

• Cover notes will have to be biligual and notarized and registered in the Brazilian Consulate of the Country of origin of the admitted /occasional reinsurer Country;

• The local broker will have to make sure that the final policy wording reflects the negotiations and the slip conditions;

• If you would like to have a Singular process to be submitted to SUSEP, you will likely need to involve a lawyer to translate your global policy wording and adapt to local legislation and local insurance rules; you then should add additional 30 days to your process .

Timeline - Facultative Basis

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Founded in 1995

Becomes a Lockton subsidiary in 2006

Two offices: São Paulo and Rio de Janeiro

Focus on middle to large corporations

Reinsurance broker as Lockton Re

Founded in 1966 in Kansas City

Privately Owned Company

58 offices throughout U.S., Europe, Latin America,

Asia Pacific, and Middle East

Over 4,100 employees

Commercial Insurance – Employee Benefits –

Retirement Services – Surety – Affinity Programmes

LOCKTON GROUP FACTS

LOCKTON BRAZIL FACTS

About Lockton

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About Eos Risq

CORE PARTNERS • DIOT (France) • LOCKTON (U.K., U.s.A., Asia, Latin America) • VAN BREDA (Belgium) • ASSITECA (Italy)

OBJECTIVE Service European Multinational Clients Worldwide COMMON IDENTITY • Partnership or privately owned and independent

brokers, each amongst the market leader in their own Country;

• We deliver solutions in 135 Countries through European roots;

• Service partners choosen for their knowledge, quality and capabilities.

COMMON SERVICE TOOLS AND ACTIVITIES • Global Standard Service Guidelines; • Technology Tools; • Regular meetings with partners and

correspondents.

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Risk Management - Pirelli

1. Pirelli Group Overview - Structure

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2. Pirelli Group Overview – Worldwide Presence

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3. The Risk Management in Pirelli

RISK MANAGEMENT ORGANIZATIONAL STRUCTURE

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When the Risk Management team was built there were two different approaches to be

followed:

Local Global • In-depth knowledge of the

local market

• Direct contact with relevant

players

• Strategic vision of the Group

exposures

• Overall control of the risk

transfer process

vs

Local + Global

• Global approach to the management of the risk

• International programs

but also

• Regional Risk Management Coordinators

• High visibility of the local markets

Cristiane França Alves

http://www.pirelli.com/

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RISK MANAGEMENT ORGANIZATIONAL STRUCTURE

THE SUCCESS OF THE STRUCTURE

We are a focused team, with specialized professionals

present in different regions of the world, but centralized

in a single Worldwide Risk Management Structure.


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4. The Risk Management in Brazil / Latin America

• Implementation of Insurance Programs

• Claims Management

• Supervision of broker’s activities

• Loss Prevention, BCP, BIA…


44



• Implementation of Insurance Programs


Property

TPL

Marine

Credit

D&O

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• Claims Management


Loss Report for all events;

Claim Procedure: indicates the responsibilities of

each area in the company; how to

proceed in a litigation and when to do

voluntary agreements;

Inland Insurance: Pirelli Brazil has its own Monitoring Center

to control all its shipments. This area also controls if the

shipment follows all the rules determined by our PGR (risk

management Plan).

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4. The Risk Management in Brazil / also Latin America

• Supervision of broker’s activities


Broker is a consultancy for Risk Management

Department in Brazil. Few activities are followed by the

Broker.

The situation is different in other countries of the

region where Pirelli does not have a local team (Risk

Management department).

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4. The Risk Management in Brazil, but also Latin America

• Loss Prevention, Business

Continuity Plan


Local Coordinator

Loss Prevention: •Follow up the recommendations •Follow up the investments •Follow up supply contracts

BCP: • Risk assessment •Action plan

Global Risk Management

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ABGR

The ABGR was established in 1983 with the mission of

bringing together all the “Risk managers” in Brazil, in

order to understand what the local companies were doing

to protect themselves.

Then as a second step, ABGR realized the need to take

specialized knowledge to its associate members.

History – ABGR (Brazilian Risk Managers Association)

World in 1983

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http://pt.wikipedia.org/wiki/Ficheiro:Challenger_Launch.jpg

49

ABGR MISSION:

ABGR’s mission is to develop, better and make public Risk Management in Brazil, to its

associate members in specific and Risk Management and Insurance Market in general,

through the press, on line media, courses and seminars, as well as technical and

educational specific projects.

ABGR

50

For 2012 we have prepared an agenda of various workshops to our associate members with

the following subjects, that part of them are the main current exposures in Brazil

Culture: DO PREVENTION!

LP, BCP, BIA, Quality

We care about the share holders and the stake holders , so we have Loss Prevention

and BCP as a main target because we want to eliminate or minimize the probability of

having a business interruption.

We also have quality as a main target because we care about brand, about image

exposure, so we also want to eliminate or minimize the probability of a recall or third

part damage.

Supply contracts

• To do Prevention • To control the exposures and if the risk are under control, mitigated

and correctly covered.

ABGR

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Floods, Landslides and Tornados

CAT Risk and Supply Chain

Highways, railroad, ports, airport and energy

lines.

mainly low income population

AFFECT

ABGR

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52

CAT Risk – in Brazil?

Highways, railroad, ports, airport and energy lines.

ABGR

53

Benefits

Few players and the legislation that transfers the State` s

obligation to the private sector. Nowadays, we have a very good

medical service with modern resources, covered by the

insurance policy as a result of legal determination.

Health Care:

Pension Plan

• AT 83 instead AT 2000 • Guarantee profitability of 6% a year

* Open Entity – contracts offer around 3% a year

Human Resource

How a lack of development and

retention program could affect the result

of the companies?

ABGR

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54

ABGR attained an important role in the political and regulatory

scenery in Brazil.

ABGR – Political Role

And why did ABGR do it?

Few years later, we saw ourselves fighting against the New regulation

that brought negative changes to the reinsurance market in Brazil.

In the middle of 90s ABGR started to work to end the monopoly

reinsurance period, which happened only in 2007.

ABGR

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55


Because again risk managers started to face:

strict competition cost increased , and rules that only exist in Brazil,

which is a universal tool and can not be changed in specific geographic areas… different rules to work with the reinsurance,

ABGR

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During our last Seminar in 2011, ABGR strongly claimed about

the Government position, and we humbly believe that the

opening for a public consultation promoted by SUSEP was due

to our claim.

We sent our suggestion and as an answer, SUSEP acknowledged the previous rule

lacked information and changed the regulation accordingly, and also formalized the

permission to get reinsurance directly abroad if a risk is fully declined by all Local

Reinsurers.

But anyway, we are still facing the limitation of 20% for operations between parent

companies and the obligation of paying the local cost even if we get better terms /

quotations abroad.

ABGR

http://www.netstern.com.br/abgr/www/congresso/index.asp

57

Sources

JP Morgan Brazil 2011 – Country Handbook French Embassy in Brazil – http://ambafrance-br.org French-Brazilian International Chamber of Commerce – www.ccfb.com.br BM&F Bovespa - www.bmfbovespa.com.br Brazilian Institute of geography and statistics - www.ibge.gov.br La Documentation Photographique - www.ladocumentationfrancaise.fr SIGMA report on World Insurance in 2010 - http://www.swissre.com/sigma/ Le Monde – www.lemonde.fr

http://ambafrance-br.org/



http://www.ccfb.com.br/

http://www.bmfbovespa.com.br/

http://www.ibge.gov.br/

http://www.ladocumentationfrancaise.fr/

http://www.swissre.com/sigma/

http://www.lemonde.fr/

58

Atelier C10 Brésil : risques et solutions Brazil : risks and solutions

Questions & answers

59

Merci ! Les slides seront

en ligne dès la semaine

prochaine sur www.amrae.fr

Thank you for your attention!

Slides will be available next

week on www.amrae.fr

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Latin America Equity Research 18 April 2011

Brazil 101

The 2011 Country Handbook

Emy Shayo ChermanAC

(55-11) 3048-6684

[email protected]

Banco J.P. Morgan S.A.

See page 100 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Fabio Akira

(55-11) 3048-3634

[email protected]

Banco J.P. Morgan S.A.

This 100-page handbook on Brazil serves as a useful primer and reference guide. As more investors get involved in the country, both on the securities and real economy side, we thought it worthwhile to revisit key metrics and some of Brazil’s history and processes so as to better understand the macro and capital market local dynamics.

2


Emy Shayo Cherman (55-11) 3048-6684 [email protected]

Table of Contents Things to Know.........................................................................4 Overview ...................................................................................5 Area..............................................................................................................................5 Population ....................................................................................................................6 Health...........................................................................................................................7 Education .....................................................................................................................8 Income Distribution .....................................................................................................9 The New Middle Class...............................................................................................11 Security ......................................................................................................................11 Tourism......................................................................................................................13 Competitiveness.........................................................................................................14 Economic Activity ..................................................................16 GDP ...........................................................................................................................16 Investments ................................................................................................................19 PAC............................................................................................................................20 Minha Casa, Minha Vida (MCMV)...........................................................................21 World Cup 2014, Olympic Games 2016 and other investments ................................22 Industry ......................................................................................................................24 Consumption..............................................................................................................25 Labor..........................................................................................................................27 Inflation ...................................................................................29 History .......................................................................................................................29 Main Inflation Indexes...............................................................................................30 Central Bank and Monetary Policy............................................................................31 Exchange Rate Policy ................................................................................................33 External Sector .......................................................................34 Exports.......................................................................................................................35 Imports.......................................................................................................................36 External Accounts......................................................................................................37 External Debt .............................................................................................................40 Fiscal Policy............................................................................40 The Annual Budget ....................................................................................................40 Fiscal Indicators.........................................................................................................41 Public Sector Debt .....................................................................................................42 Sovereign Credit Ratings ...........................................................................................43 Tax System ................................................................................................................43 Credit .......................................................................................46 Brazilian Mortgage System........................................................................................48 BNDES ......................................................................................................................50 Capital Markets.......................................................................51 Bovespa Indexes ........................................................................................................52

3



MSCI..........................................................................................................................54 Flow of Funds ............................................................................................................55 Pension Funds ............................................................................................................56 Mutual Funds .............................................................................................................57 Politics.....................................................................................58 Brazil’s Main Political Parties ...................................................................................59 Brazil’s Presidents .....................................................................................................59 2010 Elections............................................................................................................61 Sectors ....................................................................................63 Oil, Gas & Petrochemicals.........................................................................................63 Metals & Mining........................................................................................................65 Financials ...................................................................................................................67 Homebuilders.............................................................................................................68 Retail..........................................................................................................................71 Food ...........................................................................................................................72 Beverages...................................................................................................................73 Tobacco......................................................................................................................74 Agribusiness...............................................................................................................75 Pulp and Paper ...........................................................................................................77 Roads .........................................................................................................................78 Transportation............................................................................................................80 Electricity and Water .................................................................................................81 Annex 1: Historical Economic Data and Forecasts .............83 Annex 2: Brazil Strategy Dashboard.....................................86 Annex 3: Tables......................................................................94 Annex 4: Figures ....................................................................96

Special thanks to Catherine Foster Rezende and Vinay Joseph for their contribution to this report.

Cover photo: morgueFile.

4



Things to Know

With a total area of 8.5 million square kilometers (3.4 million square miles) Brazil is the world’s 5th-largest country.

Brazil has also the 5th-largest population in the world, with more than 190 million people.

The 6th-most populous city in the world belongs to Brazil. São Paulo has nearly 11 million people.

Table 1: Top 6 cities in the world by population City Population

Shanghai - China 13,831,900 Mumbai - India 13,830,844 Karachi - Pakistan 12,991,000 Delhi - India 12,565,901 Istanbul - Turkey 11,372,613 Sao Paulo - Brazil 11,037,593

Source: IBGE.

With a GDP around US$2.01 trillion (as of 2009), Brazil is the 8th-largest economy in the world and the largest in Latin America.

The country is formed by the union of the Federal District (Brasília), 26 states, and 5,564 municipalities divided in 5 main regions.

In 2010, more than 84% of total population was living in urban areas.

Population, income, industry and economic activity are sharply concentrated in the Southeast region, mainly in São Paulo.

Services accounts for 58% of the GDP, while industry represents 23%.

Brazil can be considered a relatively closed economy, with exports and imports representing only 11.2% and 12.1% of GDP respectively (2010).

China is about to become Brazil’s largest trade partner on both the import and export side. In 2010, it was responsible for 15% of exports and 14% of imports.

87% of total Brazilian imports are composed of industrialized products.

Brazil has a Gini coefficient of 0.567, which puts it among the countries with the worst wealth distribution in the world.

Unemployment rate reached at the end of 2010 was the lowest rate ever: 5.3%.

Credit penetration is around 45% of the GDP, high by regional standards but still low by developed countries’ standards.

Despite the improvements, historically Brazil has a pretty low level of mortgages, only around 7% of total credit and 3% of the GDP.

Brazil’s housing deficit is estimated at 5.6 million homes. Additionally, household formation drives demand for an additional 1.5 million homes a year.

Brazil is going to host two mega sporting events in the coming years: World Cup in 2014 and Olympic Games in 2016.

Although the Central Bank is not officially independent, it has de facto autonomy and has worked with an inflation-targeting regime since 1999.

In terms of market cap, the Brazilian stock exchange (Bovespa) is the largest in Latin America and the 11th-largest in the world at US$15 trillion market cap.

Together, Petrobras and Vale account for around 27% of Bovespa’s total market cap.

Brazil has had 36 presidents since the proclamation of the republic in 1889.

The country passed through a military dictatorship from 1964 to 1985.

5



Overview

Area

With a total area of 8.5 million square kilometers (3.4 million square miles) Brazil is the world’s 5th-largest country. It is also the third-largest country in the Americas, after Canada and the US, and the largest in South America, bordering all the countries of the continent except Chile and Ecuador. Brazil occupies about 40% of South America’s territory.

Table 2: Top 5 countries in the world by area km² Country Area in square kilometer

Russia 17,075,400 Canada 9,976,139 China 9,596,960 US 9,519,666 Brazil 8,547,403

Source: IBGE.

The country comprises 26 states, the Federal District and 5,565 municipalities. Brazil is divided into five main regions: North, Northeast, Midwest, Southeast and South. These administrative divisions, set by Instituto Brasileiro de Geografia e Estatística (IBGE), are composed of states with similar cultures and economical, historical and social aspects.

Figure 1: Brazil Divided by Region

North

South

Southeast

Midwest

Northeast

North

South

Southeast

Midwest

Northeast

Source: IBGE; J.P. Morgan.

Table 3: Region Details North Area 3,659,637.9 km² or 45.4% Population 15.9 million or 8.3% (2010)

4.1 people/km² GDP R$154.7 billion or 5.1% (2008)

US$5560 per capita (annual) HDI 0.764 (2005) Climate Equatorial (high temperature and high annual precipitation) States Acre, Amapá, Amazonas, Pará, Rondônia, Roraima,

Tocantins

Northeast Area 1,558,196 km² or 18.3% Population 53.1 million or 27.8% (2010)


US$4075.2 per capita (annual) HDI 0.720 (2005) Climate Tropical near the coast and semi-arid in the interior States Alagoas, Bahia, Ceará, Maranhão, Paraíba, Pernambuco,

Rio Grande do Norte, Sergipe

Midwest Area 1,606,371.5 km² or 18.9% Population 14.1 million or 7.4% (2010)


US$11,087 per capita (annual) HDI 0.815 (2005) Climate Savanna climate States Goiás, Mato Grosso, Mato Grosso do Sul, Distrito Federal Southeast Area 924,511.3 km² or 10.9% Population 80.4 million or 42.1% (2010)

86.91 people/km² GDP R$1,698.6 billion or 56.0% (2008)

US$11,528 per capita (annual) HDI 0.824 (2005) Climate Tropical in the northwest, semi-arid in the north and

temperate in the south

States Espírito Santo, Minas Gerais, Rio de Janeiro, São Paulo South Area 575,315 km² or 6.8% Population 27.4 million or 14.4% (2010)


US$9936 per capita (annual) HDI 0.831 (2005) Climate Subtropical in almost all of the region States Paraná, Rio Grande do Sul, Santa Catarina

Source: IBGE, J.P. Morgan. Note: HDI – Human Development Index (United Nations).

6



Population

Brazil has the 5th-largest population in the world, with more than 190 million people. Brazilians are unevenly distributed in the territory. More than 40% are concentrated in the Southeast region, while just 7% live in the Midwest.

Figure 2: Brazil’s population # of People

175,000,000

180,000,000

185,000,000

190,000,000

195,000,000

200,000,000

2005 2006 2007 2008 2009E 2010E 2011E 2012E

Source: IBGE.

Brazil’s population is currently growing at an annual rate of 1%, with a declining trend. Since 1960, the growth rate of the Brazilian population has fallen, having slowed from more than 3% per year in 1950-1960 to 1% in 2008. An IBGE research estimates that this positive rate is going to decrease until 2040, when population growth rates will turn negative.

Figure 3: Population growth until 2050 Millions of People

170

180

190

200

210

220

2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 Source: IBGE.

Life expectancy at birth in Brazil is increasing and reached almost 73 years in 2010, while in 1998 it was 69.6 years. In general, men do not live as long as women. While men born in 2009 are expected to live until 69 years of age, women are expected to live to almost 77 years. Despite all the developments observed in this indicator, Brazil still has a low life expectancy rate compared to developed countries. Japan is the country with the highest life expectancy, with 82.6 years on average, and Brazil occupies the 92nd position in the world, behind 6 other Latin American countries.

Figure 4: Average Life Expectancy Years

78.676.4

75.3 7573.7 72.9 72.8

68707274767880

Chile Uruguay Argentina Ecuador Venezuela Colombia Brazil

Source: IBGE, UN.

The expected number of children born per woman in Brazil is also falling. The fertility rate was 1.9 in 2007-2008, ranking Brazil 136th out of 195 countries (the first being the country with the highest birth rate). With this number the country is below the world’s average, which is 2.5 children per mother. The trend suggests stabilization at 1.5 children per woman and the maintenance of this number in the long term.

The fertility rate is youth inflected in Brazil, meaning that on average women become mothers earlier than in the developed countries. The birth of children in Brazil is more concentrated among women between 20 and 24 years.

Figure 5: Fertility rate Number of children per woman

4.063.43

2.79 2.51 2.392.06 1.86 1.76 1.59 1.53 1.51 1.5

0

1

2

3

4

1980 1985 1990 1995 2000 2005 2008 2010E 2015E 2020E 2025E 2030E

Source: IBGE.

On average, the population density in Brazil is 22.6 persons per square kilometer. With this number the country can be considered a sparsely populated area, given the world average is 45.8 people per square kilometer. The most populated place in the world is Macau (China) with more than 18,000 of people per square kilometer.

The population in Brazil is more concentrated on the coast, which is partly explained by the European colonization (1500s onward) that took place in those areas. In the North region, the country still has

7



unoccupied areas, mainly because of the presence of huge and dense forests, such as the Amazon.

Population distribution can also be understood as a reflection of economic development. São Paulo, where the population density reaches 160 people per square kilometer, accounts for more than one third of the country’s GDP.

Among Brazilian regions, while the North is responsible for hosting only 7% of the country’s population, the Southeast hosts 40%, with more than 22% of the population living in São Paulo, the largest state of the Southeast region.

Figure 6: Population density by state

0 – 10

10 – 40

40 – 70

70 – 100

100 – 200

200 or more

Hab/km²

0 – 10

10 – 40

40 – 70

70 – 100

100 – 200

200 or more

Hab/km²

Source: IBGE.

Urbanization: A movement of migration to urban areas can be observed in the whole world. In 2007 more than half of the world’s population was living in cities. Brazil is no exception to this tendency. Since 1950 the urbanization rate has been rising, and the population living in urban areas has more than doubled. In 2010 more than 84% of the total Brazilian population was living in urban areas. The problems caused by this fast and intense flow of people can already be observed in almost all big cities in the country. The lack of planning to receive all these new city dwellers was responsible for a disorderly urban growth, which was not followed by improvements in infrastructure, such as transportation, sewage, hospitals and schools.

Figure 7: Urban Population as % of Total

36.1%

56.0%

75.6% 78.4% 81.3% 82.8% 84.3%

67.7%

45.1%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

1950 1960 1970 1980 1991 1996 2000 2005 2010 Source: IBGE.

Health

The Brazilian health system is made up of a complex network of public and private institutions that regulate, legislate and oversee the health system. They also provide finance, manage health services, produce and distribute health inputs and research and train human resources in health.

In 2007 the public sector was responsible for 49% of health spending in Brazil. These expenses are divided among the central government, the states and the municipalities. The central government generated 47% of the resources, the states 26% and the municipalities 27%. The private sector was responsible for the remaining 51% of spending with health. The private share resources were utilized in insurance (51%), medicine (28%) and direct disbursements (21%). In terms of expenses per capita, considering both the public and the private sector, Brazil spends during a year US$483.87 on health per person.

The country has a Unified Health System (Sistema Único de Saúde – SUS), created in 1988, that aims to provide universal health coverage. Today, the SUS reaches 75.9% of the population. The remaining 24.1%, are covered by the Supplementary System (usually private health plans), but they are also entitled to access to SUS’s health services. The government is engaged in developing projects aiming to facilitate the population’s access to basic care. An example is a program called “People’s Pharmacies,” which facilitates access to essential medicine.

In Brazil total expenses associated with healthcare amounted to 8.4% of GDP in 2008. This is not a bad number. Indeed, compared to other BRIC countries, Brazil is the one with the highest allocation to health in terms of GDP. But Brazil is still very far from the expenditure on healthcare of developed markets.

8



Figure 8: Healthcare Expenditures as a % of GDP (2008) %

16.0

11.1 10.4 9.6 9.0 9.0 8.8 8.4 8.16.9 5.9 5.2 4.3 4.0

0

3

69

12

15

18

US

Fran

ce

Germ

any

Arge

ntina Italy UK

Aust

ralia

Braz

il

Japa

n

Chile

Mex

ico

Russ

ia

China India

Source: World Health Organization (WHO).

In 2008 more than 45.7 million people were linked to health plans, representing only 24.1% of the population. Of these, 63.1% are associated with complete private health plan and 19.1% are linked with complete public health plans (typically civil servants and public sector retirees).

Table 4: Healthcare Members (2008) % Health Plan % of Total Population With health plan 24.1 with complete private health plan 15.2 with complete public health plan 4.6 with private or public plan - limited coverage 2.6 plan with non identified coverage 1.6 Without health plan (SUS coverage only) 75.9 Total 100

Source: ANS.

Total revenue of the health insurance sector came in at R$65.5 billion in 2009. In the last few years, the sector started to see increases in the number of health plan members, and consequently, revenues started to grow. Since 2003, while the number of insured has increased by 36%, sector revenues have increased by 130%.

Figure 9: Heath Plan (Insurance) Sector Revenues R$ Billion

28.5 32.237.1

42.151.9

60.3 65.553.7

010203040506070

2003 2004 2005 2006 2007 2008 2009 2010 (Jan-Sep)

Source: ANS.

Education

The Brazilian education system is divided into 3 levels: basic, secondary and higher education. Theoretically, basic education is mandatory for children between 6 and 14 years old and free for everybody (including adults). The basic level takes 9 years to be fully completed. Secondary education lasts 3 years, is also free but is not mandatory. Higher education, which includes university study, is free only in public universities.

On average, a Brazilian student spends 6.9 years at school, which is not enough to complete the basic education. Only 22% of the population is able to complete secondary school. This is an extremely poor indicator, since in Argentina, for example, this percentage jumps to 55%. Nowadays, registration at basic education reaches 97% of students between 7 and 17 years old. This percentage decreases considerably for secondary education. Only 9% of adults complete a post-secondary (college) program.

Brazil also has a poor indicator when it comes to illiteracy rates. In 2007, 14.1 million people were illiterate. The country is behind almost all the countries in Latin America and even behind several other emerging markets.

Figure 10: Illiteracy Rates 2007 % of total population

34.0

12.0 10.4 10.0 9.3 7.3 7.2 6.7 5.4 4.8 3.5 1.1 1.0 0.5 0.2 0.00.05.0

10.015.020.025.030.035.040.0

India

Sout

h Af

rica

Peru

Braz

il

Boliv

ia

Colom

bia

Mex

ico

China

Para

guay

Vene

zuela

Chile

Italy US

Russ

ia

Cuba

Geor

gia

Source: UN – UNDP.

Although the illiteracy rate is high, it has fallen consistently over the last 50 years. In 1960, 45% of the population did not attend school and consequently did not know how to read. This rate is continuously falling, and in 2007 the illiteracy rate was 10%, the lowest percentage ever.

9



Figure 11: Illiteracy Rate in Brazil %

45.0

33.0

25.019.0

14.7 13.8 13.3 12.4 11.8 11.6 11.4 11.0 10.4 10.0

0.0

10.0

20.0

30.0

40.0

50.0

1960 1970 1980 1991 1997 1998 1999 2001 2002 2003 2004 2005 2006 2007 Source: IBGE.

According to the OECD, Brazil spends US$1,550 per student per year on basic education. As can be seen in the figure below, this amount is far from the OECD average (US$7,283).

Figure 12: Education Expenditure per Student In Equivalent US$ converted using PPPs

02 5005 0007 500

10 00012 50015 000

Luxe

mbo

urg

Switz

erlan

d No

rway US

Aust

riaDe

nmar

kIc

eland UK Italy

Swed

enNe

ther

lands

Belgi

umCa

nada

Sl

oven

iaFr

ance

Japa

nAu

stra

liaIre

land

Spain

Germ

any

Finla

ndKo

rea

Portu

gal

Isra

elCz

ech

Hung

ary

Esto

niaPo

land

Slov

akRu

ssia

Chile

Mex

icoBr

azil

Turk

ey

OECD Average

Source: OECD.

The weak results observed in education indicators seem not to be in line with government expenses in the sector. In 2007 Brazil spent 5.1% of its GDP on education (primary, secondary and higher levels). Compared to other countries, this percentage is reasonable. In 2007, Chile spent 3.4% of its GDP on education and Argentina 3.8%. So why hasn’t education in Brazil reached international standards? The problem is that the government spends so much on students that are in higher education (university) that it has few resources left for students in the primary and secondary education. In 2008, while the public sector spent R$25,000 per student per year in basic education (which lasts 9 years), it spent almost R$60,000 per student per year enrolled in college education (which typically lasts 4 years).

Table 5: Education Expenses (2006) Total investment in education as a % of GDP

Year Primary Secondary Higher 2000 2.7 0.6 0.9 2007 3.1 0.7 0.8

Total Investment in Education per Student (in R$) Year Primary Secondary Higher 2000 11,032 3,971 61,363 2007 22,073 5,511 55,445 2008 25,587 6,366 59,050

Source: INEP/MEC.

Only 18.7% of the population between 17 and 24 years old has access to higher education, and among these students only 27% are in a public university. In Argentina 75% of the college students attend public university and in Mexico 66%.

Income Distribution

One of Brazil’s greatest problems is the distribution of incomes among the population. The country ranks poorly in international comparisons as one of the countries with the highest income inequalities in the world. According to the Gini coefficient, which measures income distribution in the population and is one of the most used inequality measures – zero means perfect equality and one perfect inequality – Brazil has always been among the worst performers, reaching in 2007 the 113th position among 123 countries..

Table 6: Gini Coefficient (2007) Country Gini 2007

1 Denmark 0.232 2 Sweden 0.25 3 Slovenia 0.258 4 Norway 0.258 5 Bosnia and Herzegovina 0.262 7 France 0.267

11 Germany 0.283 23 European Union 0.316 50 India 0.368 69 Russia 0.405 91 Mexico 0.461 94 China 0.469 99 Argentina 0.483 111 Chile 0.549 113 Brazil 0.567 115 South Africa 0.578

Source: CIA World Factbook.

10



In the last four decades of the 20th century (1960-2000), Brazil showed very little evolution in terms of wealth distribution. The first signs of improvement started in the beginning of the 21st century, when the country was able to align economic growth with inequality reduction, mostly due to a more stable macro environment. Indeed, income inequality has been declining sharply and continuously. Still, in spite of this important decline, at the current rate of improvement it would take more than 20 years for Brazil to achieve a level similar to those countries with high development.

Between 2001 and 2009, the level of inequality in Brazil declined 8.4%, moving from 0.593 to 0.538. Comparing this with other countries, one can say that the rhythm of this movement is relatively accelerated since only one quarter of the countries measured were able to reduce their inequalities quicker than Brazil.

Figure 13: Gini Evolution in Brazil

0.5300.5400.5500.5600.5700.5800.5900.6000.610

1995 1996 1997 1998 1999 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: IPEA.

One interesting thing to analyze is the distribution of Brazil’s income according to income brackets. The share of total income owned by the richest 1% of the population is almost the same as the share owned by the poorest 50%. Moreover, the richest 10% own more than 40% of the country’s income, while the poorest 50% own only 15%. The graph below makes clear why nearly 90% of the world is still showing less concentrated income distribution than Brazil.

Figure 14: Income distribution (2009) %

12.2%

30.7%

41.8%

15.5%

0%

20%

40%

60%

80%

100%

Richest 1% Follow ing 9% Follow ing 40% Poorest 50% Total Source: IPEA.

The main poverty reduction programs The Bolsa Família program: Created in 2003, Bolsa Família is nowadays the largest conditional cash transfer program in the world, serving more than 12 million families, or around 50 million people, in the country. The program includes the lowest-income social groups, with household per capita income up to R$140. Its focus is on initiatives in education, health, hunger and social developments. The value received by each family varies between R$22 (basic benefit per child) and R$200 per month (basic allowance of R$68 for families with under R$70 in income plus 5 children – see table below), depending on the family income and the number and the age of their children. The basic benefit of R$68 is paid to families with income of up to R$70 per capita, even if they have no children.

Table 7: Bolsa Família Benefits (values as of 2010) Number of Children Monthly Benefit by Income Segment

Until 15 years old

From 16 to 17 years old

Until R$70 per capita

From R$70 to R$140 per capita

0 0 R$ 68.00 - 1 0 R$ 90.00 R$ 22.00 2 0 R$ 112.00 R$ 44.00 3 0 R$ 134.00 R$ 66.00 0 1 R$ 101.00 R$ 33.00 1 1 R$ 123.00 R$ 55.00 2 1 R$ 145.00 R$ 77.00 3 1 R$ 167.00 R$ 99.00 0 2 R$ 134.00 R$ 66.00 1 2 R$ 156.00 R$ 88.00 2 2 R$ 178.00 R$ 110.00 3 2 R$ 200.00 R$ 132.00

Source: Ministerio do Desenvolvimento Social e Combate a Fome.

The Bolsa Família Program is a conditional cash transfer program, which means that to receive the benefit the families must fulfill certain conditions imposed by the government, such as immunization monitoring and school attendance. Children between 6 and 15 years of age must be properly enrolled at school and attending at least 85% of the classes. If the family disobeys any condition five consecutive times, its benefit is canceled.

The volume of benefits disbursed by the federal government to support the Bolsa Família programs was R$3.4 billion in 2003 and R$13.4 billion in 2010, or 0.8% of the GDP, with further growth likely for the next few years. The program covers all the regions in Brazil

11



but is concentrated most heavily in the poorest territories of the country, especially the Northeast.

Benefício de Prestação Continuada program (BPC): Together with Bolsa Família, the BPC is one of the most important programs of cash transfer in Brazil. BPC is responsible for assuring one monthly minimum wage, to the elderly and disabled, who belong to families with a per capita income under one quarter of the minimum wage per month. Since its implementation in 1996, the program has increased the number of recipients, reaching 3.4 million families in 2009.

The New Middle Class

In Brazil it is very common to use a letter to indicate a particular socioeconomic segment. Class A refers to the richest sectors of the population, while class E refers to the poorest. A household is classified in one or another economic “class” depending mostly on its total income. For example, households that are considered class C in Brazil (middle income) have monthly earnings between R$1126 and R$4854 a month.

Table 8: Economic Classes: household earnings per month R$

Minimum Maximum Class E 0 705 Class D 705 1126 Class C 1126 4854 Class B 4854 6329 Class A 6329

Source: CPS – FGV.

One of the great transformations that has taken place in Brazil since 2003 is the formation of a middle class. In the 1980s and 1990s, it was common to say that Brazil was a country of extremes, that people were either rich or poor as the middle class lacked critical mass. Since then, however, the middle class has been growing and today constitutes the majority of the Brazilian population. Indeed, from 2003 to 2009, the middle-income segment (class C) increased by 44%, according to the Centro de Pesquisas Sociais of FGV.

Table 9: Distribution of Economic Classes % of total population

2003 2004 2005 2006 2007 2008 2009 Class E 28.1% 25.4% 22.8% 19.3% 18.3% 16.0% 15.3% Class D 26.7% 27.2% 27.1% 26.3% 25.1% 24.4% 23.6% Class C 37.6% 39.7% 41.8% 44.9% 46.9% 49.2% 50.4% Class B 4.0% 4.0% 4.2% 4.7% 5.0% 5.3% 5.5% Class A 3.6% 3.7% 4.1% 4.7% 4.7% 5.1% 5.1%

Source: CPS - FGV

Main characteristics of “The New Middle Class” According to CPS – FGV (see “The New Middle Class: The Bright Side of the Poor,” coordination by Marcelo Neri), 35% of the new middle class is composed of retirees and about 23% of people who are registered workers. Public sector workers make up 7% of the middle class, while people in the informal market makes up about 18.6%. The research mentioned above indicates that in 2009, 33.9% of class C had a computer with internet connection and 86.2% had a mobile phone. The middle class has an average of 7.18 years of education, while 10.5% is in or has been to college. In terms of basic utility services, 57.8% of class C has access to sewage and 87.5% benefit from daily garbage collection. More details are in the table below.

Table 10: Access to Goods and Services of Different Economic Segments % of total

Class A+B Class C Class D Class E Computer with Internet Access

76 34 10 7

Mobile Phone 96 86 77 63 Average years of schooling

12 7 5 5

College (Post - Secondary) Education

48 10 2 2

Sewage 72 58 40 31 Daily Garbage Collection 92 87 77 64 Laundry Machine 86 53 25 16 Refrigerator 100 97 93 80 Television 100 98 96 91 Freezer 36 18 8 6

Source: CPS – FGV.

Security

Security in Brazil has been an important theme, mainly because the country is about to host two mega sporting events that will draw a great number of tourists. The worries about security are perfectly justified when we look to the country’s background. In the last few years alone, two important events called the authorities’

12



attention to the security situation: the PCC attack in 2006 in São Paulo and the recent “war” against drug trafficking in Rio de Janeiro.

According to the World Economic Forum (2009), Brazil figures among the countries with the worst security indexes in the world. By all indicators, the country is poorly ranked and below the world average. Within 133 countries, Brazil was ranked 89th in reliability of police services, 111th in organized crime and 118th in business costs of crime and violence.

The figure below registers the number of homicides per 100,000 inhabitants. Once more, Brazil figures among the countries with the worst statistics. The homicide rate has been steadily declining, but it is still above 20 homicides per 100,000 people, placing the country in the top 20 by homicide rate.

Figure 15: Homicide Rate per 100,000 People (2009)

48.0

35.0 34.025.2

15.0 14.9 11.05.5 5.0 1.7 1.4 1.3 1.2 0.9 0.4

0.010.020.030.040.050.060.0

Vene

zuela

Colom

bia

Sout

h Af

rica

Braz

il

Mex

ico

Russ

ia

Peru

Arge

ntina US

Chile

Hung

ary

UK

Aust

ralia

Germ

any

Sing

apor

e

Source: J.P. Morgan. * Brazil data as of 2007.

In 2010, estimates show that there were around 470,000 prisoners in Brazil. According to a study by the University of Rio de Janeiro (UERJ) and based on information from the Justice Ministry, from 2000 to 2007 the number of prisoners in Brazil increased by more than 80%, from 232,755 in 2000 to 422,590 in 2007. The deficit in the penitentiary system is also increasing. In 2007 the Brazilian penitentiary system was short room for 117,000 prisoners, generating an enormous problem of overcrowding in the prisons.

Figure 16: Penitentiary System Deficit

62,293

60,714

116,844

103,433

90,360

50,000

70,000

90,000

110,000

2003 2004 2005 2006 2007 Source: Ministerio da Justiça.

Security investments: As can be seen in the figure below, public security investment has evolved significantly since 2000. In 10 years, investments increased by almost 350% and were expected to reach R$3.4 billion at the end of 2010.

Figure 17: Evolution of Public Security Investments R$ Billion

0.81.2

0.9 1.0 1.1 1.2 1.4

2.02.5 2.5

3.4

0.00.51.01.52.02.53.03.54.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010f Source: Ministerio da Justiça.

The number of personnel in the police is growing but not at the same pace as the population. In 2003 there was one security enforcement person for every 310 inhabitants. This number increased to 1 for 315 in 2007. The security personnel contingent was almost 600,000 people in 2007, including civil and military police and firefighters, up 5.3% from 2003. The civil police are responsible for investigating crimes such as murder, kidnapping, etc. The military police make sure that order is maintained by patrolling the streets, bringing suspects to the police station, etc. In addition to those, the federal police is also an arm of the security services, responsible for federal crime issues such as arms and drug smuggling, border control, crimes against the financial system, etc. The federal police force is also growing. In 2009, it reached 14,136, being 11,346 police officers and 2,790 administrative posts. This represents an increase of 51% compared to 2003.

Figure 18: Federal Police Personnel Units

6000

8000

10000

12000

14000

16000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Mapa de Controle de Lotação SLM/DRH/CRH/DGP.

Regarding the penitentiary system, according to the justice ministry, in 2003-2009, a total of R$1.02 billion was invested in the construction of 97 prisons,

13



expansion of 14 and refurbishment of 23. 12% of this amount was invested in new security equipment. But once again, it is important to highlight that the investments are not accompanying the increasing number of prisoners, since the deficit of vacancies in the penitentiaries has only widened.

Tourism

Despite all its natural beauty and its huge and diversified territory, Brazil is not among the 30 most visited countries in the world. One of the reasons for the low international demand could be the distance between Brazil and core tourism centers. In addition, issues such as safety and security, lack of infrastructure and skilled labor also contribute to low tourism penetration in the country. Lately, one would have to think that the strong BRL has been an inhibitor of tourism in Brazil. Still, even with the low numbers of international tourists in Brazil, the country’s assessment is positive: 92% of tourists who come to Brazil leave intending to come back (according to Embratur).

The situation of tourism in Brazil has gradually improved. From 2002 until 2008, the flow of tourists to Brazil increased by 33.6%. In the same period, the growth of international tourism in the world was 31%. The country had 4.8 million visitors in 2009, ranking as the fourth-largest tourist destination in the Americas and the main destination in South America.

Figure 19: Tourist Arrivals in Brazil Million

3.784.13

4.795.36 5.02 5.03 5.05 4.8

0

1

2

3

4

5

6

2002 2003 2004 2005 2006 2007 2008 2009 Source: Ministério do Turismo.

The greatest part of foreigner tourists visiting Brazil in 2008 came from South America (41.0%) – mainly from Argentina and Chile. Europeans represented 35.2%, coming especially from Italy and Germany, and North Americans account for 15.2% of the international tourism in Brazil.

Below we see Brazil’s main regions in terms of tourism. Rio de Janeiro is the foreigner’s favorite destination

while Bahia (on the Northeast cost) is the preferred destination for domestic tourists, especially during Carnival. São Paulo is the business and financial center receiving the most of the people who come to Brazil for business reasons or commercial events. Among the most popular destinations are also the Amazon rain forest, the Pantanal in the Midwest region and the country’s capital, Brasilia, famous for its complex and innovative architecture.

Figure 20: Main Travel Destinations

Northeast Coast

Amazônia

Pantanal

Rio de Janeiro

São Paulo - Business

Brasilia

Northeast Coast

Amazônia

Pantanal

Rio de Janeiro

São Paulo - Business

Brasilia

Source: IBGE; J.P. Morgan.

Brazil is ranked 45th in the overall tourism & travel competitiveness index and 5th among American countries, behind Canada, the US, Barbados and Costa Rica. Since 2007 the country has improved 14 places, and the outlook is positive, mainly due to the World Cup (2014) and Olympic Games (2016), which should boost tourism in the region. The most competitive countries in terms of tourism are Switzerland, Austria and Germany, holding the first, second and third positions, respectively, for three years in a row.

14



Table 11: Travel & Tourism Competitiveness Index 2007 2008 2009

Switzerland 1º 1º 1º Austria 2º 2º 2º Germany 3º 3º 3º France 12º 10º 4º Canada 7º 9º 5º Spain 15º 5º 6º Sweden 17º 8º 7º US 5º 7º 8º Australia 13º 4º 9º Singapore 8º 16º 10º

Brazil 59º 49º 45º

Source: World Economic Forum.

The overall index is the result of a combination of three subindexes: (1) regulatory framework, (2) business environment and infrastructure, and (3) human cultural and natural resources. Brazil’s overall classification is marked by extreme results, sometimes positive but sometimes extremely negative.

Competitive advantages: The country is ranked 2nd out of all the countries for its natural resources and 14th for its cultural resources, with a great portion of protected land area and the most diverse fauna in the world.

Competitive disadvantages: Unfortunately, in terms infrastructure Brazil remains underdeveloped, with the quality of roads, ports, railroads and air transport ranked 110th, 123rd, 86th and 101st, respectively. Safety and security continue to be of serious concern, with Brazil ranked 130th out of 133 countries. Another key point is the lack of price competitiveness, attributed in part to the extent and effect of taxation, in terms of which Brazil is classified the worst in the world (133rd).

Table 12: T&T Competitiveness Index Breakdown (2009) Categories Rank Overall Index 45 Regulatory framework 95 Policy rules and regulations 94 Environmental sustaintability 33 Safety and security 130 Health and hygiene 80 Prioritization of travel and tourism 84 Business environment and infrastructure 69 Air transport infrastructure 46 Ground transport infrastructure 110 Tourism infrastructure 45 ICT infrastructure 60 Price competitiveness in T&T industry 91 Human, cultural and natural resources 4 Human resources 55 Affinity for travel & tourism 108 Natural resources 2 Cultural resources 14


Competitiveness

Brazil ranked 56th out of 133 countries in the 2010 World Economic Forum (WEF) Global Competitiveness Index. Since 2007 the country has started to see its competitiveness improving, and compared to the 2009 ranking, Brazil is up 8 places. Switzerland leads the ranking as the most competitive economy in the world, followed by the US, which fell one position due to the financial crisis. Among LatAm countries only Chile, occupying the 30th position, is ahead of Brazil.

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Table 13: Global Competitiveness Index (GCI) – 2009-2010 Rank Country Change (Comparing to

2008)

1 Switzerland +1 2 US -1 3 Singapore +2 4 Sweden 0 5 Denamark -2 7 Germany 0 8 Japan +1 13 UK -1 16 France 0 29 China +1 30 Chile -2 45 South Africa 0 48 Italy +1 49 India +1 56 Brazil +8 60 Mexico 0 63 Russia -12 65 Uruguay +10 85 Argentina +3


The overall index is composed of 3 subindexes: a) basic requirements, b) efficiency, c) innovation and sophistication. Analyzing the breakdown it can be clearly noted that Brazil’s shortcomings are concentrated in basic requirements. In all items of this category the country scores worse than the world average. The institutional environment (93rd), macroeconomic stability (109th) and the efficiency of the labor market (80th) continue to be poorly assessed. The education system at all levels remains in serious need of upgrading; in fact, the quality of Brazilian primary education occupies the 119th position among 133 countries.

Another important matter that is still pushing Brazil’s overall index down is taxation. Brazil is known as one of the countries with the most complicated tax systems in the world. The World Economic Forum shows that the extent and effect of taxation was ranked at the 133rd position, which means, the worst in the world.

Also poorly ranked were items correlated with bureaucracy, which compromised market efficiency. The number of procedures required to start a business was ranked 126th and time required to start a business was ranked 128th.

When it comes to business sophistication (32nd) and innovation (43rd) Brazil scores better than average. Brazil is also the 10th-largest market in the world, which is certainly one of the main competitive strengths of the country. Regarding financial market sophistication (51st), Brazil showed good bank soundness (10th) and was also well ranked in regulation of security exchanges (10th).

Despite the efforts made by the country and the improvements of the last two decades, the World Economic Forum still considers Brazil a poorly developed country in terms of macroeconomic stability. In 2008 Brazil was ranked 122nd and in 2009 improved 13 positions, ranking 109th out of 133 countries.

Table 14: Brazil’s classification breakdown Indicator rank/133

Overall Index 56 Basic Requirements 91 Institutions 93 Infrastructure 74 Macroeconomic stability 109 Health and primary education 79 Efficient Enhances 42 Higher education and training 58 Goods market efficiency 99 Labor market efficiency 80 Financial market sophistication 51 Technological readiness 46 Market size 10 Innovation and Sophistication Factors 38 Business sophistication 32 Innovation 43


The survey also highlights the most problematic factors for doing business. In Brazil almost 20% of the respondents pointed to tax regulation as the largest constraint for doing business. In second place came tax rates (18.5%), followed by restrictive labor regulation (14%)

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Figure 21: The most problematic factors in doing business %

0 2 4 6 8 10 12 14 16 18 20

InflationPolicy instability

Inadequately educated w orkforceCorruption

Inadequate suply of infrastructureAccess to financing

Inefficient gov ernment bureaucracyRestrictiv e labor regulations

Tax ratesTax regulations


Regarding the infrastructure pillar a lot of improvement is likely to be seen, especially for a country that is scheduled to host two mega sporting events (the World Cup in 2014 and the Olympic Games in 2016). Brazil is poorly developed in all infrastructure categories. A particular concern is quality of ports (127th), roads (106th) and air transportation (89th). A movement toward upgrading and extending networks can already be seen, but a lot should be done to reach a competitive standard. Brazil’s low rank at 74th puts the country behind not only the Latin American but also the BRIC regional average.

Table 15: Infrastructure breakdown Infrastructure rank/133 Quality of overall infrastructure 81 Quality of roads 106 Quality of railroad infrastructure 86 Quality of port infrastructure 127 Quality of air transport infrastructure 89 Avaliable seat kilometers 12 Quality of electricity supply 55 Telephone lines 61


Economic Activity

GDP

According to the IMF, the Brazilian economy is the eighth largest in the world by nominal GDP, the second largest in the Western hemisphere (behind the US) and the largest in Latin America. In 2009 the country’s nominal GDP reached US$1.57 trillion, or R$3.1 trillion. The prospects for the Brazilian economy are positive, and in 2011 the country should surpass Italy to become the 7th-largest economy in the world.

Table 16: 2010 Nominal GDP US$ Billion, estimated

Country Nominal GDP 1 US 14,624.2 2 China 5,745.1 3 Japan 5,390.9 4 Germany 3,305.9 5 France 2,555.4 6 UK 2,258.6 7 Italy 2,036.7 8 Brazil 2,023.5 9 Canada 1,563.6

10 Russia 1,476.9 11 India 1,430.0 12 Spain 1,374.8 13 Australia 1,219.7 14 Mexico 1,004.0 15 Korea 986.256

Source: IMF.

In 2009, real GDP reached -0.6%, interrupting a sequence of robust growth (average of 4.8% from 2004 to 2008). The negative result was mostly a consequence of the 2008 crisis. Still, Brazil has shown significant powers of recovery, and GDP grew by 7.5% in 2010, the strongest in almost two decades. For 2011, J.P. Morgan forecasts that GDP will reach 4.0%. Our economists also assume that Brazilian potential growth is around 4.0%, which is higher than Latin America average at 3.6%.

The performance of the economy in the last 15 years can be divided into two main periods. First came the Fernando Henrique Cardoso administration (1995-2002) and second, the Lula administration (2003-2010). Both presidents stayed in the post for eight years, or two consecutive mandates.

In the first period, the country was passing through several adjustments, in order to stabilize the economy and regain international credibility. As a Finance Minister, even before his first mandate (1995-1998), Fernando Henrique Cardoso created and implemented the Real Plan, finally controlling the hyperinflation that had characterized Brazil for the better part of the past 15 years. His administration also conducted several structural reforms, including a deeper privatization initiative of state-owned companies. Cardoso’s second mandate (1998-2002) was marked by several crises, starting with Russia, culminating in the BRL

17



devaluation of January 1999, the energy rationing of 2001 and the great instability caused by uncertainties related to Luis Inácio Lula da Silva’s (Lula) election in 2002. It was during this time that fiscal policy was taken more seriously, and the economic team of the time implemented the so called macroeconomic “tripod” that is in place right now: a floating exchange rate, fiscal responsibility and the inflation-targeting regime. Average growth during the Cardoso years was modest, averaging 2.3% per year.

In the second period, with the economy stabilized, the country had concrete opportunities to grow. During President Lula’s administration, the average growth was 4.0% per year and if not for the 2008 crisis, this number could have been higher. The economic success of the Lula administration was in great part due to the maintenance of the economic stability pillars implemented during the Cardoso years.

Figure 22: Brazilian GDP Growth % oya

-3.0

0.0

3.0

6.0

9.0

12.0

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Lula's AdministrationAv erage: 4.0%FHC's Administration

Av erage: 2.3%

Source: IBGE.

Despite stronger economic growth in the last few years, Brazil has been growing below the emerging market average: Asia, led by China and its constant double-digit growth rates, is mainly responsible for Brazil’s difficult comparisons. From 2004 to 2008, Brazil’s average GDP growth was 4.8%, while the emerging market average was 7.3%.

Figure 23: Economic Growth: Brazil vs. EM vs. G-7 % oya

5.7

3.2 4.06.1

5.2

-0.6

7.5

4.0

7.5 7.3 8.2 6.0

2.5

7.1 6.4

2.9 2.4 2.6 2.1-0.1

2.02.5

-3.5-4.5-2.5-0.51.53.55.57.5

2004 2005 2006 2007 2008 2009 2010* 2011*

Brazil EM G-7

Source: IMF; IBGE.

Compared to that of other Latin America countries, Brazilian growth has not been that strong. From 2003 to 2009 Latin America countries have grown on average 4.6%, while in the same period, Brazilian average has reached only 3.5%. Indeed, Brazil had one of the worst performances, only ahead of Paraguay and Mexico. In the period mentioned the country with the strongest growth was Argentina (7.4%), followed by Peru (6.2%).

Figure 24: Latin America GDP Average Growth 2003-2009

7.46.2 5.8 5.3

4.6 4.6 4.3 3.8

1.73.33.5

012345678

Arge

ntina

Peru

Vene

zuela

Urug

uay

Colom

bia

Ecua

dor

Boliv

ia

Chile

Braz

il

Para

guay

Mex

ico

Source: IMF.

GDP breakdown 2010 – Growth per sector: With growth of 7.5% in 2010, the best since 1986, all sectors registered hefty growth rates that were helped by easy comparisons. On the supply side, the highlight was mineral extraction, with a gain of 15.7%. Other activities that registered double-digit growth were manufacturing, civil construction, commerce and finance.

Table 17: Real GDP Growth – Supply Side Y/Y % Change

2008 2009 2010Agriculture 6.1% -4.6% 6.5%Industry 4.1% -6.4% 10.1% Mineral Extraction 3.5% -1.1% 15.7% Manufacturing 3.0% -8.2% 9.7% Civil Construction 7.9% -6.3% 11.6% Utilities 4.5% -2.6% 7.8%Total Services 4.9% 2.2% 5.4% Commerce 6.1% -1.8% 10.7% Transportation 7.0% -2.5% 8.9% Information Services 8.8% 3.8% 3.8% Financial Activities 12.6% 7.1% 10.7% Other Services 4.3% 3.5% 3.6%Real Estate Rental 1.8% 1.9% 1.7%Health & Education 0.9% 3.3% 2.3%GDP 5.2% -0.6% 7.5%

Source: IBGE.

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More important, on the demand side, growth of fixed capital formation (investment) was the highlight, with gains of 22% in 2010 helping to add to the share of investment in the overall economy. Still, we note that household consumption has also been a very strong force behind GDP expansion, gaining 7% in 2010. A strong economy combined with a strong exchange rate led to a 36% increase in imports, while exports gained on the back of rising commodity prices. For 2011, the economy is expected to decelerate to 4.0%, but household consumption is still robust, with expected gains of 5.8%. Although investments will decelerate, forecast gains of 9.3% are healthy considering the very strong base of comparison. Note that J.P. Morgan forecasts that the balance of external transactions will be halved, coming from a deficit of 2.8% in 2010 to a deficit of 1.4% in 2011.

Table 18: Real GDP Growth – Demand Side Y/Y % Change

1995 - 2006 2008 2009 2010 2011f GDP at market prices 2.6 5.2 -0.6 7.5 4 Household Consumption

2.6 3.8 4.2 7.1 5.8

Government Consumption

1.9 4.1 3.9 3.4 3.3

Gross Fixed Capital Formation

1.6 9.1 -10.3 22.5 9.3

Exports 7.7 15.3 -10.2 11.7 6.7 Imports 5.1 13.3 -11.5 36.6 15.6 Net Exports -1.8 1.4 -2.8 -1.4 Domestic Absortion 6.9 -2.1 10.3 5.4

Source: J.P. Morgan Economics.

GDP composition: Looking at GDP composition (weight), household consumption is the main component on the demand side. This is not news, as in the last two decades household consumption has been responsible for around 60% of the country’s GDP. Government consumption is the second most representative component, accounting for more than 20% of GDP. Fixed capital formation in Brazil has been the subject of important discussions. Investments have been accounting for around 18% of GDP, which is a modest number, especially compared to other countries’. On the external accounts side, there is significant variation in terms of export and import contributions. Exports were very weak in the period of the fixed exchange rate, accounting for about 8% of GDP, while imports at that time were hovering around 9.5% of GDP. This relationship was reversed when the BRL was devalued in 2001. Exports started to recover and got a share of about 15% of GDP. Lately, the strong

FX is reducing the share of exports, which is around 11% of GDP while imports are slightly more (12%).

Figure 25: GDP Components by Expenditure (Demand Side) % of total GDP (2010)

60.6%

21.2% 18.4%11.20%

-12.1%

0.80%

-20%

0%

20%

40%

60%

80%

HouseholdConsumption

Gov ernmentConsumption

Fix ed CapitalFormation

Ex ports Imports Inv entoryChange

Source: IBGE.

On the supply side of GDP, among the productive sectors, the highlight has been services. The sector accounts for 57.5% of GDP, with health & education (14%) and commerce (10%) the most representative kinds of service (a category entitled “other services” has a 12.6% share). Industry comes second, at 22.9% of GDP, with manufacturing (13.4%) the most important activity, followed by civil construction (4.5%). Taxes account for around 15% of GDP, and agriculture has the smallest participation, representing only 5% of GDP.

Figure 26: GDP Components by Sector (Supply Side) % of total GDP, average of the last 4 quarters until 3Q2010

Industry - 22% Serv ices - 58%

Tax es - 15%

Agriculture - 5%

Source: IBGE.

Per capita GDP Per capita GDP reached R$19K in 2009, or US$10.8K. This represented an important increase from the levels observed in 2009, as a result both of higher nominal growth (15.5%) and of a 12% appreciation of the exchange rate.

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Figure 27: GDP per Capita USD and BRL

34724849 5209 5320 5077

3186 2861 3097 3665 4812 58677283

8706 834810814

37663477

0300060009000

120001500018000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

In USD In BRL Source: Banco Central do Brasil.

Regional GDP Brazil’s GDP has a particular characteristic: more than a half of it is concentrated in the Southeast region (56%), where São Paulo, Rio de Janeiro and Minas Gerais are located. Despite occupying only 10.8% of Brazil’s territory, the region hosts a great part of the country’s economic activity. The level of industrialization in the Southeast can be compared to that of some developed countries, and the region also has the most advanced agriculture in Brazil. Furthermore, it boasts the largest transportation fleet, the most schools, the best hospitals and medical care, among others.

Figure 28: Regional Participation in Brazilian GDP (2008) %

Southeast 56%

Midw est 9%

South 17%

Northeast 13%

North 5%

Source: IBGE.

Conversely, the region responsible for the lowest share of GDP is the North. Although it has the largest territory extension (if it was a country it would be the seventh-largest country in the world), it has the lowest population density, which means that a great part of the territory is unoccupied. Its economic activity is limited, and tourism is an important source of the region’s income.

São Paulo, Brazil’s engine: When it comes to economy and industry, São Paulo is the most important state in Brazil. With more than 40 million inhabitants, the state is not only the most populous in the country but also the richest. It has more than 156 inhabitants per square

kilometer and is responsible for one third of the country’s GDP, or over R$1 trillion in 2008. The state’s economy is very diversified, with the important presence of the following activities: sugar, oranges, coffee, autos, metals, airplane construction (it is the headquarter of Embraer), financial services, among others.

Table 19: Real GDP Growth per Region %oya

2006 2007 2008 North 4.7% 3.8% 4.8% Northeast 4.8% 4.8% 5.5% Southeast 4.0% 6.3% 5.6% South 3.2% 6.4% 3.4% Midwest 2.8% 6.8% 6.0% Brazil 4.0% 6.1% 5.1%

Source: IBGE.

Investments

In 2010, gross fixed capital formation in Brazil was 18.4% of GDP, confirming once more the weak profile of the country’s investment. As seen in the figure below, Brazil had the third-lowest fixed investment level in EM as of 2009. Compared to the other BRIC economies, Brazil is again the laggard, behind China, India and Russia, with 44.8%, 34.5% and 22.7%, respectively.

Figure 29: Emerging Markets Gross Fixed Capital Formation % of GDP (As of 2009)

44.834.5

27.8 25.2 24.5 23.9 23.2 22.7 21.5 19.8 19.4 19.3 18.7 16.6 14.9 13.7

0.010.020.030.040.050.0

China India

Indo

nesia

Peru

Mex

ico

Mala

ysia

Colom

bia

Russ

ia

Czec

h.Re

publi

c

Polan

d

Egyp

t

Sout

h.Af

rica

Chile

Braz

il

Turk

ey

Philip

pines

Source: World Bank.

During the military period, the investment/GDP ratio used to be higher than the current level, mainly due to industrialization and heavy public sector investment, which put a burden on Brazil’s fiscal accounts. The macroeconomic instability of the 1980s and part of the 1990s curbed productive investment from the private sector at the same time that the public sector capability to invest was constrained by fiscal concerns. Today, the federal government is once more focused on raising Brazil’s investment ratio.

20



Figure 30: Gross Fixed Capital Formation in Brazil % of GDP

15

17

19

21

23

25

27

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Source: World Bank.

The low investment ratio can also be observed in the high levels of capacity at which the economy operates. Except for the 2008 crisis period, when the country’s industry went on a sudden stop, utilization has been operating close to full capacity since 2006.

Figure 31: Capacity Utilization (% of total installed capacity) %

60.0

65.0

70.0

75.0

80.0

85.0

90.0

Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Source: FGV.

PAC

The Programa de Aceleração do Crescimento – PAC – is a federal government program launched in 2007, aiming to accelerate the country’s economic growth through investments in infrastructure, such as housing, transportation, utilities and sanitation. At the time of launching, the government forecast more than R$650 billion in investments between 2007 and 2010. Regarding the origin of the money, the estimates were that 45% would come from state-owned companies, 40% from the private sector and 15% from the national budget. Some of the coordinators of the program’s first phase were current President Dilma Rousseff (Chief of Staff at the time) and current Planning Minister Miriam Belchior.

Figure 32: Public Investment as a % of GDP %

0.3 0.5 0.5 0.6 0.7 0.9 1.0 1.21.1 1.0 1.0 1.0 1.1

1.41.9

2.0

0.00.51.01.52.02.53.03.5

2003 2004 2005 2006 2007 2008 2009 2010f

Federal Gov ernment Public Companies

PAC

Source: 10º Balanço do PAC.

According to PAC’s last release (December 2010) investments already executed (but not concluded) have totaled R$619.0 billion, or 94.1% of the promised amount for 2007-2010. If we consider only the finished (delivered) investments, the result is equivalent to R$444.0 billion, or 67.6% of the estimated original amount.

Table 20: PAC Investments R$ billion Sector Total Estimated Total Concluded % Logistics and Utilities 427.8 225.2 52.6 Housing and Sewage 228.7 218.8 95.7 Total 657.4 444.0 67.5

Source: 11º Balanço do PAC.

PAC 2: The second phase of the growth acceleration program was launched in March 2010, and the government’s original estimates were for investments of around R$1.5 trillion in 6 different areas: PAC Cidade Melhor (investments in sanitation, paving, urban mobility), PAC Comunidade Cidadã (investments in nurseries, pre-schools, community police station and health), PAC Minha Casa, Minha Vida (the government housing program), PAC Água e Luz para Todos (water and electricity for all), PAC Transportes (transportation investments – roads, railroads, ports and airports) and PAC Energia (investments in oil, natural gas, renewable energy and electricity transmission and generation).

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Table 21: PAC 2 Investment Estimates R$ billion Preliminary Estimates 2011-2014 After 2014 Total PAC Cidade Melhor 57.1 - 57.1 PAC Comunidade Cidadã 23.0 - 23.0 PAC Minha Casa, Minha Vida 278.2 - 278.2 PAC Água e Luz para Todos 30.6 - 30.6 PAC Transportes 104.5 4.5 109.0 PAC Energia 461.6 626.9 1088.5 Total 955.0 631.4 1586.4

Source: Federal government.

Minha Casa, Minha Vida (MCMV)

Minha Casa, Minha Vida (Portuguese for my house, my life) is a federal government program which aims to facilitate access to housing for lower-income families and, consequently, to increase the possibility of these families owning their own homes by also granting mortgage subsidies. Created in 2009, the first phase of the program had the goal to construct in two years (2009 and 2010) 1 million properties directed to families with income below 10 minimum wages per month. According to Caixa, MCMV reached its goal in terms of number of units, contracting over 1 million units by the end of 2010. Of these, 57% were directed to families with income under 3 minimum wages.

The MCMV program aims to increase mortgages, adjusting the loan’s installments and the initial down payment to families’ payment capacity. The resources are subsidized by the Union (i.e., the federal government) and FGTS, the workers’ guarantee fund.

Historically, mortgages in Brazil have been pretty low, representing only around 7% of total credit and 3% of GDP at this point. The figure below shows that since the implementation of the MCMV program, credit directed to mortgages increased, coming from 5.2% of total credit in the beginning of 2009 to 8.1% at the end of 2010, and it is still rising in 2011. Indeed, this is the credit category that has grown the most in Brazil, 55.5% in 2010 alone, followed closely by auto loans.

Figure 33: Mortgages as a % of total credit %

4.50%

5.50%

6.50%

7.50%

8.50%

Jan-03 Oct-03 Jul-04 Apr-05 Jan-06 Oct-06 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10 Source: Banco Central do Brasil.

The table below shows the balance of the program through the end of 2010. Analyzed by income segment, the program had a more efficient evolution among the families earning up to 3 minimum wages (MW), with more than 100% of the proposed units contracted. However, in large cities, the target for contracts with the population under 3 MW was not met, with this shortfall compensated by the smaller municipalities.

Table 22: MCMV Breakdown Income Segment Proposed Units Contracted Units % Up to 3 MW 400,000 574,874 57.2 from 3 to 6 MW 400,000 284,079 28.3 from 6 to 10 MW 200,000 146,075 14.5 Total 1,000,000 1,005,028 100.0

Source: Caixa Economica Federal.

Minha Casa, Minha Vida 2: The second phase of MCMV was officially announced at the end of March 2010 as part of the PAC 2 program. Although details are still pending, the program predicts the construction of 2 million houses in 2011-2014. 60% of the houses, or 1.2 million units, are destined for families with income below 3 MW. Another 30% are for families with income from 3 to 6 MW, and the remaining 10% are for families with incomes of 6 to 10 MW. One of the changes introduced in the second phase of MCMV is that the price ceiling for units that qualify for MCMV was raised.

Table 23: Ceiling Price for Units under Minha Casa Minha Vida R$ Thousands

MCMV1 MCMV2 % change Sao Paulo 130 170 30.8% Other Capitals 100 150 50.0% Cities with Population over 250K 80 130 62.5% Cities with Population over 50K 80 100 25.0% Others 80 80 0.0%

Source: J.P. Morgan.

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Controversy surrounded the program in early 2011 as the government announced a budget cut of R$50 billion, which, among other things, cut the projected resources for Minha Casa Minha Vida in 2011. The total budget for MCMV in 2011 had been R$12.7 billion, but it was reduced by R$5 billion. Still, the R$7.6 billion budget for 2011 is R$1 billion higher than the amount budgeted for 2010. When the program was launched (1Q 2010) it was established that the overall budget through 2014 was going to be over R$70 billion.

World Cup 2014, Olympic Games 2016 and other investments

In a few years Brazil will host two mega sporting events: the Soccer World Cup in 2014 and the Olympic Games in 2016. Being the host country of a mega sporting event is a huge challenge, demanding massive investments from both the private and public sectors.

Why is Brazil interested in hosting two mega sporting events? For Brazil the candidacy meant visibility and international recognition for all the economic progress made in the last decade, in the same way that the Olympic Games of 2008 were a stamp of approval for China. The arguments in favor of the events include job creation, increase in the flow of tourism, urban revitalization, investments in infrastructure and more foreign investment. Still, studies show that the effects of a mega sporting event on the host country’s economy are controversial. Some believe that the long-term effects are not that significant and that the expenditures associated with the investments do not bring the expected returns (e.g., Greece). But for most analysts this kind of event suggests significant opportunities to accelerate the country’s economic and social development.

The amount of investments and their destinations are still somewhat nebulous for both events. The government has the challenge to divide its resources among sports infrastructure, urban mobility, ports, airports, hotels, security, telecommunication and the health system. The projects are not 100% defined, and although there are forecasts, the final cost of the events is not at all clear, much less whether it will be met. All in all, the estimate is that the World Cup will demand government investments of R$17 billion, with additional resources coming from the private sector.

Table 24: Government Investment Plan – World Cup R$ Million

Host City Loans (Caixa/

BNDES)

Investment Total % of Total

Belo Horizonte - MG 1,323.3 1,033.4 2,356.7 10.0

Brasilía - DF 761.0 1,096.7 1,857.7 7.9

Cuiabá - MT 784.7 238.2 1,022.9 4.3

Curitiba - PR 465.6 124.8 703.4 3.0

Fortaleza - CE 814.4 756.0 1,570.4 6.7

Manaus - AM 1,175.0 1,293.7 2,468.7 10.5

Natal - RN 611.5 780.2 1,391.7 5.9

Porto Alegre - RS 456.2 382.3 968.5 4.1

Recife - PE 1,045.1 238.1 1,283.2 5.4

Rio de Janeiro - RJ 1,590.0 1,621.3 3,211.3 13.6

Salvador - BA 941.8 298.7 1,240.5 5.3

São Paulo - SP 1,482.0 3,924.6 5,496.6 23.3

Total 11,450.6 11,788.0 23,571.6 100.0

Source: Portal da Transparência.

The World Cup in Brazil is going to take place in 12 different capitals (listed above), located in Brazil’s five regions, demanding an efficient transportation infrastructure, among other things. The country plans to spend R$11.4 billion on transportation and R$5.7 billion on stadiums. Regarding the stadiums, none existing meets FIFA standards, meaning that they will either be built from scratch (Sao Paulo, for example) or undergo extensive renovations (Rio de Janeiro). Resources for stadiums are around US$2.7 billion.

Table 25: World Cup Investments (Public and Private) Sector Urban Mobility US$4.4 Billion Stadiums US$2.7 Billion Hotels US$556 Million Airports US$3.1 Billion Ports US$441 Million TOTAL US$13.2 billion

Source: Government estimates.

The Summer Olympic Games in 2016 are going to take place only in Rio de Janeiro, thus concentrating expenditures in one city only. Despite all the investments made for the World Cup, the city will receive an additional R$12 billion from the public sector to finance investments in some strategic areas.

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Initially the government is planning to focus on the transportation sector, directing 60% of the available funding to this industry. Accommodations, another critical sector, will receive R$2.6 billion, or 20% of the government’s projected total investment.

Table 26: Public Sector Investments Plan – Olympic Games Sector Investment

(R$ million) %

Accommodations 2,590.50 20.69 Sport Facilities 1,518.40 12.13 Security 471.9 3.77 Technology 477.5 3.81 Transportation 7,460.00 59.59 Total 12,518.30 100

Source: Portal da Transparência.

After all investments and expenditures made by the private and public sectors, the big question mark is: how to take advantage and enjoy all the new infrastructure that is going to be built in Brazil. If the intention is to build a legacy, one must consider the use of the facilities after the event. The country needs to develop infrastructure projects thinking about their economic viability for the future. In this vein, the Pan American Games in Rio de Janeiro in 2007 are not a good example. After the event, some sports facilities were underutilized and abandoned. The event was initially budgeted at R$500 million, but at the end of the day it ended up costing R$3.3 billion, according to the Federal Auditing Court (TCU – Tribunal de Contas da União)

High-speed train: Aiming to supply the super demand faced mainly by air transport, the government is proposing the construction of a high-speed train between Rio and São Paulo. Along a route 511km long, the train should pass through 38 municipalities in the states of São Paulo and Rio de Janeiro. The trip should take 1h33 minutes (nonstop at speeds up to 350km/h. The estimated costs of the investments are very high, reaching R$34 billion (according to a study made by the BNDES).

Figure 34: High Speed Train Total Costs by Sector %

71.1

11.3

9.87.8Civ il Works

Ex propriation and Social-ev ironmental Measures

Sy stems and EquipamentsAcquisition

Undercarriage

Source: BNDES.

There are some international consortiums interested in the project – French, Spanish, Korean and Japanese – but the bidding process keeps being postponed due to lack of definition in terms of financing. In addition, one great concern is the environmental issue, since the train would pass through some complex regions and would require certain special environmental approvals.

Pre-salt: Brazil oil production was 2.1 million boe/d in 2010. Petrobras now wants to increase this production to 3 million boe/d by 2014 (of which 241k boe/d will come from the pre-salt areas) and to 4 million boe/d by 2020 (1,078k boe/d from pre-salt).

Figure 35: Petrobras Domestic Oil and Gas Production Thousands of barrels/day

1500 1540 1493 1684 1778 1792 1855 1971 21002980

3950252 251 265 274 277 273 321 316 384623

1109

0100020003000400050006000

2002 2003 2004 2005 2006 2007 2008 2009 2010E 2014F 2020F

Oil Gas Source: Plano Estratégico Petrobras 2020.

For the production increase, Petrobras has established a capex plan of US$118.8 billion in E&P alone for the period between 2010 and 2014. Of this, US$33 billion will go to pre-salt areas and US$75.2 billion to post-salt. The capex would include exploration, development with production and infrastructure.

24



Table 27: Petrobras Capex 2010-2014 – Distribution by Area US$ bil % of total

Total Capex 224 100 E&P - Exploration and Production 118.8 53.0% Petrochemical 5.1 2.3% Corporate 2.8 1.3% RTC - Refining, Transportation, and Commercialization

73.6 32.9%

Distribution 2.5 1.1% G&E - Gas and Energy 17.8 7.9% Biofuel 3.5 1.6%

Source: Plano Estratégico Petrobras 2020.

Electricity: Large investments are planned for the electricity sector in Brazil over the next few years. EPE – Brazil’s Energy Research Company – forecasts that electricity consumption will grow roughly in line with GDP. Therefore, if no additional energy is supplied, Brazil energy grid risks shortfalls as soon as this year.

Figure 36: Supply-vs-Demand Forecast by EPE In avg TW, alternative sources include: Biomass, wind and small hydro plants

Source: EPE and J.P. Morgan.

According to EPE, the sector will demand R$134 billion in new investments between 2010 and 2019. This is only considering projects that were not yet sold and should be available for future auctions. R$77 billion go to hydro generation, R$31 billion to alternative energy sources and R$26 billion to transmission. Note that this capex estimate does not include the three large hydro plants in the Amazon basin (Belo Monte, Santo Antonio and Jirau), which together should require around R$50 billion.

Industry

Industrial activity in Brazil represents around 23% of the country’s nominal GDP. Looking at its evolution, it can be noted that the share of industrial GDP has been declining over the past few years, with a peak of almost 26% in 2004. This decline can be mostly attributed to a decline in manufacturing activity. It is not a coincidence that this turnaround is happening at the same time that China’s penetration in Brazil is growing

and that the BRL has been appreciating. Still, despite a loss in share, industrial GDP had a very strong performance in 2010, especially in 1H.

Figure 37: Industrial GDP % oya

-8.0%

-3.0%

2.0%

7.0%

12.0%

1993

1995

1997

1999

2001

2003

2005

2007

2009

Source: IBGE.

Industrial activity in Brazil is pretty much concentrated in the Southeast region, mainly in the state of São Paulo. The region is an industrial center marked by diversity and production volume. The industry in the Southeast is technologically more sophisticated than in the other regions and thus attracts a lot of multinational companies, mainly because of its more specialized labor market and its strong consumer market. In the South, industry has an important linkage to agricultural production. The region is also an important producer of intermediate goods, complementing Southeast production. The Northeast industry is more focused on agribusiness. The region has been evolving lately but still suffers from the South-Southeast competition. The industrial activity in the North and Midwest is unimpressive compared to that of the other regions, but investment programs are aiming to improve it.

In 2010, industrial production increased by 10.4% in Brazil, but coming from a very low base, as industry contracted 7.4% in 2009. The 2010 result is the strongest since 1986, but most of the gains were in 1H (16.2% versus 5.6% in 2H). During 2H, industrial production disappointed, and it is widely thought that some of the weakness is due to export-intensive sectors, which have been hampered by the strong exchange rate. Also, a reverse import substitution might be taking place, as the strong FX make import products more attractive than domestic ones amid an environment of strong demand.

25



Figure 38: Industrial Production % oya

-20%-15%-10%-5%0%5%

10%15%20%

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Source: IBGE.

The industrial sectors that stood out in 2010 were vehicles, machinery and equipments, and basic metallurgy, increasing by 24.2%, 24.3% and 17.4%, respectively. The sector that underperformed most was tobacco, decreasing production 8% in 2010.

Capital goods: The capital goods industry did extremely well in 2010, increasing by 21%. This industry was the most affected during the crisis but was also the one with the strongest recovery.

Figure 39: Industrial Production by Category % oya

-8.8 -7.4 -6.4-1.5

20.811.4 10.5 10.3

5.2

-17.4-20-10

010

2030

Capital Goods Intermediate Goods Total Industry ConsumerDurables

Semi and Non-Durables

2009 2010 Source: IBGE.

Consumer goods: We can differentiate the consumer goods production into two main groups: durable goods, and nondurable goods. The figure below shows that durable goods react more aggressively to the economic scenario. When the economy is strong, consumption of durable goods soon starts to boom, encouraged by attractive credit conditions and high levels of consumer confidence. On the other hand, when the economy is passing through a recession period, the production and the consumption of durable goods are strongly affected once consumers prioritize necessary goods (staples/nondurable goods) over durable goods.

This was pretty much what happened in the last three years. The economic crisis decelerated the production of durable goods, but the country’s recovery and the robust environment stimulated the sector, which reached

extremely high levels of production. In the same period, production of nondurable goods stayed practically unchanged, with only moderate oscillations.

Figure 40: Durable vs. Nondurable Goods Production % oya

-40%

-20%

0%

20%

40%

60%

Jan-05 Oct-05 Jul-06 Apr-07 Jan-08 Oct-08 Jul-09 Apr-10

Durable Goods Non-Durable Goods Source: IBGE.

Consumption

Consumption has been a compelling story in Brazil in the last few years. The intensive migration of lower-income Brazilians to the middle-income segments brought to the market more than 30 million potential consumers who are able to buy things that were out of their consumption universe before, especially as they have access to credit. In 2010, retail sales gained 10.9%, ahead of the 5.9% registered in 2009.

Figure 41: Retail Sales % oya, 3MMA, nsa

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Jul-0

9

Jan-

10

Jul-1

0

Source: IBGE.

The positive consumption environment is marked by a low unemployment rate and a constant increase in real wages, which have boosted consumer confidence. Indeed, the consumer confidence index reached record levels in 2010.

26



Figure 42: Consumer Confidence NSA

95.0

100.0105.0

110.0

115.0120.0

125.0

Sep-

05

Jan-

06

May

-06

Sep-

06

Jan-

07

May

-07

Sep-

07

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

Source: FGV.

The consumption of durable goods is booming, stimulated by the facilities offered by the credit market. The figure below shows the commerce activity indicator for furniture, appliance, electronics and computers, which is the basket most positively affected by this consumption boom. The evolution of consumption is clear, since the index more than tripled in ten years.

Figure 43: Consumption of Furniture, Appliance, Electronics and Computers Index Annual Average, volume

100.0 96.3 99.4 114.7137.8

180.9 201.0249.6

295.6333.3

365.4

050

100150200250300350400

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Serasa Experian.

Brasil has one of the largest consumer markets in the world, ranked 9th out of 133 countries by the World Economic Forum.The top five markets by size are the US, China, Japan, India and Germany. Brazil has the largest domestic market in Latin America.

The household ownership of consumer goods is improving, and in 2008 almost 100% of the population had electric energy and 95% had a television. The penetration of personal computers in Brazil is still low, but this number is likely to increase rapidly in the next years as computers become more accessible to the lower-income segments. In 2002 computer penetration was 14.2%, but it had jumped to 31% by 2008.

Figure 44: Household Ownership % of Household

0 10 20 30 40 50 60 70 80 90 100

Electric EnergyOv en

Telev isionRefrigerator

RadioTelephone

Water FilterLaundry

ComputerInternet Access

Freezer

Source: PNAD 2008.

In 2009/2010 there was a very strong advance in the automobile market. In order to stimulate the domestic market after the 2008 crisis, the government reduced the Industrialized Product Tax – the IPI – thus decreasing auto prices and increasing consumption a great deal. The tax incentive ended in 1Q 2010, but even so, auto sales continued to grow, reaching an all-time record in 2010 of over 3 million units. However, even with the recent good performance, Brazil is still a laggard in terms of vehicles per capita. There are 6.9 inhabitants per vehicle in Brazil, while in Mexico there are 4, and in the US there is almost one vehicle per person.

Figure 45: Inhabitants per Vehicle (2008) 6.9

4.74

2.92 1.9 1.7 1.7 1.7 1.6 1.5 1.2

012345678

Braz

il

Arge

ntina

Mex

ico

Sout

h Ko

rea

Polan

d

Germ

any

Japa

n

Fran

ce UK

Spain Ita

ly US

Source: Anfavea.

Consumption allocation: According to a survey conducted by IBGE, called Pesquisa do Orçamento Familiar (POF), the most representative item in the consumption basket of an average family in Brazil is housing. On average 35.9% of total consumption is destined for housing, which encompasses rent, furniture, appliances, water, gas, electricity and taxes. The second main item is food, composing 19.8% of total consumption, followed by transportation, responsible for 19.6% of consumption expenses. These three main items correspond to 75% of total consumption.

The consumption breakdown points to some social weakness that can be observed every day in Brazil. Expenses for education correspond on average to only 3% of total consumption, while in Mexico, for example,

27



this ratio jumps to 9%. The greatest problem in Brazil is the magnitude of the expenses associated with primary necessity items, composing 75% of an ordinary family’s income and leaving only 25% for other expenses.

Table 28: Consumer Spending Breakdown as a % of Total Household Consumption (2008) % Items % Food 19.8 Housing 35.9 Clothing 5.5 Transportation 19.6 Hygiene and Personal Care 2.4 Health Care 7.2 Education 3.0 Culture 2.0 Smoke 0.5 Personal Services 1.1 Other 2.9

Source: POF – IBGE.

Also, it is interesting to note that consumption is allocated differently among the regions. The poorer the region, the higher the share of food consumption in the total expenditure basket, as resources are scarcer.. In the North, for example, food consumption represents 25.8% while in the Midwest this percentage is 17.7% of total household consumption.

Figure 46: Consumption Allocation by Region (2008) %

19.8 25.8 24.2 18.3 18.5 17.7

35.9 33.6 32.8 37.2 35 37.9

19.6 16.5 18.2 19.5 21.9 21.2

24.7 24.1 24.8 25 24.6 23.2

0%

20%

40%

60%

80%

100%

Brazil North Northeast Southeast South Midw est

Food Housing Transportation Others Source: POF – IBGE.

Labor

In 2010 the labor market in Brazil had a very positive performance, perhaps one of the best in the world. In Brazil there are two main job surveys: (1) the household survey is conducted by the IBGE and is a general survey that includes anyone over 10 years of age who has worked in the reference week, independent

of the activity exercised; (2) the payroll survey, known as CAGED, is released by the labor ministry and shows how many people were hired and fired in the formal labor market.

The household survey The unemployment rate in Brazil has improved significantly, especially during the year of 2010. The rate was at 5.3% in December 2010, a record-low mark, leading some economists to argue that the country has already reached full employment.

Figure 47: Unemployment Rate %, until YE2010

5.0

6.0

7.0

8.0

9.0

10.0

11.0

Jan-

06

May

-06

Sep-

06

Jan-

07

May

-07

Sep-

07

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

Source: IBGE.

Despite the decrease in the unemployment rate, there is a concerning issue that is becoming more apparent lately: the lack of skilled labor. The demand for skilled labor is increasing, and the society has not been able to meet companies’ needs. Trying to solve this problem, corporates are creating training programs inside their own plants to qualify future employees. This is a long-term issue, and its only solution is constant improvements in the education system, which is still very precarious in Brazil.

Another important development in terms of the labor market is the increasing share of formal employees in the workforce. In 2010 more than 50% of Brazilians were registered workers. On the other hand the share of people who work informally is decreasing.

Figure 48: Composition of Labor by Type of Job %

44.8

21.7 19.0

5.09.4

51.6

17.5 18.1

4.58.3

0.010.020.030.040.050.060.0

Formal Workers Informal Workers Self employ ed Employ er Others

Dec-05 Dec-10 Source: IBGE.

28



CAGED The CAGED survey records the total number of payroll additions and subtractions on a monthly basis. This is an important thermometer for the market, once the high number of net hires is correlated to the good performance of economic activity. For example, in 2010 more than 2 million new jobs were created. This number represents an all-time record and more than double the 2009 level.

Figure 49: Net Formal Job Creation (Hires – Fires) Thousands

658 591762 645

1,5231,254 1,229

1,6171,452

995

2,137

0

500

1,000

1,500

2,000

2,500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: CAGED.

The breakdown below shows that new hires in 2010 were more concentrated in the service sector, which was responsible for 40% of total new job creation. Commerce had the second-best performance, with 24% of total hires, followed by manufacturing industry, with 23%. The only category with negative net hires was agriculture, which lost 25,946 jobs in 2010.

Figure 50: Job Creation by Category – 2010 %

Serv ice40%

Commerce - 24%

Construction12%

Manufacturing Industry - 23%

Others - 1%

Source: CAGED.

The effects of the booming labor market in Brazil were not restricted to unemployment rate and formal job creation. In 2010 there were also improvements in terms of real wage and wage mass. Real earnings increased from R$1,430/month in December 2009 to R$1,515/month in December 2010, registering an improvement of 5.9%.

The combination of the improvements in the real wage and in the number of occupied workers generated an

extremely significant increase in the wage mass, which reached its strongest performance since the start of the series, rising by 9% just in 2010.

Figure 51: Real Wage Mass % oya, 3mma

2.0%

4.0%

6.0%

8.0%

10.0%

Jan-

05

Jun-

05

Nov-

05

Apr-0

6

Sep-

06

Feb-

07

Jul-0

7

Dec-

07

May

-08

Oct-0

8

Mar

-09

Aug-

09

Jan-

10

Jun-

10

Nov-

10

Source: IBGE.

Minimum wage: Since the implementation of the Real Plan in 1995, the minimum wage has grown 445%. In real terms, this is good evolution, considering that in the same period inflation rose 200%.

Figure 52: Minimum Wage Evolution R$ per month

100 112 120 130 136 151 180 200240 260

300350 380

415465

510 545

0

100

200

300

400

500

600

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: MCM Consultores.

The minimum wage adjustment happens according to a formula. It stipulates that the minimum wage is readjusted by the prior-year inflation plus the level of GDP growth from two years back, if positive. This logic of readjustment should occur at the beginning of every year. At the start of 2011, the government decided to abide by this rule and make it a law that will be in place until 2015. Despite several complaints from workers’ unions, newly elected President Dilma Rousseff decided to abide by the minimum wage formula, and the minimum wage was set at R$545.

What is interesting is that each increase in the minimum wage immediately triggers a chain of higher government spending. For 2011, for example, a 1% increase in minimum wage immediately translates into an additional R$1.5 billion in government expenditures per year. This happens because a large set of government spending is tied to the national minimum

29



wage, which is used as an index for minimum pension benefits (social security) and as an indirect index for the spending of a number of social programs.

Inflation

History

Inflation performance over the years tells us a lot about Brazil’s history. Until 1994 the country’s economy suffered periods of extremely high inflation, which were only overcome by the introduction of the Real Plan and the Brazilian Real (R$), the current currency. Nowadays Brazil works with the inflation-targeting system to keep inflation under control.

Inflation-targeting system: The inflation-targeting regime was adopted in 1999, giving to the Central Bank the responsibility of conducting monetary policy. The BCB objective is to reach the inflation target. The target is determined by the National Monetary Council (CMN), which is composed of the Finance Minister, the Planning Minister and the Governor of the Central Bank. The IPCA is the inflation index that benchmarks the process. The CMN sets not only an inflation target but also an interval tolerance band for inflation. The CMN meeting usually takes place in June of each year, and its members set the target for two years after (for example, in 2011 the target for 2013 will be set).

Table 29: Inflation-Targeting System Year Target Tolerance Interval IPCA %oya 1999 8.0% 6.0% - 10.0% 8.94 2000 6.0% 4.0% - 8.0% 5.97 2001 4.0% 2.0% - 6.0% 7.67 2002 3.5% 1.5% - 5.5% 12.53 2003 3.25% 1.25% - 5.25% 9.3

4.0% 1.5% - 6.5% 2004 3.75% 1.25% - 6.25% 7.6

5.5% 3.0% - 8.0% 2005 4.5% 2.0% - 7.0% 5.69 2006 4.5% 2.5% - 6.5% 3.14 2007 4.5% 2.5% - 6.5% 4.46 2008 4.5% 2.5% - 6.5% 5.9 2009 4.5% 2.5% - 6.5% 4.31 2010 4.5% 2.5% - 6.5% 4.91 2011 4.5% 2.5% - 6.5% - 2012 4.5% 2.5% - 6.5% -

Source: Banco Central do Brasil. Note: In January 2003, adjusted inflation targets of 8.5% for 2003 and 5.5% for 2004 were established.

The inflation-targeting system seems to be working well for Brazil. Since 2006 the target has been fixed at 4.5% with a tolerance interval of 2.0%, meaning that inflation can hover between 2.5% and 6.5%. Still, it is widely understood that the central bank objective is to aim at the center of the target (4.5%) and not elsewhere within the bands.

Figure 53: Inflation Rate since 2006 %

0

5

10

15

20

Jul-9

9

Jul-0

0

Jul-0

1

Jul-0

2

Jul-0

3

Jul-0

4

Jul-0

5

Jul-0

6

Jul-0

7

Jul-0

8

Jul-0

9

Jul-1

0

IPCA Target max min Source: IBGE; Banco Central do Brasil.

Inflation timeline 1920: Inflation started to be measured in Brazil.

1945: Brazil’s economy reached considerable stability, with inflation at 3% a year.

1960s: Period of economic growth and industrialization promoted by President Juscelino Kubitschek. Inflation rates increased to 90% a year.

30



1964-1985 (military regime): During the whole military regime, inflation remained at high levels. The authorities used to manipulate data in order to keep the rates low. Hence, data from that period are not reliable.

1986-1994: After the redemocratization Brazil went through its most turbulent period relative to inflation. The rate jumped from 72% in 1986 to 1,973% in 1989. Prices used to rise literally every day. Many economic plans were introduced (Bresser, Cruzado, Collor, among others), but all attempts were unsuccessful. The middle-income segment was hardest hit: Wages lost value very quickly, and in 1990 President Collor confiscated banks’ savings.

1994-1999: In 1994, then-Finance Minister Fernando Henrique Cardoso announced the Real Plan, putting in circulation a new currency and aiming to finally reach price stabilization. In this period, the inflation rate fell dramatically, from 916% in 1994 to 22% in 1995, and the country started to rescue its credibility in the international scenario. The fixed exchange rate was the main anchor of price stability, which over time became extremely costly and unsustainable for the government. The successful introduction of the Real Plan and lower inflation led to the election of President Cardoso in November 1994.

1999-Now: With the floating of the exchange rate in January 1999, inflation fears rose. The government acted quickly, increasing taxes, cutting spending and, more importantly, introducing the inflation-targeting regime. This regime is in place now and, with the exception of the period between 2001 and 2003, the targets have been met.

Indexation: One of the key problems with rising prices in Brazil is that the economy is still indexed to inflation to some degree. For example, the formula of minimum wage readjustment has a price component, the return of pension funds is inflation plus 6%, rents are indexed to inflation, and so are utility tariffs and a number of other contracts. One of Brazil’s key challenges is to de-index the economy.

Main Inflation Indexes

Brazil is well known for having a myriad of inflation indexes, many times leading to significant confusion. There are two families of indexes that are the most important: the IGPs, collected by Fundação Getulio

Vargas (FGV), and the IPCs, collected by Instituto Brasileiro de Geografia e Estatística (IBGE).

The IPC family (IBGE) IPCA: The IPCA is today the benchmark consumer price index of Brazil, mostly because it is the inflation index used for inflation-targeting purposes by the Central Bank. The survey of prices usually takes place during the calendar month and is released before the 10th of the next month. It takes into account costs for families that earn between one and 40 minimum wages and that live in 11 metropolitan regions. The IPCA-15 has the same methodology as the IPCA, the only difference being the price collection date, which is the 15th of the reference month, with the prices reflecting changes since the 15th of the month before. The IPCA was 5.9% in 2010 while the IPCA-15 was 5.79%.

Table 30: IPCA Weight per Category and Metropolitan Region (Dec-2010) %

Weight per Price Category Weight per Metropolitan Area Food and Beverage 23.0 São Paulo 33.1 Housing 13.3 Belo Horizonte 10.8 Household Articles 4.2 Salvador 6.9 Clothing 6.8 Rio de Janeiro 13.7 Transportation 18.9 Porto Alegre 8.9 Healthcare 10.8 Curitiba 7.4 Personal expenses 10.4 Recife 4.1 Education 7.2 Belem 4.2 Communication 5.5 Fortaleza 3.9

Goiania 3.7 Brasilia 3.4

Source: IBGE.

INPC: The INPC has the same methodology as the IPCA but takes into account households that earn between one and six minimum wages monthly (instead of up to 40 minimum wages). Therefore, the weights for each category are different than the IPCA’s. Food, for example, has a heavier weight in the INPC calculation than in the IPCA. The INPC closed 2010 higher than the IPCA because it has a larger food weighting. While the INPC rose by 6.4%, the IPCA ended the year at 5.91%.

31



Figure 54: IPCA vs. INPC oya%

0%

3%

6%

9%

12%

15%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

INPC IPCA Source: MCM Consultores.

The IGP family The IGP family is composed of three main indexes: the IGP-DI, the IGP-M and the IGP-10. All of them have the same composition, the only differences being the collection and release dates. The IGP-M has two previews before the final monthly number is released. It is the most common FGV index because it is the one used to readjust contracts – for example, rents.

Table 31: IGP Price Index Calendar Index Collection Date Release Date IGP-M From the 21st of the previous

month to the 20th of the current month

Around the 30th of each month, with two earlier previews

IGP-10 From the 11th of the previous month to the 10th of the current month

Around the 20th of each month

IGP-DI Calendar month Around the 10th of each month

Source: FGV.

The IGPs have an interesting composition: 60% of the index is composed of wholesale prices (IPA), 30% of the index is consumer prices (IPC) and the remaining 10% covers construction costs (INCC).

Figure 55: IGP-M and Its Components % oya

-9.0%

1.0%

11.0%

21.0%

31.0%

41.0%

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

IPA Agriculture Industry Source: MCM Consultores.

The IPA (wholesale prices) is the closest matrix that Brazil has for producer prices (PPI). It can be classified by origin of the product (agriculture = 29%, industrial = 71%) or by its destiny (consumption = 34%, production

= 66%). It is in the IPA that one can measure the price pressure emanating from commodity prices. It is also the IPA that captures changes in the exchange rate, as many commodities that are part of the index are priced in USD. The IPA-10 gained 13.7% in 2010 on higher commodity prices (especially agriculture) after declining by 4.4% in 2009.

The IPC (consumer prices) surveys households that earn between one and 33 minimum wages in 12 major capital cities. It classifies products in seven categories (food, housing, clothing, health/personal expenses, education/recreation, transportation, others). The IPC increased by 6.1% from January to December 2010.

The INCC (construction costs) takes into account construction costs and subdivides the index into labor costs and materials/services. The INCC increased by 7.6% in 2010.

IPCA vs. IGP-M Over time, the IGP-M and the IPCA tend to converge. Still, major changes between both indexes happen at times of commodity price pressure (which is stronger in wholesale prices than in retail) and at times of wide FX variation. Note in the chart below that the IGP-M surpassed by far the IPCA in 1999, 2002, 2008, and 2010, times when the BRL and/or commodity prices oscillated most.

Figure 56: IPCA vs. IGP-M % oya

-2.0%

3.0%

8.0%

13.0%

18.0%

23.0%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

IPCA IGP-M Source: MCM Consultores.

Central Bank and Monetary Policy

The Central Bank in Brazil was created in 1964 and is the main monetary authority in the country. Since its creation, the central bank of Brazil has had more governors than years of existence. Remaining more than a year as the governor of the central bank was a challenge due to problems related to economic stability and publicly perceived credibility. Former Governor Henrique Meirelles was the one who remained the

32



longest in the post: He was governor during the eight years of Lula’s mandate (2003-2008).

The current governor, chosen by President Dilma Rousseff, is Alexandre Tombini. He holds a Ph.D. in economics from University of Illinois and has worked in the Central Bank since 1998. He pledged to abide by economic continuity, focused on inflation control and considerable autonomy for the setting of interest rates.

Table 32: Brazil Central Bank Chairmen since 1985 Central Bank Chairman Period Brazil's PresidentAntonio Carlos Lemgruber Mar-85 to Aug-85Fernão Bracher Aug-85 to Feb-87Francisco Gros Feb-87 to Apr-87Lício de Faria Apr-87 to May-87Fernando Milliet May-87 to Mar-88Elmo Camões Mar-88 to Jun-89Valdico Bucchi Jun-89 to Mar-90Ibrahim Eris Mar-90 to May-91Francisco Gros May-91 to Nov-92Gustavo Loyola Nov-92 to Mar-93Paulo Cesar Ximenes Mat-93 to Sep-93Pedro Malan Sep-93 to Dec-94Gustavo Franco Dec-94 to Jan-95Persio Arida Jan-95 to Jun-95Gustavo Loyola Jun-95 to Aug-97Gustavo Franco Aug-97 to Mar-99Armínio Fraga Mar-99 to Jan-03Henrique Meirelles Jan-03 to Jan-11 LulaAlexandre Tombini Jan-11 to - Dilma Rousseff

José Sarney

Fernando Collor

Itamar Franco

Fernando Henrique

Source: Brazil Central Bank.

It is important to note that the current central bank has been using hybrid instruments of monetary policy to try to contain rising inflation. The so-called (and now famous) macro-prudential policies are aimed mostly to cool down credit markets so that demand is also contained. Today, most regulatory measures adopted by the central bank are known as macro-prudential measures, whether they are aimed at monetary policy or at FX policy.

Table 33: Recap of recent macro-prudential measures Date Description

25-Feb-10 Increase in time deposits RR to 15.0% from 13.5% and additional RR to 8.0% for both demand and time deposits

28-Jun-10 Increase in demand deposits RR to 46% from 42%

1-Dec-10 Announced a 15% minimum payment for credit card bills

1-Dec-10 Increase in time deposits RR to 20% and additional RR for both demand and time deposits to 12%

1-Dec-10 Increase in capital requirements on long-term consumer loans

28-Mar-11 IOF tax on credit card expenditures abroad were increased to 6.38%, from 2.38%

29-Mar-11 The government introduced a 6% IOF tax on external loans shorter than 1 year

6-Apr-11 Extension of the 6% IOF tax on external loans for issuances maturing in up to two years

8-Apr-11 IOF tax on consumer credit raised to 3.0% (from 1.5%)

Source: J.P. Morgan Economics.

BCB independence/autonomy: The Central Bank in Brazil is not independent from the government and is in fact a kind of sub-arm of the Treasury Ministry. However, since the Cardoso years, the central bank enjoys de facto operational autonomy, having the freedom to decide on interest rates without having to answer to political pressure. This autonomy has given credibility to the institution and, therefore, to the interest rate decisions of the past few years, at least in the great majority of cases. Having said that, it is important to note that the BCB’s autonomy has been questioned lately as markets are unsure if the monetary authority will indeed take the bitter medicine to allow inflation to converge with the targets or if it will tolerate inflation higher than the center of the target.

The COPOM: As mentioned in the inflation section, Brazil operates under an inflation-targeting system, and it is the responsibility of the central bank to set up an interest rate that leads to the convergence of inflation to the set targets. Interest rates are set by the Monetary Policy Committee – COPOM – which was established in 1996 with the objective to conduct monetary policy. There are monetary policy meetings every six weeks for a total of eight meetings a year. The COPOM has eight voting members who decide on interest rates: The Chairman of the central bank, the directors of monetary policy, economic policy, special studies, norms and regulation, international affairs, surveillance and regulation, and administration. If there is a tie in the vote, it is up to the Chairman to break it.

33



Figure 57: Selic Rate vs. Inflation yoy Growth %

8

11

14

17

20

23

26

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-102%4%6%8%10%12%14%16%

Selic Rate

Inflation yoy growth

Source: BCB and MCM Consultores.

Exchange Rate Policy

In January 1999 the government finally allowed the BRL to float. This meant that the Central Bank was no longer responsible for sustaining the exchange rate in the pre-established limits, which in 1998 had led to a depletion of about US$50 billion in international reserves.

Central bank’s role on the FX: When the floating exchange rate was introduced in 1999, the Central Bank was supposed to intervene only occasionally and in a limited way. But since 2004 the BC has done interventions almost daily, acting as a dollar buyer or seller, depending on the FX trend at the time. Lately, the Central Bank has also been using regulatory barriers (mostly taxation), aiming to control FX inflow into Brazil.

Since the introduction of the floating exchange system in 1999, the economy has passed through different periods, leading to significant volatility in the BRL, especially in times of crisis.

Figure 58: Exchange Rate R$/US$

0.81.31.82.32.83.33.8

Jan-95 Jul-96 Jan-98 Jul-99 Jan-01 Jul-02 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10

Inplementation of the Floatinting Ex gchange

rate regime

President Lula Election Global Credit

Crisis

Source: Bloomberg.

1999: The introduction of the floating exchange regime led to a significant depreciation in the BRL, taking it from R$/US$1.2 in December 1998 to R$/US$2.05 in January 1999, a depreciation at almost 70% in just one month.

2002/03: Brazil was facing a severe confidence crisis triggered by uncertainties regarding the presidential election. The main running candidates were Luis Inácio Lula da Silva (PT) and José Serra (PSDB). The market was concerned that Lula, the opposition candidate, would win the elections and make good on the populist themes that marked his previous electoral attempts. Markets were unsure if Lula would follow the economic policies in place during the Cardoso administration and if he would fulfill the commitments with the public debt. In this period the dollar came close to R$/US$4, the highest value since the implementation of the BRL.

2008: The most serious global economic crisis since the Great Depression of 1929 generated a global confidence crisis. The collective uncertainties led foreign capital to leave Brazil, searching for what it hoped were safer havens, thereby causing BRL weakness.

2010/11 – “FX war”: A world of negative real interest rates and plenty of liquidity led to very high inflows into Brazil, inflows attracted by strong economic recovery post the crisis and by high interest rates. The currency strengthened and led Finance Minister Guido Mantega to declare in 2010 that Brazil was in a currency war against other nations. The main concern of the authorities is avoiding the de-industrialization of the country, which would be caused by a lack of competitiveness of the Brazilian manufacturing industry in light of the strong exchange rate.

Figure 59: Real Exchange Rate

60

80

100

120

140

160

Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Source: Banco Central do Brasil.

FX controls The strengthening currency led the government to implement a series of measures to avoid the over-appreciation of the FX, starting in October 2009. FX controls are not new to Brazil, and they were introduced in the recent past upon the advent of the Real Plan in 1994. Then, the objective of capital controls was not to put additional pressure on the pegged exchange rate in a context of a rising current account deficit. The most commonly used instrument was the IOF (tax on

34



financial operation), which was increased or lowered several times during the 1990s depending on whether the government was aiming to attract or dissuade foreign portfolio flow.

Figure 60: Interest Rate by Country (end of 2010) %

0.05 0.125 0.5 0.75 1.0 1.25 2.0 2.5 2.75 3.0 3.5 4.05.5 5.5 5.56 6.25 6.5 6.5

10.75

02468

1012

Japa

n

US UK

Czec

h.Re

pucli

c

EU

Swed

en

Thail

and

Sout

h.Ko

rea

Russ

ia

Chile

Polan

d

Aust

ralia

Hung

ary

Sout

h.Af

rica

China India

Turk

ey

Indo

nisia

Braz

il


Recently, the government has started to use the IOF more often. Objectives differed, with the 2008 IOF hike aimed at boosting tax revenues, which were depleted by the end of the CPMF tax. From 2009 onward, the clear objective of taxation was to reduce the volume of exchange rate inflows into Brazil. In October of that year, the government announced a 2% tax (IOF) on all foreign purchases of Brazilian securities (equity and fixed income). The currency responded to the measure, but during 2010, appreciation forces were in place once more and in October 2010, the government announced that the IOF tax for foreign purchases of fixed income instruments would increase from 2% to 6%. There were other measures adopted, for example the increase in the limit of dollars that the Treasury is allowed to buy in the open market and also permission granted for the Brazilian Sovereign Wealth Fund to purchase FX. In 2011, the central bank announced that reserve requirements would rise from 0% to 60% on USD short positions held by local institutions. It also imposed a 6% IOF tax on external corporate bonds and notes with maturities of less than 360 days.

Table 34: Recent History of Brazil’s IOF on Securities Date Measure 17-Mar-08 1.5% only on fixed income 23-Oct-08 Reduced to zero 19-Oct-09 2% on fixed income and equities 5-Oct-10 4% on fixed income; 2% maintained for equities 19-Oct-10 6% on fixed income; 2% maintained for equities


External Sector

Exports and imports in Brazil have risen dramatically in the last decades but especially since 2003. Until the 1990s the government was the main promoter of economic growth, keeping the economy closed for purchases in the external market. Imports were restricted by pricing and non-pricing barriers and also by exchange rate controls. After 1990, the barriers were gradually eliminated and the exchange rate appreciated. Thenceforth, external commerce increased significantly, and Brazil started to be an important player in the international scenario, mainly as a commodity exporter.

Figure 61: Trade Current (Exports + Imports) US$ Billion

0.00

100.00

200.00

300.00

400.00

500.00

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: MDIC

Since Brazil opened its doors to the international market in the early 1990s, deficits in the trade balance were observed just 6 times (out of 20). Between 1995 and 1999, when the Real Plan was in place, the BRL was strong against the dollar, encouraging imports over exports. Since 1999, after the implementation of the floating exchange rate, trade balance results started to get better, and from 2001 on the balance presented a surplus. The increase in commodity prices observed since the end of 2002 was a very important factor behind the increase in Brazilian exports. On average (in 1990-2010) Brazil has had a trade surplus of US$14.9 billion, and in 2010 the trade surplus was US$20.3 billion. The government aim is to maintain the trade surplus at current levels at the very least, though consensus expects it to fall by half in 2011.

35



Figure 62: Trade Balance US$ Billion

-100

1020

304050

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: MDIC

Exports

Compared to other countries in Latin America, Brazil can be considered a relatively closed economy, with exports/GDP of only 11.2% in 2010, pretty much the same level as in 2009. Looking to the main Latin economies, Brazil is the one with the lowest exports/GDP ratio. In Mexico exports represent 28% of GDP, in Chile 38% and in Argentina 21%. The good news, therefore, is that Brazil’s GDP ends up being relatively insulated from international crises, as we saw in 2008-2009.

Figure 63: Total Exports as a % of GDP (2009) %

46.538.1 35.7

27.8 26.5 23.6 21.4 18.3 16.311.3

0.0

10.0

20.0

30.0

40.0

50.0

Para

guay

Chile

Boliv

ia

Mex

ico

Urug

uay

Peru

Arge

ntina

Vene

zuela

Colom

bia

Braz

il

Source: World Bank.

Despite attempts of diversification, Brazil is still one of the greatest commodity exporters in the world. Indeed, the participation of commodities in Brazil export basket is increasing and reached its peak in 2010, when 45% of total exports were composed of commodities, not counting those products that are industrialized but have commodities as the main input. If one considers industrialized products that are mostly made of commodities, the participation of commodities rises to about 60% of total exports. Manufactured goods, which were responsible for about 60% of exports in 2000, declined to 39% in 2010. Semi-manufactured products remained practically unchanged in the last two decades and are responsible for around 14% of total exports.

Figure 64: Brazil’s Export Composition by Category (2010) %

Commodity45%

Manufactured39%

Others - 2%Semi-Manufactured

14%

Source: MDIC.

In 2010 Brazil exports reached US$201.9 billion, and in 2009 the country was the 23rd-largest exporter economy in the world. The main export products are iron ore (14.3%), soy (8.4%) and crude oil (8.0%). As we can see in the table below, nine of the 11 most representative products in Brazil’s export basket are commodities, enforcing once more the Brazilian identification with this category of product. The only non-commodity products that are main exports are autos and airplanes.

Table 35: Main Brazilian Exports (2010) % Products % of Total in 2010 Iron Ore 14.32 Soy (all products) 8.40 Oil 8 Crude Cane Sugar 4.61 Poultry 2.87 Coffee 2.57 Pulp 2.35 Passenger Autos 2.19 Airplanes 1.97 Beef 1.91 Sugar 1.71 Others 49.10

Source: MDIC.

The same happens when we look to the main export companies. The great majority of the companies listed below are commodities exporters. Indeed, only Embraer (rated N by JPM aerospace & defense analyst Joseph Nadol) is purely a manufactured products exporter. The other nine companies have at least one part of their exports focused on commodities. What is also interesting to note is the export concentration around Vale (rated OW by JPM Latam metals & mining analyst Rodolfo de Angele) and Petrobras (rated N by JPM Latam oil & gas analyst Sergio Torres). Together, these

36



two companies are responsible for more than 20% of total Brazil exports.

Table 36: Top 10 Exports Companies in Brazil (2010) % Main Companies % Total Exports Vale 11.91 Petrobras 9.01 Bunge Alimentos 2.13 Embraer 2.06 Samarco Mineração 1.59 Cargill Agricola 1.50 ADM do Brasil 1.30 Braskem 1.22 Sadia 1.13 Brasil Foods 1.05

Source: MDIC.

Brazil’s largest trade partner is China, with 15.2% of total export in 2010. In 2009 China overtook the first position from the US, and that situation prevailed in 2010. China is not only holding its first position but also is likely to increase its participation in the next years. Among Latin America countries, Argentina appears as an important trade partner, taking 9.2% of Brazilian exports.

Table 37: Destination of Brazilian Exports (2010) %

2008 2009 2010 Country % of Total 3 1 1 China 15.2 1 2 2 US 9.6 2 3 3 Argentina 9.2 4 4 4 Netherlands 5.1 5 5 5 Germany 4 6 6 6 Japan 3.5

15 7 7 United Kingdom 2.3 8 16 8 Chile 2.1 9 11 9 Italy 2.1

10 13 10 Russia 2.1

Source: MDIC.

Imports

Since Brazil started to combine strong economic growth with a strong exchange rate, imports started to rise. In 2010 Brazil imports reached US$181.6 billion, and in 2009 the country had the 24th-largest volume of imports in the world. Among Latin America countries, Brazil is

the second-largest importer in terms of volume, second only to Mexico.

Figure 65: Brazilian Monthly Imports US$ Billion

1.0

5.0

9.0

13.0

17.0

Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Source: MDIC

Brazilian imports are well diversified in terms of country of origin. Imports come mainly from the US (14.9%), China (14.1%) and Argentina (7.9%). The European Union as whole is responsible for almost 22% of total Brazil imports.

Table 38: Origin of Brazilian Imports %

2008 2009 2010 Country % of Total 1 1 1 US 14.9 2 2 2 China 14.1 3 3 3 Argentina 7.9 4 4 4 Germany 6.9 7 6 5 South Korea 4.6 5 5 6 Japan 3.8 6 7 7 Nigeria 3.3 9 8 8 Italy 2.7 8 9 9 France 2.6 11 14 10 India 2.3

Source: MDIC.

In early 2011, China is poised to overcome the US as the number one source of Brazilian imports. China’s participation in imports in 2000 was about 2%, rising to 14.1% at the end of 2010.

37



Figure 66: Imports from China % of Brazil total imports

2.2 2.43.3

4.55.9

7.38.8

10.511.6

12.514.1

0

3

6

9

12

15

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: MDIC.

Brazilian imports’ main feature is the high concentration of manufactured goods. In 2010, 86.9% of total imports were industrialized products and 13.1% were commodities. Specifically, the main imported items were crude oil (5.6%), passenger vehicles (4.7%) and medicine (3.1%).

Among Brazilian regions, the Southeast is the destination of more than half of imports, with almost 40% going to São Paulo. The South appears in second place, taking 22%. The other 3 regions have a smaller participation in imports, with the Northeast responsible for 10%, the North for 7% and the Midwest for 6%.

Figure 67: Imports Destination by Regions (2010) %

Southeast - 56%

South - 22%

Northeast - 10%

North - 7%Midw est - 6%

Source: MDIC.

External Accounts

Current account: Brazil’s current account deficit in 2010 was 2.3% of GDP, which means an imbalance of US$47.5 billion. After a significant period of current account surplus (June 2003-December 2007), the country started a new cycle of deficit in 2008. The goods news is that FDI and portfolio inflows have been enough so far to finance the external gap.

Figure 68: Current Account % of GDP

-5.0-4.0-3.0-2.0-1.00.01.02.0

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Source: Banco Central do Brasil.

There are two main triggers that led to an increase in the current account deficit over the last few years. First is the fact that the trade balance has been shrinking, from US$40 billion in 2007 to US$20 billion in 2010. Second, the service deficit has widened significantly over the past few years, rising from around US$13 billion in 2007 to close to US$28 billion in 2010.

Figure 69: Service Account Deficit Rising R$ Thousand

-35000

-30000-25000

-20000-15000

-10000-5000

0

Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Source: Banco Central do Brasil.

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Table 39: Current Account by Country % of GDP Country 2010 2011E 2012E China 5.2 5.7 6.3 Germany 5.3 5.1 4.6 Russia 4.9 5.6 3.9 Japan 2.8 3.1 2.3 Argentina 0.9 0.1 -0.5 Mexico -0.5 -0.9 -1.1 Chile 1.9 0.5 -1.3 UK -1.1 -2.2 -2.0 France -2.1 -2.8 -2.7 US -3.2 -3.2 -2.8 Brazil -2.3 -2.6 -3.0 India -3.2 -3.7 -3.8 Spain -5.5 -5.2 -4.8 Greece -10.4 -8.2 -7.1 Turkey -6.5 -8.0 -8.2 Portugal -9.9 -8.7 -8.5

Source: IMF.

Foreign direct investment (FDI): FDI reached US$48.5 billion in 2010, beating its previous all-time record. For the first few months of 2010 FDI flows were weak, disappointing the expectations. However, over the last few months, volume started to improve quickly, especially in December, when the flow reached US$15.4 billion, or 32% of total 2010 volume.

The record volume reached in 2010 consolidated the cycle of increases in FDI, started in 2005 and interrupted only in 2009, by the economic crisis.

Figure 70: Annual Brazilian FDI US$ Billion

10.8

19.0

28.9 28.632.8

22.516.6

10.1

18.1 15.118.8

35.6

45.1

25.9

48.46

0.0

10.0

20.0

30.0

40.0

50.0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Banco Central do Brasil.

According to central bank data, the country sending the most direct investments to Brazil in 2010 was Luxembourg, responsible for almost 16% of total FDI, followed by the Netherlands and Switzerland. Clearly, these do not sound like countries that have been

investing heavily in Brazil on their own count. It is important to note that the reporting of country of origin in terms of FDI can be misleading, as the central bank takes into account only the country where the funds originated. However, perhaps one country had resources deposited in a third country and sent the money to Brazil from there. One good example is probably China, which appears with only US$392 million in investment, even though it bought stakes at some Brazilian companies (notably Sinopec bought 40% of Repsol’s capital for US$7 billion, and Sinochem purchased 40% of Peregrino’s oil field for US$1.7 billion). Sobeet, a Brazilian NGO, estimates that Chinese FDI into Brazil reached US$17 billion, but this data point doesn’t appear in the BCB numbers, perhaps because the capital for payment was sent via other countries, thus not appearing in the BCB statistics.

Figure 71: Participation of Key Countries in Brazilian FDI % of total FDI, 2010

Lux emburg16%

Netherlands - 14%

USA - 12%

Sw itzerland12%

France - 7%

Others40%


Looking at a sectoral breakdown for FDI inflows, industry was the main investment destination, with 36.8% of total FDI, followed closely by agriculture and mineral extraction (34.5%). In nominal terms, agricultural and mineral extraction increased by almost 300% oya in 2010, due to a great increase in oil and gas extraction and in iron ore extraction. It is interesting to note that services, which was the leading FDI category in both 2008 and 2009, fell to third place, with only 28.7% of total share. Indeed, in 2010 (Jan to Nov), services were responsible for 28.7% of FDI inflows, chief among them investments in commerce (ex-autos), and financial activities.

39



Table 40: FDI Distribution per Sector % of Total

% of Total FDI Sector 2009 2010

Agriculture and Mineral Extraction 14.5 34.5 Extraction of Oil and Natural Gas 8.4 18.9 Metallic Mineral Extraction 4.1 12.7 Industry 42.6 36.8 Chemical Products 4.9 14.1 Metallurgy 4.9 14.1 Coke, oil derivates, biofuel 11.8 6.7 Services 42.9 28.7 Commerce (ex-autos) 7.3 4.8 Financial Services 9.1 3.5 Utilities 3.1 2.2


Portfolio investment: Foreign portfolio net flows accumulated US$67.8 billion in 2010, which is not only 47% higher than in 2009 but also a record high. Both equity and fixed income presented good performance.

• Total equity flows (primary and secondary market, local and ADR) reached US$37.7 billion, being responsible for 55.6% of total foreign portfolio flow. Equity investments were pretty much the same as in 2009, but with one great difference. While in 2009 a great part of flows were destined to the secondary market, in 2010 it was mostly in the primary market. Indeed, according to Bovespa, foreign portfolio inflows in the secondary market were only around US$3 billion in 2010.

• On the fixed income side, results were extremely robust, especially before October 2010, when the government decided to raise the IOF tax for foreign investments in fixed income from 2% to 6%. One way or another, fixed income net flows reached US$30.1 billion in 2010, the highest in history for the period and almost three times higher than the inflow observed in the same period in 2009. We note that fixed income flows have decelerated a great deal since the imposition of the higher IOF and remained at low levels in 1Q 2011.

Figure 72: Foreign Portfolio Investment in Brazil US$ Billion

26.2

-7.6

37.137.7

21.9

6.8

9.130.1

-100%

-50%

0%

50%

100%

2007 2008 2009 2010

Equities Fix ed Income Source: Banco Central do Brasil. Note: 2010 data are January to November.

International reserves: Brazilian international reserves reached US$288.6 billion at the end of 2010, increasing more than 20% relative to the previous year. Indeed, reserves have risen very sharply in 2011 so far, reaching close to US$320 billion at the start of April, an 11% rise from the close of 2010. From 2002 to 2010 the volume of international reserves increased by almost 700%.

Figure 73: Brazil International Reserves US$ Billion

37.5 48.9 52.5 53.385.2

179.5 192.9239.1

288.6

0

50100

150200

250300

350

2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: IMF.

In the last few years, Brazil became one of the countries with the highest level of nominal international reserves in the world. Actually, Brazil has the highest reserves among Latam countries and is also among the countries with the highest reserves in the world.

Figure 74: International Reserves by Country (end of 1Q11) US$ billion

0 250 500 750 1,000 1,250 1,500 1,750 2,000 2,250 2,500

Mex icoHong.Kong

South KoreaIndia

BrazilTaiw anRussiaJapanChina

Source: IMF except for China and Taiwan (Bloomberg). China data are for YE2010.

40



External Debt

In 2009, external debt in Brazil reached US$350.4 billion, or 19.3% of GDP. Comparing to other LatAm countries, we observe a contradictory result: Brazil has, at the same time, the highest volume of debt and the lowest external debt/GDP ratio. Still, external debt increased by 26.8% oya 2010. If intercompany loans are excluded, Brazilian external debt reaches US$271.1 billion.

Table 41: External Debt in Latin America (2010 estimate) Total External Debt

(US$ Billion) % of Short

term* as a % of GDP

Brazil 352.0 16.2% 9.6% Mexico 199.2 22.3% 18.4% Chile 85.7 25.2% 39.3% Colombia 57.0 7.7% 19.7% Peru 38.5 17.4% 24.1% Argentina 145.2 22.7% 41.1% Venezuela 82.1 20.3% 39.0%

Source: J.P. Morgan; Brazil data are from Banco Central do Brasil and IBGE.

The profile of the Brazilian external debt has changed significantly since the 1980s. Before, the public sector was the greatest debtor (in 1985, for example, it was responsible for about 82% of total external debt). Nowadays, the non-financial public sector accounts for about 30% of total external debt. In 2010, the public sector was expected to pay about US$6 billion in interest payments on external debt.

Table 42: Registered External Debt Stock – By Debtor As of December 2010

US$ Billion % of Total Medium and Long Term Debt 199.5 62.4% Non-financial public sector 82.8 25.9 Financial Public Sector 17.3 5.4% Private Sector 99.3 31.1% Short Term Debt 25.0 7.8% Total External Debt (A) 224.5 70.2% Intercompany Loans (B) 95.1 29.8% C = (A + B) 319.6 100.0%


In February 2008 the Central Bank announced that, for the first time in history, Brazil had enough resources to cover its external debt. This means that international reserves were higher than total public external debt, making the country a net external creditor.

Fiscal Policy

This is the Achilles’ heel of the Brazilian macro story. Fiscal accounts are perhaps the last frontier in consolidating macro stability. The Brazilian government taxes too much in order to pay for public spending, which in its large majority is geared to the payment of civil servant wages, social security and interest payments. This is problematic because, without a revamping of the public administration, only a fraction of the yearly budget related to discretionary spending can be used to adjust fiscal policy. The lack of structural reforms to address issues such as social security and the earmarking of a great deal of budgetary expenses has led to a continuous increase in tax collection as a percentage of GDP. There is a consensus in Brazil that fiscal policy needs to be addressed so that interest rates can be structurally lower. The government’s position on this issue is not often clear, but in the beginning of 2011, President Dilma Rousseff announced a budget cut of R$50 billion, aiming to attain a primary surplus target of around 3% of GDP in 2011.

Figure 75: Federal Government Revenues and Outlays % of GDP, 12 month rolling

14%

16%

18%

20%

22%

Dec-97 Jun-99 Dec-00 Jun-02 Dec-03 Jun-05 Dec-06 Jun-08 Dec-09

Net Rev enues (net of trasnfers) Total Ex penditures (ex -interest pay ments) Source: MCM Consultores Associados.

The Annual Budget

In the first half of each year, the Ministry of Planning and Budget prepares a document with the main macro forecasts that are to guide the budgetary process. It then presents a version to Congress, which amends it and puts it to vote. The interesting part of the budgetary process is that what is approved is not necessarily what will be implemented. The Brazilian budget is not fixed. Instead, every two months the Finance Ministry makes an assessment of how revenues are coming out in relation to the planned expenditures and adjusts the budget accordingly. However, as mentioned above, the flexibility for cuts is only on items related to discretionary spending. For 2011, for example, only 10.4% of the budget is for discretionary spending.

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Table 43: Breakdown of Expenses of the Brazilian 2011 Budget % of total budget (preliminary budget version) Mandatory Expenditures 89.7% Debt Amortization 40.4% Social Security 17.1% Wages and Social Programs 9.5% Interest Payments 8.8% Transfers to States and Municipalities 8.4% Other Financial Expenses 3.8% Other Mandatory Expenses 1.5% Contingency Reserve 0.3% Discretionary Spending 10.4% of which Health 30% Education 13% Bolsa Familia (Family Grant) 7% PAC Program (infrastructure) 22% Others 28%

Source: Ministry of Planning and Budget.

Fiscal Indicators

Fiscal data for Brazil started to be consolidated in a comprehensive manner in the 1990s. Markets tend to focus on the primary surplus results, as this is the main fiscal target that the government pursues. Also, the primary surplus (revenues minus expenses excluding interest payments) allows for a better evaluation of how the government expenses are evolving. Still, there is a rising emphasis on the nominal data as an overall balanced budget is seen by many as a pillar to economic stability in Brazil.

Primary surplus: The primary surplus gained importance in the late 1990s, when Brazil signed a rescue program with the IMF. The primary surplus became the main fiscal target and to this day, the government sets its fiscal goals in the annual budget by fixing a primary surplus target. In the late 1990s the target was relatively modest, at around 2-2.5% of GDP, but later it was brought up. In January 2003, when former President Lula took office, Finance Minister Antonio Palocci implemented a new round of fiscal correction, further increasing the primary surplus target to 4.5% of GDP. Since then, especially in the last couple of years, the target was brought down and its methodology revised a number of times. Today, the primary surplus target for 2011 is set at R$180 billion for the consolidated public sector (around 3% of GDP),

but it excludes expenses from Petrobras, Eletrobras, some infrastructure investments, among other things.

Figure 76: Primary Surplus % of GDP, 12 month rolling, new methodology (excludes Petrobras and Eletrobras)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%


Nominal deficit: The nominal deficit might be today a clearer way to track Brazil’s fiscal performance as it tends to be a better reflection of the overall fiscal status of the country. The nominal deficit reached its best point at the end of 2008, at -1% of GDP. The advent of the 2008 crisis led the government to open its coffers and provoked an increase in the nominal deficit, which closed 2010 at -2.9% of GDP.

Figure 77: Nominal Deficit % of GDP, 12 month rolling

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%


Interest payments: Interest payments have been steadily declining in Brazil as interest rates are lowered. In the past, interest payments reached almost 10% of GDP, at a time when part of the debt was linked to the exchange rate and it devalued. Today, lower interest rates and a better debt profile (more fixed-rate debt than before) have allowed interest payments to hover between 5% and 5.5% of GDP over the last two years.

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Figure 78: Interest Payments % of GDP, 12 month rolling

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%


Public Sector Debt

Over the past few years there has been a revamping of the profile of the Brazilian public sector debt. Perhaps the worst point was observed in 2002/2003, when the debt-to-GDP ratio reached over 60%, as a great deal of the debt was denominated in foreign currency at a time when the BRL suffered an important devaluation. Since then, overall debt has been declining, and now it is stabilizing around 40% of GDP.

Figure 79: Net Public Sector Debt % of GDP, new methodology excluding Petrobras and Eletrobras

35.0

40.0

45.0

50.0

55.0

60.0

65.0

Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Source: Banco Central do Brasil.

One of the main reasons behind the decline in the net public sector debt is that Brazil went from being a net external debtor to a net external creditor. First, the government bought back a significant amount of external debt, even taking out of circulation the “C” bond, which was the Brazilian benchmark debt instrument for most of the 1990s. Also, higher reserves have netted out the remaining external debt that Brazil still holds (the level of reserves is greater than that of external debt), turning Brazil into a net external creditor and contributing to a reduction in the overall level of net public sector debt. This doesn’t mean that Brazil doesn’t have public sector external debt; just that it has the matching resources to retire it if needed. Indeed, as of December 2010, Brazil held around US$100 billion in public sector external debt.

Figure 80: Net Public Sector Debt Split into Internal and External Debt % of GDP

-15.0

5.0

25.0

45.0

65.0

Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

Internal Debt Ex ternal Debt Source: Banco Central do Brasil.

Internal (domestic/local) debt: Even though the level of domestic debt remained pretty constant for much of the last decade, important changes took place in the internal debt profile.

• The level of floating-rate debt linked to the Selic declined significantly, while fixed-rate and inflation-linked debt increased.

• The level of FX-linked debt was greatly reduced, which makes Brazil less vulnerable to exchange rate variations.

Table 44: Composition of the Stock of Public Debt % of Public Debt (after foreign exchange swap)

2002 2004 2006 2008 2010 Prefixed 13.7 20.1 36.1 32.2 37.9 Price Index 12.5 14.9 22.5 29.3 28.1 Selic 46.2 52.4 40.2 33.6 32.5 FX 37.0 9.9 -1.1 3.3 0.6 TR and Others 2.1 2.7 2.2 1.6 0.9


The average maturity of the overall domestic debt held by the public has increased from around 27 months at the end of 1999 to about 40 months at the end of 2010. Even though there is significant shorting of maturities around crisis periods, the overall evolution continues to be one of extending maturities. Note that inflation-linked instruments have longer maturities, reaching 77 months on average and being the instruments that contributed most to the lengthening of the average maturity for total debt. Average maturity for fixed-rate instruments (LTN) is around 17.9 months.

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Figure 81: Average Maturity of Brazil’s Public Sector Local Debt Months

25

30

35

40

45

Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Source: Banco Central do Brasil.

Although the great majority of local Brazilian debt is owned by Brazilians, foreigners are increasing their participation, which reached 10.6% in December 2010 of total outstanding debt held by the public, up from 5% in December 2008 and 7.1% in December 2009. Foreigners owned mostly instruments at the long end of the curve.

Gross debt: Gross debt is simply the stock of outstanding government debt of all institutions in the general government, with no deductions for the financial assets that the government holds (for example, international reserves). Gross debt in Brazil is significantly larger than net debt, currently at 58% of GDP, or 18 p.p. higher than net debt.

Figure 82: Net Debt vs. Gross Debt % of GDP

35.0

45.0

55.0

65.0

75.0

Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

Net Debt Gross Debt Source: Banco Central do Brasil.

Sovereign Credit Ratings

Until 2006 the core rating agencies rated the investments in Brazilian public debt securities as speculative. In 2007, the less-known R&I rating agency was the first to recognize Brazil’s investment grade. But the upgrade was only fully recognized by the market in April 2008, when Standard & Poor’s gave Brazil a BBB- rating, meaning that the country was joining the select group of countries with investment grade. The last agency to announce Brazilian investment grade was Moody’s, in September 2009. In March 2011, Fitch Ratings upgraded Brazil within the investment grade

category, citing that fiscal consolidation combined with a healthy GDP growth would continue to improve the country’s debt profile.

Table 45: Investment Grade 2003 2004 2005 2006 2007 2008 2009 2010 2011

S&P B+ BB- BB- BB BB+ BBB- BBB- BBB- BBB-Fitch B+ BB- BB- BB BB+ BBB- BBB- BBB- BBB

Moody's B2 B1 Ba3 Ba2 Ba1 Ba1 Baa3 Baa3 Baa3Source: Ministério da Fazenda Note: Shaded area is investment grade rating.

Tax System

Brazil is known as one of the countries with the most complicated and expensive tax systems in the world. The main reason for this is that Brazil has many taxes, of which several are indirect and cascading, functioning in a system without unified legislation at any government level. The precarious tax system is blamed for inhibiting business activity and, consequently, harming economic and social development.

Table 46: Complexities of the Brazilian Tax System Main Complexities

- Different taxes are levied on the same product

- Six indirect taxes on goods and services. Most countries have one or two

- Constantly changing legislation

- At the federal level, four taxes and three tax systems

- At the state level, 27 different legislations (one for each), different rates and criteria - Two taxes on business profits

- High bureaucratic costs

- Disputes with the tax authority

Source: "Tax Reform," Brasilia, D.F., February 28, 2008.

Tax collection in Brazil has been rising nonstop since 1997/98. At that time, the Brazilian government promoted a fiscal shock in the economy, trying to counteract the effects of the Asian crisis that were fast making their way into Brazil. President Cardoso’s government increased taxes and tried to cut spending. However, it was successful only in the first goal. Total tax collection in Brazil increased from 25% of the GDP in the mid-’90s to about 35% in 2009. On the other hand, expenses at the federal level increased from 15% of GDP in 2001 to 19% of GDP in 2010.

44



Figure 83: Total taxation as a % GDP % of GDP

202224262830323436

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Lula 1 Lula 2FHC 2FHC 1

CollorItamarSarney

Source: Instituto Brasileiro de Planejamento Tributário.

Not only are taxes high in Brazi, they are also among the highest in the world. A study by the Instituto Brasileiro de Planejamento Tributário indicates that if Brazil were an OECD member, it would have the 14th-highest taxes among members.

Figure 84: Brazil Ranks 14 within Countries with the Highest Tax/GDP Ratio (2009) % of GDP

48.2 46.4 43.5 43.2 43.1 42.8 41.9 41 39.1 37.9 37.5 37 34.8 34.5

0

10

20

30

40

50

Denm

ark

Swed

en Italy

Belgi

um

Finla

nd

Aust

ria

Fran

ce

Norw

ay

Hung

ary

Slov

enia

Luxe

mbu

rgh

Germ

any

Czec

hRe

publi

c

Braz

il

Source: OECD and Instituto Brasileiro de Planejamento Tributário.

Tax distribution During the period of the military regime, fiscal policy in Brazil was completely centralized. States suffered limitations on their taxation powers and became highly dependent on the federal government. With the 1988 Constitution came the reformulation of the tax system, aiming to increase the level of fiscal autonomy of the states and municipalities. The reformulation did not work well. It consolidated public sector imbalances due to the disorganized evolution of the process. New taxes were created and the old ones were revised upward.

Nowadays, the country is still under the same fiscal regime, created in 1988, and a tax reform has become a primary necessity. In terms of centralization, the federal government is still responsible for more than two thirds of the collections, leaving 26% of the total for the states and less than 5% to municipalities.

Figure 85: Tax Burden by Jurisdiction %

Total Federal Tax es - 69.5%

Total State Tax es - 26%

Total Municipal Tax es - 4.6%


Bottom line: The problems surrounding the Brazilian tax system have been diagnosed for a long time, and over the last ten years different administrations have tried to approve a tax reform. Because of the political complexities involved in this endeavor, the government usually chooses to change taxes in line with its own interests, promoting bits-and-pieces changes in the legislation that end up complicating the system even more. Taxes in Brazil end up crowding out private sector entrepreneurship.

Main taxes An ordinary Brazilian is subjected to several taxes and may not know where all the money is going. The complexity of the system makes its comprehension a difficult task. Below are listed some of the most known taxes divided by the jurisdiction responsible for its collection. A brief explanation of the taxes with highest participation in the country’s overall revenues follows.

Table 47: Main taxes charged in Brazil Federal Taxes Tax on Imported Goods (II) Tax on Manufactured Goods (IPI) Income Tax (IR) Tax on Financial Transaction (IOF) Rural Land Tax (ITR) Natonal Institute of Social Security (INSS) Contribution for Social Security Financing (COFINS) Length of Service Guarantee Fund (FGTS) Integration Program employees-company (PIS/PASEP) State Taxes On the Circulation of Goods and Services (ICMS) On Property of Vehicles (IPVA) Municipality Taxes On Property and Urban Land (IPVA) Tax on any Kind of Service (ISS)


45



ICMS: This is the tax on the circulation of goods and services. It is a state tax and thus there are 27 different legislations (one for each state). Every manufacturer, distributor, retailer or provider of almost every type of merchandise or service pays the state ICMS and passes the cost along to the consumer. ICMS in Brazil is basically a hidden tax, meaning that the tax is embedded in the product price. Therefore most Brazilians are unaware of how much the ICMS actually costs them.

INSS (Social Security): Both employers and employees are subject to social security contributions. The employee contribution depends on level of income, and varies from 8.0% to 11% of the gross wage. There is also a limit of contribution (R$405), meaning that even if the employee earns more than R$3,689.66 he/she can not contribute more than the limit. Generally, the employer contributes 20% of the gross salary of the employee (22.5% in the financial sector), even if the wage is greater than the limit.

Table 48: INSS Contribution by Income Level Wage Range % of total wage Until R$ 1,106.90 8% From R$ 1,106.91 to R$ 1,844.83 9% From R$ 1,844.84 to R$ 3,689.66 11% Contribution Limit: R$ 405.86

Source: Social Security Ministry.

Personal income tax: All personal income earned in Brazil is subject to federal income tax. The country has a progressive taxation system under which individuals are taxed up to a maximum of 27.5% of their income. Brazilian taxpayers must present an annual income tax declaration, to be delivered by the last day of April each year.

Table 49: Income Tax Contribution by Income Level for 2011 Annual Income Tax Ratio Up to R$17.989,80 Exempt From R$17.989,81 to R$26.961,00 7.50% From R$26.961,01 to R$35.948,40 15% From R$35.948,41 to R$44.918,28 22.50% Above R$44.918,28 27.50%

Source: Treasury Ministry.

FGTS (Length of Service Guarantee Fund): Under the FGTS employers make a deposit of 8% of a worker’s wage in the Caixa Economica Federal. The balance is released to the worker if he/she is fired or under certain special conditions, for example, for home purchase if

the person does not own real estate. Nowadays, the FGTS is one of the most important sources of real estate credit. It is also a key component of the BNDES’s yearly financing.

COFINS: This is a federal tax charged on a company’s gross receipts and destined to finance social security. The current COFINS rate is 7.6%, but in 2004 the government implemented changes to this tax, making it non-cumulative, that is, the tax is paid only once during the production of an item or service.

Corporate income tax: Companies in general pay 15% of taxes on profits, plus an additional 10% if profits are above R$240K per year. Companies that have sales of less than R$48 million in a calendar year qualify for the calculation of income taxes over estimated profits (rather than observed). In this case, rates differ for different activities, ranging from 8% for cargo transportation and 32% for services in general.

Figure 86: Most Representative Taxes in Brazil % of total collection

Others - 27%

FGTS - 5%

COFINS - 11%IR - 18%

INSS - 18%

ICMS - 21%


Taxes on security investments: In a nutshell, locals pay 15% capital gains tax on equities and no tax on dividends. For fixed income investments, the tax rate depend on how long the investment lasts: for fixed income investments of under 6 months, the tax is 22.5%, and it falls to 15% for investment of 2 years or more. Foreigners in general are exempted from capital gains and dividend taxes in Brazil, unless they come from countries that do not tax income or tax income lower than 20%. In those cases, investors do incur 15% capital gain taxes on stocks. Foreigners investing in fixed income instruments are exempted from capital gains taxes. In October 2009, the government introduced a 2% IOF tax on foreign purchases of Brazilian equities and fixed income instruments. In October 2010, the IOF tax for fixed income was increased to 6%.

46



Credit

Credit has been booming in Brazil since 2004, when interest rates finally started to come down to more mundane levels. There are three key issues that may explain the historical low level of credit penetration in Brazil. First, high interest rates acted as inhibitors of credit, since its high cost was not accessible for individuals and companies. Second, banks didn’t need to go into the credit business as it was very profitable to finance the government debt, considering the high rates of return. Finally, it was only in 2004 that it was clear that the Brazil economy had stabilized on a sustainable path, allowing for more jobs, higher wages and, therefore, more credit affordability.

In 2004 total credit represented 25% of the GDP and in December 2010 this ratio had jumped to over 46% of GDP The advent of credit has been a key factor propelling domestic demand as a key GDP growth component.

Figure 87: Credit as a % of GDP %

20

25

30

35

40

45

50

Jan-

01

Oct-0

1

Jul-0

2

Apr-0

3

Jan-

04

Oct-0

4

Jul-0

5

Apr-0

6

Jan-

07

Oct-0

7

Jul-0

8

Apr-0

9

Jan-

10

Oct-1

0

Source: Banco do Brasil.

Comparing to Latam countries, at the end of 2009 Brazil had the second-highest credit/GDP ratio, behind only Chile, with 71.2% of GDP.

Figure 88: Credit as a % of GDP by Country (in 2009) %

71.2

45.037.1 35.2 34.4

26.5 23.4 23.416.2

0.010.020.030.040.050.060.070.080.0

Chile Brazil Peru Colombia LatinAmerica

Ecuador Argentina Venezuela Mex ico

Source: Inter-America Development Bank.

Despite the sharp rise, credit continues to grow: On a year-on-year basis, total credit has been presenting double-digit increases since 2004. The economic crisis of 2008/2009 slowed credit growth, but since then, it has picked up again, especially consumer credit. The growth rate is likely to decelerate in 2011 as interest rates increase and the economy slows down, but double-digit growth is still expected (banks’ general guidance for loan growth hovers between 15% and 18%).

Figure 89: Total Credit Growth %oya

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

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5

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09

Jul-0

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Jan-

10

Jul-1

0


Consumer credit was mainly responsible for the rise in the credit/GDP ratio. In 1995, credit to consumers represented less than 10% of total credit, and nowadays this ratio is near 35%. This evolution is supported by a good macro environment and shows the rising power of the consumer, which now faces less bureaucracy than before to get a loan. Moreover, there are more credit instruments, matching different consumer profiles and offering conditions equivalent to the capacity to pay.

Figure 90: Credit to Individuals % of total credit

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

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Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10


Breakdown of total credit: Below is the distribution of credit in Brazil. The improvements in the consumer portion of total credit emphasized before have generated a reconfiguration in the credit breakdown. The industrial sector was the most affected – it represented almost 30% of the credit in 2001 and now accounts for 22%. It is important to remember that although some sectors have lost participation in the total credit picture,

47



this does not mean that the nominal amount of credit decreased, as total credit in the country has practically doubled over the last few years, reaching R$1.1 trillion in 2010. 10% of total credit is destined for the commercial sector, 7% for the rural sector and only 4% for the public sector.

Figure 91: Total Credit Destination by Debtor %

Industrial Sector 22%

Commercial Sector 10%

Public Sector - 4%Others - 17%

Indiv iduals - 32%

Housing - 8%Rural Sector - 7%


Breakdown of consumer credit: The breakdown of credit to individuals also evolved in an interesting manner. One of the key factors that allowed for a sharp expansion of this segment was the creation of the payroll loan, extended to retirees, civil servants and formal sector workers. Banks like payroll loans as they can discount installment payments straight from the employee/retiree paycheck. The figure below shows that almost 50% of consumer credit is for personal loans, of which payroll loans are a great part. Second comes auto financing, responsible for 33% of total non-earmarked consumer credit in Brazil. Note that mortgages are at the end of the line with only 1.7% of total consumer credit. Even though mortgage accounts for about 8% of total credit in Brazil, most comes from earmarked resources at Caixa Economica Federal, and only a small fraction from banks. Still, this is the consumer credit category that has grown the most, with a 60% increase over the last 12 months (as of Dec 2010).

Figure 92: Breakdown of Consumer Credit per Credit Type % of total non-earmarked credit, Dec 2010

49.4%

33.0%

7.1% 4.3% 2.4% 2.1% 1.7%0.0%

10.0%20.0%

30.0%40.0%50.0%

PersonalCredit

AutoFinancing

Credit Card Ov erdraft ConsumerGoods

Financing

Others Mortgage


In terms of corporate loans (non-earmarked), more than 55% of the total goes to finance working capital.

Non-performing loans: Consumer NPLs have not increased despite the rise in credit. Following the 2008 crisis, consumer NPLs rose but by mid-2009 had started to decline and continued to do so into 2010. This trend wasn’t repeated for corporate, as NPLs in that segment came from a very low base. NPLs (over 90 days’ non-payment) are hovering around 6% for consumers and 3.5% for corporate.

Figure 93: Non-performing Loans % of total loans (YE2010)

5.0

6.0

7.0

8.0

9.0

Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-101.01.52.02.53.03.54.0

Consumer NPL (right) Corporate NPL (left)


Average loan maturity: Other than lower interest rates, one of the main factors that helped to make loans more affordable to consumers is the extending of maturities. At the end of 2010, average maturity for consumer loans is 550 days, or 100 more days then at the eve of the credit crunch in September 2008. Average maturity for corporate loans is lower, at 395 days currently.

Figure 94: Average Maturity for Consumer Credit Days

200250300350400450500550600

Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Source: Banco Central do Brasil.

Spreads: A key characteristic of the Brazilian banking sector is that spreads are high. Even though interest rates fell over the last few years, rates charged for consumer loans are still extremely high, averaging 40 p.p. annually in 2010. The main factor responsible for these high rates are banking spreads, currently at over 30 p.p. for consumer loans and 19 p.p. for corporate loans. Often the government talks about ways to reduce

48



banking spreads, but without a clear revamping of the tax system, the full introduction of a positive credit bureau and a continued decline in interest rates, spreads tend to remain at high levels.

Figure 95: Average Spreads for Consumer Loans % a.a.

25

35

4555

65

75

Jan-

00

Jan-

01

Jan-

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Jan-

03

Jan-

04

Jan-

05

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11


Loans from the public sector: Since the advent of the 2008 crisis, public sector financial entities have become a lot more active in loan concession. As private banks recoiled, public ones tried to guarantee the pace of economic growth by granting credit, often at subsidized rates, when credit was scarce. Today, public sector credit is responsible for 42% of total credit in the Brazilian system, levels that are a lot higher than those of the pre-2008 crisis period. While the government strategy was successful in preventing a crisis, the policy of credit stimulus, especially via subsidized rates at the BNDES, remained in place long after the economic recovery was at full steam. Some argue that the high level of public sector credit in Brazil is an impediment to effective interest rate policy in the country as a great deal of credit is done at less than the benchmark rate.

Figure 96: Public Sector Credit as a % of Total Credit %

30%

32%34%

36%38%

40%42%

44%

Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Source: Banco Central do Brasil.

Consumer leverage: The credit boom of the last few years has started to raise questions regarding consumer leverage. Data to measure this leverage is limited in Brazil, but recently the central bank developed a series showing that while the total debt stock of households is low relative to annual earnings, the debt service is high.

As of December 2010, the total debt stock of Brazilian households was 37.4% of annual income.

Figure 97: Household Debt Stock as a % of Annual Income %

22.0%24.0%26.0%28.0%30.0%32.0%34.0%36.0%

Jun-

06

Oct-0

6

Feb-

07

Jun-

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Jun-

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Oct-0

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0

37.4%


Household debt service stood at 22.4% as of December 2010. Although this is lower than in the past, the level is high and largely justified by the interest component (12.7%) rather than the principal (9.7%).

Figure 98: Total Debt Service as a % of Annual Earnings %

8%9%

10%11%12%13%14%15%

Jun-

06

Oct-0

6

Feb-

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Jun-

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Oct-0

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Jun-

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Feb-

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Jun-

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Feb-

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Jun-

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Oct-1

0

Interest Pay ments Principal

12.7%

9.7%


Brazilian Mortgage System

Source: J.P. Morgan’s Brazilian Homebuilders 101 by Adrian E Huerta and Marcelo Motta (2010 and 2011 editions)

Historically, mortgages in Brazil have always presented a weak performance. Getting credit to finance a house used to be a big challenge, and only a few could have their own house. Since 2006, and mainly after the implementation of the Minha Casa Minha Vida program, mortgages started to increase and in November 2010 registered their highest level: 3.7% of GDP.

49



Figure 99: Mortgages as % of GDP %

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jun-

01

Jan-

02

Aug-

02

Mar

-03

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-

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Feb-

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Apr-0

7

Nov-

Jun-

08

Jan-

09

Aug-

09

Mar

-10

Oct-1

0

Source: J.P. Morgan, estimates, Central Bank.

Despite the evolution in the latest years, mortgages in Brazil have been pretty weak if compared to other countries’. In 2008, Brazil figured among the countries with the lowest mortgages-to-GDP ratio, registering only 2.6%. Brazil’s ratio is behind its main Latam peers’ and also most of the emerging countries.

Figure 100: Mortgages by Country as a % of GDP

67.4 66.6

47.435.7

28.3 24.1 22 20.8 15.5 14.8 10 9.8 9.5 4.9 4.4 2.6 2.2 2.1 1.7 0.7 0.30

1020304050607080

US UK

Germ

any

Japa

n

Mala

ysia

Fran

ce

Sout

h Af

rica

Kore

a

Thail

and

Chile

Colom

bia

Mex

ico

Boliv

ia

India

Polan

d

Braz

il

Peru

Indo

nesia

Arge

ntina

Vene

zuela

Turk

ey

Source: Warnock and Warnock (2008).

There are two main sources of funding in Brazil, saving accounts or SBPEs (Sistema Brasileiro de Poupança e Emprestimo) and the FGTS (Fundo de Garantia do Tempo de Serviço, the Brazilian public pension fund to which all Brazilian employees make mandatory contributions).

SFH: Sistema Financeiro de Habitação (Housing Financial System) was created in 1964 to develop the mortgage market in Brazil. Its main sources of funding are savings deposits in the financial system, including deposits at government-owned CEF, which is the main vehicle for directed mortgage lending in the country, with a market share of 70% in 2009, as well as another 22 private and public financial institutions. The participating banks comprise the Sistema Brasileiro de Poupança e Emprestimo or SBPE (Brazilian Saving and Loan System). The other source of funding for SFH is employees’ payment to FGTS.

SBPE: Traditionally, the SBPE has encompassed all public- and private-sector banks except those focused on the rural segment. In 2009 mortgages from SBPE amounted to R$56 billion, representing 65% growth vs 2009.

Banks in the SBPE have to devote 65% of savings deposits, which are remunerated at “Tax Referential” (TR) plus 6.17% a year, to mortgages. Of the 65%, 80% has to be lent at no more than TR + 12% a year and the remaining 20% can be allocated in mortgages at market rates. However, banks are allowed to comply with this requirement through a variety of regulatory facilities. If banks have a shortfall in their directed lending requirement, they are penalized with a lower return on the shortfall amount (TR flat vs. the TR + 6.17% that they have to pay on the savings deposit).

FGTS: Provides funding through compulsory savings from employees. Originally conceived as unemployment insurance, it is now used for a variety of purposes, including providing support to workers who are terminally ill, helping workers purchase a house, providing financial assistance for employees who are laid off and, more recently, infrastructure investments. Employees contribute from 8% to 11% of their salary, depending on the income segment (deposited at Caixa Economica Federal, the main user of the assets) to the fund every month. The money at FGTS yields TR + 3% a year.

Changes in FGTS: Over the last years we saw several changes in how employees can use their FGTS resources. One of the most relevant for the housing market was the increase of the maximum housing price that can be purchased withdrawing FGTS balance, to R$500,000 from R$350,000 previously. Another positive change for the housing market was the permission to use the FGTS on consortium bids and debt amortization; another measure under study by Brazilian Congress is the possibility of a father or mother using FGTS to buy an apartment for a daughter or son.

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Figure 101: FGTS + SBPE Total Mortgage Disbursements R$ Billion

5.8 4.9 5.5 6.0 6.9 10.316.3

25.2

40.549.7

0102030405060

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

FGTS SBPE Source: CBIC and CEF.

BNDES

Since its creation in 1952, the Banco Nacional do Desenvolvimento Econômico e Social – BNDES – has performed different strategic roles in propelling the cause of Brazilian development. In the 1970s, it was a key enabler of the capital goods industry and an enabler of the import substitution model. The bank was a lender to companies at times of distress during the 1980s’ successive crises. In the 1990s, the BNDES had a key role in the privatization process, and now the BNDES is back to the role it first performed of funding the country’s industry and infrastructure, but with a scope and with a funding that are unprecedented. Today the BNDES is responsible for 21% of the credit in Brazil, or 9.2% of GDP.

Figure 102: BNDES Participation in Credit Rose after 2008 Crisis

16%17%18%19%20%21%22%

Dec-

07Fe

b-08

Apr-0

8Ju

n-08

Aug-

08Oc

t-08

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5%

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8%

9%

10%

% of total credit (lef t) % of GDP (rigth) Source: Banco Central do Brasil.

The BNDES credit expansion is evident when looking at disbursement data. In 2009, BNDES disbursements increased by 46% relative to 2008. In 2010, loans increased even more, reaching R$168 billion (22.5%), including R$25 billion that the bank invested in the Petrobras capitalization.

Figure 103: BNDES Disbursement R$ Billion

19.1 21.3 20 23.4 25.738.2 35.1 40 47.1 52.3

64.992.2

137.4

168.4

0

50

100

150

200

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: BNDES.

Of the R$168.4 billion in loans extended in 2010, 47% went to industry, 31% to infrastructure and 16% to commerce. The BNDES forecast for total investment (public and private) in 2010 to 2013 is that it will be R$859 billion, with industry getting over 60% of total, largely in terms of the oil & gas sector. The highlight on the infrastructure front, which is expected to get R$310 billion in investments, is in terms of electric energy, mostly due to the three large hydroelectric plant developments in the Amazon basin.

Table 50: BNDES’s Investment Perspectives

2005 - 2008 2010-2013 % % per yearIndustry 344.0 549.0 74.7 11.8

Oil and Gas 201.0 340.0 112.8 16.3Mining 53.0 52.0 -3.0 -0.6Steel 27.0 51.0 99.4 14.8Petrochemical 9.0 34.0 70.8 11.3Autos 21.0 32.0 37.7 6.6Electronic 15.0 21.0 98.9 6.8Pulp and Paper 18.0 19.0 10.4 2.0

Infrastructure 199.0 310.0 55.3 9.2Electric Energy 68.0 98.0 45.6 7.8Telecom 66.0 67.0 2.0 0.4Sewage 22.0 39.0 76.2 12.0Railway 16.0 56.0 195.5 24.2Highway 23.0 36.0 73.1 11.6Ports 5.0 15.0 217.6 26.0

Total 543.0 859.0 58.2 9.6

R$ bil Growth

Source: BNDES.

Where do the BNDES resources come from? Nowadays there are two main sources of funding for BNDES: social contribution tax and the Treasury. The social contribution taxes used to account for more than 60% of BNDES total funding, but from 2008 its participation started to decrease. In 2009 the social contribution funds were responsible for 42.5% of BNDES total funding. On the other hand the Brazilian Treasury resources committed to the BNDES have been increasing by a great deal: to R$130 billion in 2009 from R$37.2 billion in 2008 and R$8.2 billion in 2007.

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In 2009 the Treasury was responsible for 36.7% of total loans and in 2010 extended another R$80 billion to the BNDES. Other funding resources include hybrid debt and equity instruments, provisions, among others. It is important to note that returns from past loans also constitute an important funding source.

BNDES and the 2008/09 crisis: In the second half of 2008, the global crisis provoked a sudden stop in the common credit channels. As in other countries, the government of former president Lula adopted a countercyclical strategy to stimulate the economy, and the BNDES, Banco do Brasil and Caixa Economica Federal were the main vehicles for implementing it. As a result, BNDES loans ballooned and, according to the bank’s officials, are not likely to decline in 2011 from 2010 levels (R$168 billion). Still, there is wide recognition, even among BNDES officials, that the private sector will have a more active role in financing long-term development and that the main catalyst for that will be lower interest rates.

Figure 104: BNDES vs. Capital Markets R$ Billion

40 47.1 52.364.9

92.2

137.4168.4

17.224.5

61.8

110.2131.3 128.8

70.4

186.3

9.3

2004 2005 2006 2007 2008 2009 2010 2011

BNDES Loans Primary Offerings Registered at the CVM Source: BNDES.

The BNDES subsidiary, BNDESPar, is responsible for the bank’s capital market operations, and its main attribution has to do with the management of a huge equity portfolio. At the end of 2010, the BNDES equity portfolio totaled R$118.5 billion, or 22.8% of total BNDES assets, accounting for 37% of the bank’s net income for the period. The BNDES equity portfolio is highly concentrated in the oil and mining sectors due to its key stakes in Petrobras and Vale.

Table 51: Sector Composition of BNDES Equities Portfolio Sector R$ bi % of portfolio Oil & Gas 42.7 36.0 Mining 26.6 22.5 Electric Energy 14.5 12.2 Food 10.8 9.1 Pulp and Paper 4.6 3.9 Telecom 3.7 3.1 Steel Industry 2.4 2.0 Metallurgy 2.1 1.8 Transportation 1.9 1.6 Consumer Goods 1.5 1.3 Others 7.7 6.5 TOTAL 118.524 100

Source: BNDES.

Capital Markets

According to the World Federation of Exchanges, in terms of market capitalization, BM&F Bovespa is the 11th-largest stock exchange in the world and the largest in Latin America.

Figure 105: 15 Largest Stock Exchanges in Terms of Market Cap US$ Trillion

13.4

3.9 3.8 3.6 2.9 2.7 2.7 2.2 1.6 1.6 1.5 1.5 1.4 1.3 1.2

0.03.06.09.0

12.015.0

US N

YSE

NASD

AQ O

MX

Toky

o SE

Lond

on S

E

Euro

pe N

YSE

Shan

ghai

SE

Hong

Kon

g

TSX

Grou

p

Bom

bay

SE

India

SE

BM&F

BOVE

SPA

Aust

ralia

n SE

Deut

sche

Bör

se

Shen

zhen

SE

Swiss

SE

Source: World Federation of Exchanges.

Market cap: The Bovespa market cap reached US$1.54 trillion in 2010. Since 2002, the Bovespa has increased its market value dramatically. From 2002 to 2007 Bovespa grew an average 64% per year, coming from US$124 billion in 2002 to US$1.4 trillion at the end of 2007. Also interesting to note is the strong recovery of the Bovespa market cap after the crisis. In 2008 the sum of the market cap of all the companies listed in the stock exchange fell by 58%, but the recovery was incredibly fast. Indeed, it took less than a year for Bovespa to regain its pre-crisis value.

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Figure 106: Bovespa Market Cap US$ billion

161 229 226 185 124 234 341482

723

1,399

588

1,3411,542

0250500750

1,0001,2501,5001,750

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: BM&F Bovespa.

In Brazil, 55% of the Bovespa market cap is concentrated in only 10 companies. The main highlight is Petrobras, which by itself represents almost 15% of the Bovespa market cap. The second-largest company is Vale, responsible for almost 11% of the Bovespa’s total market cap. Still, the largest sector in the Bovespa is financials. Note that among the 10 largest companies in the Bovespa, 5 are financial institutions (ITUB4, BBDC4, BBAS3, SANB11, ITSA4).

Table 52: Brazil’s 10 Largest Companies by Market Cap (Dec 2010)

Company Ticker Market Cap (in US$ billion)

% of Bovespa Market Cap

1 Petrobras PETR4 229.1 14.8%

2 Vale VALE5 166.8 10.8%

3 ItauUnibanco ITUB4 96.7 6.2%

4 AmBev AMBV4 86.9 5.6%

5 Bradesco BBDC4 67.2 4.3%

6 Banco do Brasil BBAS3 54.1 3.5%

7 Santander BR SANB11 52.1 3.4%

8 OGX Petroleo OGXP3 38.9 2.5%

9 Itausa ITSA4 36.1 2.3%

10 Sid Nacional CSNA3 23.4 1.5%

Source: Bloomberg and J.P. Morgan.

The largest sector in the Bovespa, Financials includes almost 10% of total Bovespa companies and is responsible for about 24% of Bovespa’s market cap. Oil & Gas and Mining are the second- and third-largest sectors in the Bovespa respectively. Though both sectors do not have a great number of listed companies in the stock exchange (6 companies each), the market cap of their few but representative companies are enough to surpass other sectors’ market value.

Table 53: Bovespa by Sector (Dec 2010) Sector Number of

companies % Market Cap

(in R$ Billion) %

Financials & Insurance 33 5.3% 318.7 20.9% Oil & Gas 79 12.7% 275.5 18.1% Mining 4 0.6% 173.7 11.4% Others 79 12.7% 143.2 9.4% Food & Beverage 20 3.2% 130.2 8.5% Electricity 42 6.7% 113.3 7.4% Telecom 4 0.6% 69.2 4.5% Steel & Metallurgy 15 2.4% 67.4 4.4% Commerce 17 2.7% 45.7 3.0% Transportation 14 2.2% 41.0 2.7% Construction 26 4.2% 34.0 2.2% Chemical 15 2.4% 27.3 1.8% Software & Data 4 0.6% 23.7 1.6% Vehicle & Parts 17 2.7% 15.4 1.0% Pulp & Paper 6 1.0% 14.5 1.0% Textile 28 4.5% 13.6 0.9% Industrial Machinery 79 12.7% 9.3 0.6% Electronics 42 6.7% 6.1 0.4% Agriculture 20 3.2% 1.7 0.1% Nonmetallic Minerals 79 12.7% 1.0 0.1%

Source: Economática and J.P. Morgan.

The Brazilian stock exchange had 381 companies at the end of 2010, around 770 listed stocks and other instruments. The number of companies traded at Bovespa has been falling: In 1998, there were almost 600 companies listed in the Bovespa, but after that, the numbers started to decline. This reduction can be explained mainly due to the increasing number of mergers and acquisitions. Also, less traditional companies decided to close capital. The management of the exchange has a plan to add 200 new companies in the Bovespa by 2014.

In the period between 2006 and 2009, an average of 645 M&A transactions were announced yearly, an increase of almost 70% compared to the average observed between 2002 and 2005. In the 12 months to the end of March 2011, Brazil registered 466 M&A transactions, according to Bloomberg.

Bovespa Indexes

Ibovespa: This is the benchmark equity index for Brazil. The index is composed of a theoretical portfolio, including around 65 companies, which forms the group

53



of stocks whose negotiability index added represents 80% of total value negotiated in the Bovespa. Ibovespa is a cumulative index. Basically its number represents the present value of a portfolio that began on 2 January 1968, with a starting value of 100. The index is rebalanced every four months.

Figure 107: Bovespa Index performance BRL

30000

40000

50000

60000

70000

80000

Jan-

06

Sep-

06

May

-07

Jan-

08

Sep-

08

May

-09

Jan-

10

Sep-

10


Ibovespa’s performance has been pretty robust, with the exception of the crisis period. From January 2006 until May 2008, the index gained more than 90%, reaching over 73,000 points. With the crisis, the index suffered a lot, losing about 50% of its value. But the recovery came fast and strong.

2010 was not a typical year for the Ibovespa. The index did not have any significant oscillation, either positive or negative, trading range bound between 60,000 and 70,000 points. Even after the end of the overhangs that were weighing on the market most of the year (interest rate increases, the Petrobras capitalization, the presidential election, global concerns relating to Europe, China and the U.S. recovery), the Ibovespa remained flat and without a specific trend the whole year.

Figure 108: Bovespa Performance in 2010

580006000062000640006600068000700007200074000

Jan-

10

Feb-

10

Mar

-10

Apr-1

0

May

-10

Jun-

10

Jul-1

0

Aug-

10

Sep-

10

Oct-1

0

Nov-

10

Dec-

10

Source: Bloomberg.

IBX-50/ IBX-100: The INX-50 and the IBX-100 are also benchmark indexes. The companies that compose these indexes are very similar to those in the Ibovespa. The main difference is the way the indexes are calculated. The IBX-50 is composed of 50 companies

with highest liquidity in the Bovespa and the IBX-100 of the 100 most liquid companies. The portfolios have durations of 4 months (Jan-Apr, May-Ago, Sep-Dec) and are recalculated in the end of each period.

As expected, if we put together both indexes, the performance of Ibovespa and IBX-50 are very alike, due to the similarity in their composition and the high weight of the main companies in both.

Figure 109: IBX50 vs. Ibovespa

2000

4000

6000

8000

10000

12000

Jan-04 Feb-05 Mar-06 May -07 Jun-08 Jul-09 Sep-1010000

2000030000

4000050000

6000070000

80000 IBX-50

Ibovespa

Source: Bloomberg.

Other indexes: Bovespa also provides sector-specific indexes. This kind of index provides a segmented view of the stock, measuring the performance of the stocks issued by the representative companies of each sector. Today, there is the ITEL (telecom index), the IEE (electricity index), INDX (industrial sector), ICON (consumer), IMOB (real estate), and financial (IFNC). Other relevant indexes have to do more with corporate governance: The IGC can only be composed of companies listed on the Bovespa Level 1 or 2 or on the Novo Mercado segment. The ITAG is the index composed of companies that offer tagalong rights for minority shareholders that are higher than 80%, which is the minimum established by current Brazilian legislation. Finally, there are indexes for medium cap (MLCX), which can include companies representing 85% of Bovespa market cap. The other 15% is included in the small cap index (SMLL).

Corporate governance: Since the turn of the century, there have been important advances in terms of corporate governance. The main piece of legislation that greatly improved capital markets in Brazil was the Corporate Law approved by Congress in 2001. It established, among other things, that the number of preferential shares (PN) cannot be more than 50% of total shares and that PNs should have at least one of the following advantages: 1) A dividend that is equal to at least 25% of net income; 2) A dividend at least 10% higher than the ordinary shares’ (ON) dividend; 3) In case of a sale or LBO of the company, tagalong rights

54



of 80% and a dividend equal to the ON shares’. The Corporate Law also stipulates the rules for the composition of the company’s board, the gathering of the general and extraordinary assembly, issues pertaining to offerings and the retirement of shares in circulation, among other things. While the Corporate Law is the backbone of equity market rules in Brazil, the CVM (equivalent to the US SEC) is responsible for the regulatory framework of Brazilian security markets. Today in the Bovespa there are three levels of corporate governance:

Table 54: Summary of Corporate Governance Levels for Bovespa Companies Level 1 Free float of 25% Public offering that prioritizes capital dispersion Quarterly financial releases Public release of shareholder agreements Public release of option programs Level 2 Everything in Level 1 plus: One-year unified mandate for the board Quarterly financial releases in US GAAP 100% tagalong rights for ON and 70% for PN If the company takes itself private, or exits Level 2, it must do a public offering for the acquisition of 100% of shares in circulation Participation in the Arbitration Court Right of vote for preferential shareholders (PN) in some issues, such as M&A Novo Mercado Everything in Level 2 plus: Only one share class (ON – Ordinary) 100% tagalong rights Board includes at least five members elected by shareholders


MSCI

The Brazil MSCI index is composed of 83 companies, free float market capitalization weighted. With a 16% weighting in the MSCI Emerging Markets index, Brazil is the second-largest country in terms of representation, behind only China with its 17.5% participation.

Table 55: MSCI Brazil Weighting by Sector Weightings % Number of

Brazil EM Latam companies Consumer Discretionary 4.5 0.7 3.1 11

Homebuilders 2.5 0.4 1.7 1

Retailing 1.5 0.2 1.1 4 Consumer Staples 8.5 1.4 5.9 9

Food & staples retailing 0.6 0.1 0.4 1 Food beverage & tobacco 6.6 1.1 4.5 6

Personal Products 1.3 0.2 0.9 2 Energy 24.5 3.9 16.8 5 Financials 24.4 3.9 16.8 12

Banks 20.5 3.3 14.1 6 Diversified Financials 2.7 0.4 1.8 2

Industrials 3.2 0.5 2.2 12 Capital Goods 0.7 0.1 0.5 1 Transportation 2.5 0.4 1.7 6

Merchant Acquirers 1.9 0.3 1.3 3 Materials 23.8 3.8 16.3 15

Chemicals 0.8 0.1 0.5 3 Paper and Forest 1.1 0.2 0.7 3

Metals & Mining 21.9 3.5 15.1 9 Telecom 2.7 0.4 1.2 6 Utilities 5.6 0.9 3.8 12 MSCI Brazil 100.0 16.0 68.1 83

Source: MSCI; J.P. Morgan.

Brazil, along with Russia, is the EM country that has the most commodity companies (global price taker) represented in the MSCI, as shown in the table below.

55



Table 56: MSCI EM index composition by country: Demand Classification

MSCI Emerging Markets

Free Index

Domestic Demand

Global Capex

Global Consumer

Global Price

Takers

Total

China 12.7 0.5 0.2 4.1 17.5 India 4 1.4 2 7.4 Indonesia 1.9 0.4 2.4 Korea 5.4 2.5 3.9 2.4 14.2 Malaysia 2.2 0.6 2.8 Philippines 0.5 0.5 Taiwan 3.2 3.1 3.1 1.6 11 Thailand 1.1 0.1 0.6 1.7 Asia 31 7.5 7.3 11.8 57.6 Czech Republic

0.4 0.4

Egypt 0.3 0.3 Hungary 0.2 0.2 0.4 Morocco 0.2 0.2 Poland 1.3 0.3 1.7 Russia 1.9 0.1 5.3 7.3 South Africa

4.7 2.8 7.5

Turkey 1.4 1.5 EMEA 10.5 0.1 0.1 8.6 19.3 Brazil 8.6 7.3 15.8 Chile 1.4 0.1 1.5 Colombia 0.5 0.2 0.8 Mexico 3.7 0.2 0.5 4.4 Peru 0.2 0.4 0.6 LatAm 14.3 0.3 8.5 23.1 Total 55.8 7.9 7.4 28.9 100

Source: MSCI; J.P. Morgan.

Flow of Funds

Our basic theory is that flows are inversely correlated to risk. This was pretty much the case in 2010, when outflows were the rule considering that risk aversion was high on the back of uncertainties related to monetary policy tightening in Brazil, the European sovereign crisis, the increase in interest rates in China and the spring disappointment with the pace of the US economy. On top of that, two 2H10 events hovered for Brazilian equity investors: the capitalization of Petrobras (September, but first scheduled for 2Q) and the presidential elections (October). All these overhangs weighed on the market in 2010, and foreign net inflows into the Bovespa ended the year at only R$5.75 billion, down from more than R$20 billion in 2009, a 70% decline.

Figure 110: Foreign Equity Investments in the Bovespa (Secondary) Market BRL Billion

-2.2

0.8

-1.4

7.51.8

5.91.8

-4.2

-24.6

20.6

5.7

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Bloomberg.

Flows into emerging markets: In 2010, emerging market funds saw a record inflow of over US$84 billion versus US$64 billion the previous year (up more than 30%). Looking at a proxy for Brazil, the country was responsible for 4.2% of the total EM flow, compared to 15% in 2009, confirming that the poor flow result of 2010 is probably Brazil-centric.

Table 57: Market Data and Net Foreign Investment US$ Million

2010 Agg. US$M

2009 Agg. US$M

Stock Exchange Investors' Trading Data Japan (1wk lag) 36728 17078 South Africa 4739 8988 Brazil** 3534 10028 Taiwan 8709 13720 Korea 18595 24827 India 28686 17626 Thailand 1923 1141 Indonesia 2331 1385 Philippines 1231 132 Regional & US Mutual Fund Flows Total EM Equity**** 84112 64373 Global EM Equity* 55045 29058 LatAm Equity* 1842 8786 EMEA Equity* 6567 2017 Asia ex-Japan Equity* 19609 19108 BRIC Equity* 1049 5404 Japan Equity Funds -840 -5461 Developed Europe* -10256 2506 International Equity* 6500 18727 US Equity*** 33467 -8290 US Bond*** 149347 180622 US Money Market *** -395262 -466143

Source: Bloomberg, J.P. Morgan, I:Net, MKK, Lipper FMI, MSCI, Datastream. *EPFR Global data. ****Total EM Equity includes Global EM, LatAm, EMEA, Asia ex Japan and BRIC equity funds.

56



Investor participation in Bovespa: The profile of investors’ participation in the Bovespa has changed a lot in the last ten years. The main change was regarding financial institutions’ role in the Bovespa. At the beginning of the decade, this group was the main investor in the Brazilian stock exchange, responsible for more than one third of total volume. Nowadays, the group’s participation is only 8% and it no longer figures among the 3 main groups of investors in the Bovespa, which are now individuals, institutional and foreign investors. After 6 consecutive years as the Bovespa’s main group of investors, foreigners lost their position in 2010, due to the Brazilian economy overhangs that kept foreign investors far from Bovespa most of the year. The most representative category in 2010 was the institutional investor, taking exactly one third of the volume.

Figure 111: Investor Participation in Total Bovespa Volume %

5.0%10.0%15.0%20.0%25.0%30.0%35.0%40.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Indiv iduals Institutional Foreign Inv estors Financial Institutions Source: BM&F Bovespa.

Bovespa average daily traded volume: Bovespa’s ADTV has been reaching record levels since 2006 (with the exception of 2009), and in 2010 the average daily traded volume reached US$3.7 billion. This means an increase by 35% compared to 2009 and 18% compared to 2008. The evolution presented below illustrates the development and internationalization of the Brazilian Stock Exchange.

Figure 112: Bovespa Average Daily Traded Volume US$ Billion

0.36 0.28 0.390.77 0.57

0.35 0.41 0.27 0.20 0.27 0.420.67

1.12

2.55

3.122.74

3.69

0.000.501.001.502.002.503.003.504.00

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010


Pension Funds

The Brazilian pension fund system: The pension fund system in Brazil is basically divided into three areas: (1) Public sector: mandatory social security for public sector employees; (2) General regime: mandatory social security for formal sector employees; (3) Complementary pension: optional, can be closed (when the worker is associated with a company that offers a private social security plan) or open (available to anyone who wishes to participate, independent of the company for which the person works).

In mid-2010 there were about 370 closed-end pension plans in Brazil and approximately 2.1 million active participants actively contributing to the system. The largest closed-end pension fund was the one of the Banco do Brasil employees, which is called Previ. Its AUM accounts for 29% of the industry’s total, or R$145.6 billion as of September 2010.

Table 58: Top Ten Brazilian Pension Funds Fund Name Entity Associated AUM in R$ bn

1 PREVI Banco do Brasil 145.6 2 PETROS Petrobras 48.0 3 FUNCEF Caixa Economica Federal 39.5 4 FUNDAÇÃO CESP Cesp 17.7 5 VALIA Vale 13.1 6 ITAUBANCO Banco Itau 11.5 7 SISTEL Telecom Companies 11.1 8 BANESPREV Banco Santander 9.5 9 FORLUZ Cemig 8.6

10 CENTRUS Banco Central do Brasil 8.2

Source: Abrapp.

As of mid-2010, there was around US$583 billion in assets under management in Latin America pension funds. On average, pension funds represent 16%-22% of Latin America countries’ GDP, with the exception of Chile, where the ratio of total pension funds to GDP is comparable to that of developed countries. Regarding the asset allocation, it can be observed that almost all the countries in Latin America prefer to allocate a higher share of the AUM to fixed income. Only 32% of Latin America AUM is invested in equity.

57



Table 59: Latin America Private Pension Funds Asset Breakdown

Country AUM (US$ bi)* as % of GDP** Fixed Income Equity Brazil 270 16% 62.2% 30.4% Chile 130 79% 49.2% 46.2% Colombia 49 21% 55.1% 42.9% Mexico 101 12% 79.2% 12.9% Peru 27 21% 44.4% 48.1% Uruguay 6 18% 99.9% 0.0%

Source: J.P. Morgan. * As of August 2010 excepting Brazil (May 2010) and Colombia (July 2010). ** 2009 GDP.

Brazilian pension funds had assets under management equivalent to 15% of GDP as of September 2010. Pension investments in Brazil over the last several years have been pretty conservative, with heavy concentration in fixed income. This makes perfect sense to us, considering that Brazil had some of the world’s highest real interest rates for most of the last two decades. On average, pension fund investment in equities has been around 32%. The equity percentage of total AUM at the end of 2009 was about 33.2%, compared to 56.2% for fixed income. From January to September 2010 pension fund total AUM reached R$529 billion, with 31.6% allocated in equity and 60.9% in fixed income. Note that 2.8% of pension fund AUM are invested in real estate.

Figure 113: Pension Fund Allocation %

25

28

31

34

37

40

Dec-

01

Dec-

03

Dec-

05

Dec-

07

Feb-

08

Apr-0

8

Jun-

08

Aug-

08

Oct-0

8

Dec-

08

Feb-

09

Apr-0

9

Jun-

09

Aug-

09

Oct-0

9

Dec-

09

Feb-

10

Apr-1

0

50

53

56

59

62

65Fixed IncomeEquity

Source: Abrapp.

In Brazil there are limitations in terms of security allocations for pension funds. Recently, the legislation was changed to allow for a higher limit on equity investments, with the ceiling raised from 50% to 70%. Still, it is interesting to note that the previous 50% limit was never reached, so that the new legislation doesn’t really make a material difference. Fixed income investments (public sector debt) in general have no ceiling, and funds can opt to invest 100% of AUM in these securities. For investment in private debt (notes, receivables, etc.), the limit is 20%. Real estate

investment is capped at 8%, but investments in real estate plans fall under another category (structured products, which include multi-strategy funds), with a limit of 10%.

Mutual Funds

In 2010 the mutual fund industry had R$1.67 trillion of AUM, with only 3.5% off-shore. This amount represents around 47% of the country’s GDP. In Brazil, there are about 10,083 mutual funds registered, and more than 10.7 million accounts.

Table 60: Mutual Fund Industry Relevant Information – Oct/2010

Domestic market R$1,614.6 billion of AUM Number of funds 10,083 funds Number of accounts 10,7 million accounts Off-shore R$59.3 billion of AUM and 94 funds Total R$1,673.9 billion of AUM

Source: Anbima.

Total AUM has increased steadily since 1994. With the exception of 2002 and 2008 (both years marked by a confidence crisis in Brazil), each year presented double-digit growth from the prior year. In 1994-2010, total AUM average growth was 27% per year (inflation adjusted). In 2010 things were not different and in the year as a whole, total AUM increased by 19.2% in real terms, reaching R$1.69 trillion as of December.

Figure 114: Mutual Funds’ Total AUM R$ Billion

46 62 116 129 147 221 297 344 355516 613

739940

1,160 1,135

1,4191,691

0

250500

750

1000

12501500

1750

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Anbima.

At the end of 2010, the share of total AUM invested in fixed income funds was 27.2%, with an additional 12.2% invested in overnight rates tied to the Selic (DI). The second most preferred destination of investors is multi-strategy funds (mostly hedge funds), accounting for 24% of total AUM, or R$415 billion. The equity funds have had a more discreet participation, being responsible for only 11.3% of investments. This level

58



has been maintained since December 2007, when investments in equities reached a peak of 15.5%.

Figure 115: AUM Breakdown by Category %

Others4%

Short term - 4%DI - 12%

Fix ed Income - 27%

Multistrategy - 24%

Equities - 11%

Retirement - 11%

FIDC - 3%

Others - 7%

Source: Anbima.

The figure below shows that the fixed income share of total AUM has decreased significantly over the years. In 1995, almost 85% of the AUM was allocated in fixed income funds. At the end of the 1990s started a devolution process and new fund categories (such as DI index funds, private equity and off-shore) started to emerge as investment options.

Figure 116: Fixed Income vs. Equity vs. Multi-Strategy

0.0

20.0

40.0

60.0

80.0

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jun-

05

Jul-0

5

Jul-0

5

Fix ed Income Multistrategy Equity Source: Anbima.

Comparing mutual fund and pension fund allocations, we can say that the pension funds have a more aggressive strategy in terms of equity investments. While on average 30% of pension funds’ total AUM is allocated in equities, only 11% of mutual funds’ AUM is invested in this category. In part, this is because pension funds were active participants in the privatizations of the 1990s and thus own important shares of key Brazilian companies. In addition, mutual funds have a significant participation in multi-strategy funds, which may or may not contain a share of equities in their strategy. As a basis of comparison, in Mexico both mutual and pension funds have a similar allocation in equities: between 12% and 16%.

Politics

The Federal Republic of Brazil is a democratic state, meaning that its representatives are elected by universal suffrage, according to the Constitution of 1988. The executive power is exercised by the president, who is elected to a four-year term and may be re-elected once. The legislative power is exercised by the Brazilian National Congress, composed of two chambers. The Chamber of Deputies is the lower house and has 513 members elected for four-year terms. Each state’s representation is determined by its population, with a minimum of 8 seats and a maximum of 70 seats. The Federal Senate (upper house) has 81 members elected for eight-year terms, with elections every four years for, alternatively, either one-third or two-thirds of the seats. Each state elects three senators. To be elected president, governor or mayor in Brazil, the candidates need an absolute majority, which means they need 50% of the valid votes plus one vote to carry the election in a single round. Otherwise the two candidates with the highest number of votes go to a second round. Still, run-offs for mayor only take place in localities of over 200,000K people..

Who votes in Brazil? Voting is considered both a right and a duty in Brazil. Every citizen between 18 and 70 is subject to compulsory registration and voting. The new Constitution in 1988 allowed 16- and 17-year-olds to vote on a voluntary basis. In 2010, the Brazilian electorate reached 135 million people, with 43.5% located in the Southeast region, 27.1% in the Northeast, 14.9% in the South, 7.4% in the North and 7.1% in the Midwest.

Figure 117: Electorate Divided by Age %

1.8%6.5%

9.9%

24.1%19.7%

22.6%

8.4% 6.9%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

16-17 18-20 21-24 25-34 35-44 45-59 60-69 More than70

Source: Tribunal Superior Eleitoral.

Brazil is famous for having one of the most high-tech and trustworthy electoral systems in world. Electronic voting was introduced in 1996; and the country became the first in the world to conduct fully electronic

59



elections. The vote count happens quickly, and results are out shortly after the polls are closed.

Brazil’s Main Political Parties

PMDB: The Brazilian Democratic Movement Party is the biggest political party in Brazil, although it has never elected a president in a direct election, with the entire population able to cast a vote. Launched in 1980, the PMDB is the successor of the Brazilian Democratic Movement – MDB – which was the official opposition party to the military regime. Nowadays the PMDB is part of the governing coalition, which guarantees it some key positions in the government. Among its more famous members are current Vice President Michel Temer and former presidents Tancredo Neves and Itamar Franco.

PT: Founded in 1980, the Worker’s Party is considered one of the most important leftist parties in Latin America. The party – originally made up of trade unionists, leftist intellectuals and elements of the Catholic Church linked to liberation theology – wished, initially, to put in practice a new form of democratic socialism. The PT’s main figures are former president Luis Inácio Lula da Silva, Lula, and his successor, President Dilma Rousseff. A survey conducted in December 2009 showed that the PT is the preferred party of around one quarter of Brazilian voters.

PSDB: The Brazilian Social Democracy Party was founded in 1988 by dissidents from the PMDB and is considered a centrist political party. The PSDB grew faster than any other party in Brazilian history, electing a president of the Republic just six years after its creation. The party members are called “tucanos” because of their mascot, which is a toucan. Currently, PSDB is the main opposition party. Main representatives: former president Fernando Henrique Cardoso, Senator Aécio Neves, São Paulo Governor Geraldo Alckmin and José Serra, who has been mayor and governor of São Paulo and ran twice for president (in 2002 and in 2010).

Brazil’s Presidents

Since the advent of the republic (1889), Brazil has had 36 presidents, including Dilma Rousseff. The Brazilian republican history is very troubled and only a few presidents can be considered fully elected by democratic vote.

Table 61: Brazilian Presidents

President Period

1 Deodoro da Fonseca Nov 1889 - Nov 1891

2 Floriano Peixoto Nov 1891 - Nov 1894

3 Prudente de Morais Nov 1894 - Nov 1898

4 Campos Sales Nov 1898 - Nov 1902

5 Rodrigues Alves Nov 1902 - Nov 1906

6 Afonso Pena Nov 1906 - Jun 1909

7 Nilo Peçanha Jun 1909 - Nov 1910

8 Hermes da Fonseca Nov 1910 - Nov 1914

9 Venceslau Brás Nov 1914 - Nov 1918

10 Delfim Moreira Nov 1918 - Jul 1919

11 Epitácio Pessoa Jul - 1919 - Nov 1922

12 Artur Bernardes Nov 1922 - Nov 1926

13 Washington Luis Nov 1926 - Oct 1930

14 Getúlio Vargas Nov 1930 - Oct 1945

15 José Linhares Oct 1945 - Jan 1946

16 Eurico Gaspar Dutra Jan 1946 - Jan 1951

17 Getúlio Vargas Jan 1951 - Aug 1954

18 Café Filho Aug 1954 - Nov 1955

19 Carlos Luz Nov 1955 - Nov 1955

20 Nereu Ramos Nov 1955 - Jan 1956

21 Juscelino Kubitschek Jan 1956 - Jan 1961

22 Jânio Quadros Jan 1961 - Aug 1961

23 Ranieri Mazzilli Aug 1961- Sep 1961

24 João Goulart Sep 1961 - Apr 1964

25 Ranieri Mazzilli Apr 1964 - Apr 1964

26 Castelo Branco Apr 1964 - Mar 1967

27 Costa e Silva Mar 1967 - Aug 1969

28 Emilio Medici Oct 1969 - Mar 1974

29 Ernesto Geisel Mar 1974 - Mar 1979

30 João Figueiredo Mar 1979 - Mar 1985

- Tancredo Neves -

31 José Sarney Mar 1985 - Mar 1990

32 Fernando Collor Mar 1990 - Dec 1992

33 Itamar Franco Dec 1992 - Jan 1995

34 Fernando Henrique Cardoso Jan 1995 - Jan 2003

35 Luiz Inácio Lula da Silva Jan 2003 - Jan 2011

36 Dilma Rousseff Jan 2011 -


Below we describe briefly the most famous, popular and polarizing presidents in Brazil’s history.

Getúlio Vargas: One of the most popular political figures in Brazil’s history, Mr. Vargas was the country’s president twice, from 1930 to 1945 and from 1951 until his suicide in 1954. He is the president who stayed longest in the post: 18 years in all. Vargas assumed the

60



post initially as a provisional president after the 1930 Revolution against the oligarchic and decentralized confederation of the Old Republic. In 1937 he utilized fears of Communism to justify a dictatorial regime. Under the “New State”, Mr. Vargas abolished political parties, imposed censorship and stimulated nationalism. In 1945 he was deposed by the military. In his second government, when he was finally elected by free and secret vote, Vargas pursued a nationalistic policy, turning to the country’s natural resources and away from foreign dependency. Petrobras was created in this context. Pressured by political adversaries and the military, who wished his resignation, Vargas shot himself in August 1954. He is famous as the “the father of the poor,” mainly because of the improvements he made in the labor laws.

Juscelino Kubitschek (JK): JK had a key role in Brazil’s industrialization, and his presidency was marked by political optimism. During his government (1956-1961), the country went through a period of relative economic prosperity and political stability. He launched the famous “Plano de Metas” (Goal Plan) in order to stimulate the diversification and expansion of the Brazilian economy. The plan was based on industrial expansion and integration of the national territory. His main motto was “Fifty years of progress in five”, and the time of his government is known as “the Golden Age.” Mr. Kubitschek’s special achievement was the construction of a new capital for Brazil away from the coast, Brasília. (The plan to move the capital was 100 years old.) But JK was not free from controversies; his government was also marked by accusations of corruption, mainly involving the construction of Brasilia.

Fernando Collor de Mello: Collor was Brazil’s president from 1990 to 1992, and the first president elected by popular vote after the end of the Brazilian military regime. His government was marked by the freezing of the population’s banking assets and corruption accusations that shortened his term. Still, Collor was responsible for trade liberalization and the start of privatization. Despite that, he was unable to curb inflation. During his government, more than 920 thousand jobs were lost and annual inflation climbed to more than 1,200%. In October 2002 he resigned under accusations of corruption and influence peddling. After his resignation, the impeachment trial continued and Mr. Collor was found guilty and disqualified from holding elective office for eight years (1992-2002). He was elected senator in the 2006 elections.

Fernando Henrique Cardoso: An accomplished sociologist, professor and politician, Mr. Cardoso took command of the country in a difficult period, from 1995 to 2002. He was propelled to the presidential seat mostly due to the successful implementation of the Real Plan, which took place under his watch as Finance Minister. His election was a vote of confidence on the stability of the Brazilian economy and, especially, on the end of inflation. He was the first president since Vargas to be re-elected (indeed it was he who approved a constitutional amendment allowing re-election). On the economic front, he deepened the privatization process and also conducted Brazil through major crises, including Asia, Russia, the BRL devaluation, the energy rationing (2001) and the Lula election crisis (2002). During his government important policies were put in place such as the inflation-targeting system and the fiscal responsibility law.

Luis Inácio Lula da Silva: The most popular president in Brazil’s history ran for the post three times unsuccessfully before becoming the country’s president for eight years (2003-2010). He is a founding member of the Worker’s Party and currently its most important member. During his government he emphasized social programs, such as “Bolsa Família” and “Minha Casa, Minha Vida,” which brought him a lot of popularity. On the international relations front, his government was marked by polemical but prominent participation, including controversial statements on Iran’s nuclear program. Under his government, the Brazilian economy performed well and recovered quickly from the 2008/2009 financial crisis. Social indicators also presented significant improvements: income inequality decreased and more than 30 million Brazilians migrated to middle-income segments. After eight years of government and 85% popularity, he was a key figure in helping to elect his successor, Dilma Rousseff.

Figure 118: Last 5 Presidents’ Popularity %

0

20

40

60

80

May

-87

Dec-

88M

ar-9

0Ju

n-91

Dec-

92De

c-93

Dec-

94De

c-95

May

-97

Mar

-98

Feb-

99M

ar-0

0M

ar-0

1Ju

l-02

Apr-0

3De

c-03

May

-05

Oct-0

5Au

g-06

Aug-

07No

v-08

Dec-

09Oc

t-10

José

Sarney

Collor Itamar

Franco

Fernando

HenriqueLula

Source: Datafolha.

61



2010 Elections

Dilma Vana Rousseff was Chief of Staff until the end of March 2010. She had been in cabinet since the election of President Lula. From January 2003 until June 2005 she was the Minister of Mines and Energy, and in this function she implemented the spot energy auctions, among other landmarks of the electricity model. She was chosen Chief of Staff following the resignation of José Dirceu from the post (2005) due to accusations relating him to the “mensalão” scandal. In this capacity, Dilma became the right hand of President Lula and received the nickname of “Mother of the PAC,” the multiyear, R$600 billion infrastructure project that was launched in 2007 as the main investment/growth strategy of the Lula Administration. Ms. Rousseff was also the president of the board of directors of Petrobras. She was born in Minas Gerais in 1947 and in the mid-’60s joined the armed resistance against the military regime. She was a member of far-left guerrilla movements until she was caught and imprisoned. She stayed in jail for three years (1970-1973.) Sometime after her release, she took a degree in economics. In the 1980s she was part of the group that revived the PDT (Democratic Worker’s Party), the party of political icons such as former president João Goulart and Leonel Brizola. In the early ’90s she was the Secretary of Energy of the state of Rio Grande do Sul, and in 1998 she joined the PT (Worker’s Party). Senate: After the 2010 elections, the government coalition increased its representation in the Senate from 50 representatives to 60. This is almost 75% of the representation in the Upper House and enough to pass constitutional amendments with a comfortable margin. The party that gained the most seats was the PT, which saw its base expand by 6 representatives. The party that lost the most was the DEM, which had 15 representatives and is now down to 6. With that, the current opposition has 20 representatives in the Senate, down from 30.

Table 62: Senate Composition

Party Prior From 2011 OnPMDB 18 20

PT 8 14PTB 6 6PPS 1 5PDT 6 4PR 4 4

PSB 2 3PCdoB 1 2

PRB 2 1PSC 1 1

Non Party 1 0PSDB 14 11DEM 15 6PSOL 1 2PPS 0 1PV 1 0

PMN 0 1

Opposition

Independent

Coalition

Source: Arko Advice, J.P. Morgan.

Chamber of Deputies: The government coalition practically got enough votes to get a constitutional majority in the Lower House (3/5 of votes). According to the latest tally, the government coalition got 371 of the 513 seats in the Lower House. On the other hand, the opposition elected 111 candidates, or only 21.6% of representatives. Among those that made considerable gains in terms of representation the highlight was the PR party, whose Deputy Tiririca (SP), a candidate who campaigned as a clown (his official profession) and who is accused of being illiterate, got 1.3 million votes, becoming the deputy with the most votes in the country. Another party that advanced in the elections was the PSC, a Christian party that is supported by Brazil’s many evangelical church groups. The PT was the party that elected the most deputies, followed by its ally, the PMDB, with 88 and 79 representatives respectively. The opposition parties suffered some losses: the number of representatives of the PSDB shrank;(58 down to 53), and the DEM (former PFL) lost 23% of its former representation.

62



Table 63: Chamber of Deputies Composition

Party Prior From 2011 OnPT 79 88

PMDB 89 79PP 40 41PR 43 41

PSB 26 34PDT 23 28PTB 21 20PSC 17 17

PCdoB 12 15PRB 8 8

PSDB 58 53DEM 56 43PPS 15 12

PSOL 3 3PV 14 16

PMN 3 4PTdoB 1 3PRTB 0 2PRP 0 2PHS 3 2PTC 2 1PSL 0 1

Coalition

Opposition

Independents

Source: Arko Advice, J.P. Morgan.

Governors: While the PT and its allied parties were the winners in the presidential and congressional elections, on the gubernatorial front the PSDB had a good showing: it captured eight states, more than any other party. The opposition as a whole got 10 states, including important ones such as São Paulo, Minas Gerais, Paraná and Goiás, corresponding to 55% of the national GDP.

Table 64: Governors elected in 2010 State Governor Party

Acre Tião Viana PT Alagoas Teotônio Vilela Filho PSDB Amapá Camilo Capiberibe PSB Amazonas Omar Aziz PMN Bahia Jaques Wagner PT Ceará Cid Gomes PSB Distrito Federal Agnelo Queiroz PT Espírito Santo Renato Casagrande PSB Goias Marconi Perillo PSDB Maranhão Roseana Sarney PMDB Mato Grosso Silval Barbosa PMDB Mato Grosso do Sul André Puccinelli PMDB Minas Gerais Antonio Anastasia PSDB Pará Simão Janete PSDB Paraíba Ricardo Coutinho PSB Paraná Beto Richa PSDB Pernambuco Eduardo Campos PSB Piauí Wilson Martins PSB Rio de Janeiro Sergio Cabral PMDB Rio Grande do Norte Rosalba Ciarlini DEM Rio Grande do Sul Tarso Genro PT Rondônia Confúcio Moura PMDB Roraima Anchieta Júnior PSDB Santa Catarina Raimundo Colombo DEM São Paulo Geraldo Alckmin PSDB Sergipe Marcelo Déda PT Tocantins Siqueira Campos PSDB


63



Sectors

Oil, Gas & Petrochemicals

By Sergio Torres and team – (1) 212 622-3378 [email protected]

The Oil, Gas and Petrochemical sector is vital for the Brazilian economy because it is responsible for supplying all future demand growth for energy and fuels. Under our definition, the sector includes the Oil Services and Equipment industry. The Brazilian O&G sector is expected to become a more material source of tax revenue through expanded production and of hard currency by increasing export revenue and attracting foreign direct investment. For portfolio investors the sector is also very relevant because it boasts the largest market value (over $300 billion) and because it can still generate many new investment vehicles in the future. Additionally, Brazil constitutes a strategic market for many of the listed global Oil Majors and global service + equipment companies.

We start by describing how the energy matrix in Brazil is unique in many ways: 1) it serves a population of 190 million; 2) it is highly self sufficient; 3) it is hydro-power intensive; 4) it is the largest user of biofuels in the world (sugarcane based). As shown below. Brazil’s reliance on natural gas is one of the lowest in the world while its use of hydro-power is one of the highest.

Figure 119: Brazil’s Energy Matrix 2009

34.8%46.2%

30.3% 30.5%

52.5%38.6% 33.0%

18.6%

23.8%8.1%

27.0%

53.0%

38.4%

27.0% 34.4%

3.7%

29.4%

5.2%10.8%

1.6%

4.2%

22.8% 16.5%

70.6%

5.5%

1.3%

0.0%

2.5%

1.3%8.7%

9.6%0.7%

6.6%

39.2%31.9%

12.6%3.6% 2.9% 6.6% 6.4%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

World Brazil Colombia Argentina Mex ico United States Europe &Eurasia

China

Oil Natural Gas Coal Nuclear Hy dro Source: BP Statistical Review of World Energy 2010.

Completing the “Golden Triangle.” Brazil owns proved hydrocarbon reserves of 15.11 billion boe and daily output of 2.6 million boed, making it the third-largest producer in LatAm behind Mexico and

1 2009 data according to BP Statistical Review of World Energy 2010.

Venezuela. Brazil attracted the global spotlight in 2007 when a Petrobras discovery in ultra deep waters was quantified at 6-8 billion boe of recoverable resources, representing the world’s largest find since the Kashagan field in Kazakhstan (~13 billion boe in 2000). Since then, PBR and other operators, such as Devon, Anadarko, Exxon, have made sizable discoveries in Brazilian ultra deep waters in what has been named “the pre-salt province,” reservoirs with total depth of ~6 km under water depth of 2.5-3.0 km in the Santos and Campos basins. Brazil is now considered the southern vertex of the so-called “Golden Triangle” for deepwater exploration, comprised of the US Gulf of Mexico, West Africa and Brazil.

The federal government believes Brazil has a potential of at least 70 billion boe in yet to be discovered resources in its pre-salt acreage. After more than 3 years of appraisal drilling, approximately 1.2 billion boe of Santos pre-salt oil have been qualified as proved reserves in the Lula-Cernambi fields (formerly known as Tupi and Iracema).

Brazil is the globe’s #2 in expected oil production growth. IEA estimates that Brazil’s oil production should grow 2.1% yearly from 2009 to 2035, second in the world only behind Iraq.

Figure 120: Expected Oil Production Growth (CAGR 2009 - 2035)

3.5%2.1%2.1%

1.7%1.0%

0.9%0.5%

-2.2%-3.3%

0.0%-0.3%

-1.7%

IraqBrazil

KazakhstanS. Arabia

AfricaOther ME

RussiaUSAIran

EuropeMex icoCanada

Source: BP, IEA, J.P. Morgan.

To help reach these production estimates, Brazil relies on 77 oil companies that are authorized to produce oil in the country. Among them are names such as Shell, Royal Dutch Shell, Chevron, Exxon, BP and Statoil.

Prolific oil basins are concentrated in the Southwest of Brazil. The biggest accumulations found in the country are concentrated in the Brazilian Continental Platforms of Campos and Santos Basins. The Campos Basin accounts for ~85% of Brazil’s oil production

64



while the Santos Basin contains the most recent giant discoveries in pre-salt.

Figure 121: Simplified map of Brazilian Basins

Cenozoic basins

Continental margin basins

Rifts

Paleozoic basins

Source: Energy Ministry, J.P. Morgan.

Fuel demand growth requires expansion to refining capacity. Current refining capacity and fuel demand are almost balanced at ~2 million kbd. However, oil-based fuel demand registered a 4.4% CAGR between 2003 and 2009. PBR owns virtually all of the refining capacity in Brazil. Diesel fuel leads the consumption of oil derivatives in Brazil, reaching 779 kbd and representing 36% of total demand. Brazil is a net importer of diesel, with ~10% of total demand. Gasoline is the second-largest product, with demand at 297 kbd but declining. Ethanol has been replacing gasoline consumption, and its demand size is just as large as that of gasoline, which has made Brazil a net exporter of gasoline in recent years. Ethanol serves a fast-growing market on the back of consumer preference for flex-fuel cars, which can take 100% ethanol.

Against beliefs, fuel pricing in Brazil is market-based. Consumer prices of gasoline, ethanol, diesel and LPG are determined freely by the market. They reflect a refinery gate price (set by Petrobras), excise and sales taxes, distribution costs and, in the case of gasoline (75% gasoline-25% ethanol), they also reflect the cost of ethanol, which has a deep seasonality. Petrobras manages the refinery gate price of gasoline for blending, diesel and LPG. In order to limit the impact of long-term oil price moves in domestic inflation, PBR and the federal government often coordinate any price hike with offsetting adjustments to excise taxes.

Regulatory environment: The federal government regulates the oil and gas sector. The Brazilian state is the official owner of all crude oil and natural gas reserves in Brazil and outsources the exploitation to third parties, allocating contracts through yearly licensing rounds. The sector’s regulator is the National Petroleum Agency (ANP). Another entity is the National Counsel for Energy Policy (CNPE), which sets policy guidelines for the sector.

The sizable discoveries in pre-salt led to several changes in the economic and regulatory environment for the O&G sector. Among them:

1) Interruption of yearly offshore licensing rounds (2009);

2) Introduction of proposals for a new regulatory regime (2010);

3) Increased M&A activity (2009-2010);

4) Ambitious investment and production goals from PBR (2009, 2010); and

5) Government’s intention to create a “Brazilian” oil services and equipment industry.

The new regulatory regime was introduced in 2010. It applies only to new licenses and it pursues a higher government take and tighter government steering of the sector. The most important component is a new contracting model, named the production-sharing contract (aka PSA) that would apply to a predetermined area in the pre-salt and to any acreage deemed strategic. The current concession model would be valid for onshore acreage and other non-strategic offshore areas outside the “Pre-Salt Polygon.”

Table 65: Brazil’s major listed Oil, Gas and Petrochemical companies

Company Ticker Rating Mkt Cap (US$ Mn) Petrobras PETR4 N 232,878 OGX OGXP3 OW 42,334 HRT HRTP3 OW 6,576 Braskem BRKM5 - 11,400 Confab Industrial CNFB4 NC 1,278 Lupatech LUPA3 N 426 Panoro Energy PEN NO NC 7

Source: J.P. Morgan estimates and Bloomberg as of April 11, 2011.

65



Metals & Mining

By Rodolfo de Angele and team – (55-11) 3048-3888 [email protected]

The Brazilian Metals & Mining industry was largely developed during the industrial development programs (Brazil’s “economic miracle”) of Presidents Vargas and Kubitschek during the 1940s and 1950s. During the mid-twentieth century, strategic state steel production plants were established by the government, and steel production became synonymous with the drive toward a more autonomous development model. The sector remained predominantly state-owned until the 1990s, and in the process had become highly inefficient. It was then that the Brazilian federal government embarked on a privatization drive that began with the change of control first at Usiminas (1991) and later at Vale (1997). After privatization, Vale’s core focus was moved to mining activities, and it sold its holdings in the steel (Açominas, CSN, CST and Usiminas) and pulp businesses.

As it stands now, the steel industry in Brazil is 100% held in private hands, and until recently (before the recent surge in iron ore and coking coal prices) boasted one of the lowest-cost productions of steel in the world. Within the sub-segments, as compared to long steel, the flat steel category faces relatively more competition from the presence of greater number of players and the increasing influence of imports. Finished steel output in Brazil was 25.8Mt in 2010 (flat steel – 60%; long steel – 40%) and the main consuming sectors include civil construction, automotive, capital goods, machines and equipment, household and commercial appliances.

Figure 122: BZ – Main steel-consuming sectors

19%

22%

12%

18%29%

Tubemakers

& CR Units

Gen Engg &

Mfg

Auto Sector

Others

Construction

Source: IABr and J.P. Morgan estimates.

On the mining side, Vale has continued to gain scale since privatization and is now the second-largest

mining company in the world in terms of market capitalization, and the world’s largest iron ore producer and exporter. Along the way, while it made efforts to diversify into other commodities, such as aluminum and nickel, among others, it remains predominantly an iron ore producer and accounts for over 75% of Brazil’s iron production and exports.

Figure 123: Vale’s iron ore output has doubled since 2000 and accounts for over 75% of Brazil’s output Million tonnes

100

150

200

250

300

350

2000 2002 2004 2006 2008

0%

20%

40%

60%

80%

100%

Vale Iron Ore Vols (LHS) % of Brazil Prod.

Source: Vale, AME, J.P. Morgan.

Brazil’s GDP growth remains robust, and that bodes well for the consumption of steel. In addition, the soccer World Cup in 2014 and the Olympic Games in 2016 should create above-normal growth in demand for steel in the medium term, especially for long steel products. With a strong outlook for demand, and proximity to iron ore resources, many domestic and international players have been investing in the sector, which we estimate should result in ~7.0% CAGR growth in Brazil steel production through 2016.

Figure 124: Brazil is the 8th major crude steel producer - as of 2010 Mn tons

0100200300400500600700

China

Japa

n

Unite

d St

ates

Russ

ia

India

Sout

h Ko

rea

Germ

any

Braz

il

Ukra

ine

Turk

ey

Othe

rs

Source: WSA (World Steel Association).

66



Figure 125: Brazil’s crude steel capacity may reach ~64Mt by 2016 Million tons

-

10

20

30

40

50

60

70

Actual 2011e 2012e 2013e 2014e 2015e 2016e Total

42M t3M t 1M t 1M t

4M

7M

64M3M

Source: Company reports and J.P. Morgan estimates.

However, we are now witnessing a change in the competitive landscape of the Brazilian steel industry, especially in the flat steel side, with imports having established themselves as the fourth key player behind CSN, Usiminas and CST. In addition, with the entry of new players like Gerdau and potentially CSA in the finished steel market, the competition is likely to get more intense. Thus, the days of historically high domestic price premium are unlikely to return, in our view. Finally, with the global steel industry continuing in overcapacity (73.8% capacity utilization in Dec’10), Brazil is unlikely to remain isolated from its impact.

Figure 126: Brazilian flat-steel imports have stabilized at high levels '000 tonnes

-

100

200

300

400

500

600

Jan-01 Jul-02 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10

0%5%10%15%20%25%30%35%

Flat-steel imports (LHS)

Imports as a % of Apparent Consumption

Source: IBS, SECEX, JPMorgan estimates.

Mining industry retained its shine through the thick and thin of the latter half of last decade, which was largely possible due to the robust pace of China’s growth. Brazil continues to be one of the sought-after sources of high-quality iron ore and contributes roughly 30% of the global seaborne iron ore trade. In addition,

with abundant reserves to exploit, the country is beginning to see proliferation of junior iron ore producers, and with that, the onset of Chinese/Asian investments in the sector. Besides iron ore, Brazil also remains a small producer of aluminum and nickel.

With rising profitability, mining activities have come under regulatory scrutiny across the globe, which is likely to result in more stringent tax regulations for mining companies. Brazil is no exception, and the government is already evaluating a new proposal for mining regulations which, among other things, includes potentially higher royalties, defining a time frame for the exploitation of mining concessions and the formulation of a regulatory body for closer oversight of the mining industry. While we view changes in the mining laws as a given, we believe that these are unlikely to be as harsh as the market may currently anticipate. Moreover, the government will be wary of the disservice it will potentially do if the change in the mining laws inadvertently hinders, in any way, the performance of the Brazilian mining industry.

The outlook for the mining industry remains closely synched with the growth outlook of the emerging world and of recovering developed economies. The sector is expected to receive record investment (running into tens of billions of dollars) over the next 3-5 years, with a majority of that to be in iron ore.

The following table summarizes the major listed companies in the Brazilian Metals and Mining sector.

Table 66: Brazil’s major listed Metals & Mining companies Company Ticker Rating Mkt Cap (US$ Million)

Vale VALE OW 172,552 Bradespar BRAP4 OW 9,726 Met. Gerdau GOAU4 OW 6,084 Magnesita MAGG3 OW 1,591 Gerdau GGBR4 N 18,035 CSN CSNA3 UW 24,272 Usiminas USIM5 UW 15,177 MMX MMXM3 NR 4,155 Paranapanema PMAM3 NR 1,084


67



Financials

By Saul Martinez and team – (1) 212 622-3602 [email protected]

Industry Structure

A highly consolidated industry. The five largest banks control around 68% of loans and 75% of deposits. The two figures following demonstrate the loan and deposit market shares of the top five banks in the country. The level of market concentration is comparable to that of other banking systems in Latin America.

Consolidation in recent years has hastened market concentration. Since 2008, four sizable mergers have noticeably increased the level of market concentration. In particular, the mergers of Santander Brasil and ABN Banco Real (August 2008), Itau and Unibanco (November 2008), Banco do Brasil and Banco Nossa Caixa (November 2008), and Banco do Brasil and Banco Votorantim (January 2009) have increased the collective loan market share of the top five banks in the country to 75% from 52% at the end of 2007.

Foreign banks have a relatively limited presence. With the exception of Santander Brasil, foreign banks have not become significant players in the Brazilian banking system. In particular, foreign banks control 19% of system loans, one of the lowest percentages among major Latin American banking systems. In fact, policymakers in other major Latin American countries, notably Mexico, have cited the limited market share of foreign banks as a reason why the Brazilian banking system withstood the financial crisis as well as it did (i.e., when foreign banks pulled back their lending activity, the impact was not large enough to exacerbate the negative economic impact of the crisis).

Public sector banks have a substantial presence in the Brazilian market. The federal Treasury owns controlling stakes in three major banks that operate in the Brazilian banking system: 1) Banco do Brasil (59% stake), the country’s largest bank; 2) Caixa Economic Federal, which has roughly 76% share in mortgage lending; and 3) the BNDES, a government development bank committed to providing funding for infrastructure development. These three banks alone have more than 40% share of the Brazilian credit market.

Figure 127: Deposit Market Share 24.7%

14.4% 14.2% 13.3%

7.7%

Banco do Brasil Caixa EconomicaFederal

Itaú Unibanco Bradesco Santander Brasil

Source: J.P. Morgan and Central Bank as of September 2010.

Figure 128: Loan Market Share 20.5%

14.1%11.8% 11.0% 10.5%

Banco do Brasil Itaú Unibanco Bradesco BNDES Caixa EconomicaFederal

Source: J.P. Morgan and Central Bank as of September 2010.

Financial sector presentation Credit penetration remains relatively low on a global basis. In spite of healthy growth in the past decade (see below), financial sector penetration remains relatively low. According to data from the IPEA, 39% of Brazilian families do not have a basic checking account. Of these families, 40.6% would like to have a basic checking account. In addition, many small companies still lack access to consistent and low-cost sources of credit. Ultimately, these factors, coupled with still relatively low GDP per capita levels, drive still-low credit penetration when compared to many countries’. The figure below shows that, private sector credit as a percentage of GDP remains well below that of many countries.

Figure 129: Private credit as a percentage of GDP

194%

128%98% 90%

56% 51% 51% 49% 41% 36% 34% 27% 25% 21% 14%

05,000

10,00015,00020,00025,00030,00035,00040,00045,00050,000

USCana

daChile

Panama

Brazil

Hondura

sCost

a Rica

Central

America

El Salv

ador

Nicarag

uaColo

mbiaGuat

emala Peru

Mexico

Argentin

a

0%

50%

100%

150%

200%

250%

GDP per capta Priv ate Credit/ GDP

Source: World Bank Development Indicators.

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However, penetration levels are now high versus most Latin American financial sectors. Notwithstanding the relatively low credit penetration compared to developed and select emerging economies, many market participants point to the substantial growth in financial sector penetration in the past decade as evidence that growth will likely slow. Total loans in the Brazilian banking system have grown 18% a year, on average, since 2002. This growth has been driven by a multitude of related factors, including strong economic growth in the past decade (nominal GDP grew, on average, 10% annually from 2002 to 2010), controlled inflation, substantial growth in the middle-income sector, rising disposable income levels, and improved affordability of credit due to lower rates on loans (which, in turn, result from greater risk appetites of banks and a mix shift toward secured consumer credit such as payroll and auto loans). Ultimately, as shown in the figure below, credit to GDP in Brazil now only lags that of Chile among major Latin American banking systems.

Figure 130: Total Loans to GDP %

65%

45%

28% 26%21%

14%

0%

20%

40%

60%

80%

Chile Brazil Peru Colombia Mex ico Argentina Source: J.P. Morgan and Central Bank.

High interest rates and limited long-term funding availability inhibit growth of mortgage market. Government-owned Caixa Economica Federal (CEF) is the principal vehicle through which the federal government promotes the financial sector. However, for private banks, mortgage loans (which are still primarily to homebuilders to finance construction) represented only 3-7% of total loans at the end of Q3 2010.

However, we believe the principal impediment remains the limited availability of long-term funding available to fund longer-duration mortgages. In essence, while benchmark interest rates of 11.75% remain well below historical levels, real rates remain lofty (roughly 6%). With overnight rates so high, investors with a long-term horizon (from whom banks could borrow) have little incentive to provide funding at the longer durations necessary for banks to more adequately match asset and

liability durations. In addition, these high real rates similarly inhibit the development of an asset-backed securities market.

Regulations and policy backdrop Central Bank is the primary regulator. The National Monetary Council (Conselho Monetário Nacional, or CMN) is the primary regulatory entity in the Brazilian financial system. The CMN is composed of the central bank president, the finance minister, and the planning minister. Among its functions, the CMN gives the central bank authority to establish reserve requirements and establishes the general directives regulating the banking and financial markets. However, the central bank is the primary supervisory entity overseeing the banking system. Among its primary functions, the central bank establishes minimum capital and reserve requirements, approves mergers and acquisitions of financial institutions and must approve any capital increases or establishment of branches in Brazil and abroad.

Table 67: Brazil’s major listed Financials companies Company Ticker Rating Mkt Cap (US$ Million)

Banco do Brasil BBAS3 N 52,507 Santander Brasil SANB11 OW 44,258 Bradesco BBDC4 OW 71,702 ItauUnibanco ITUB4 OW 100,330


Homebuilders

By Adrian E. Huerta and team – (52) 81 8152-8720 [email protected]

A secular growth history: The sector has grown significantly in the past 3 years as a result of better-capitalized developers and strong mortgage growth financing. Also, the government implemented an ambitious housing program in 2009. Over the last 4 years, the sector had more than 22 IPOs and 14 follow-on offers raising ~R$25bn. In addition Brazil has positive demographics, with a young population, resulting in a family formation forecast of more than 35mn new families from 2007 until 2030, translating into 1.5mn new houses demanded every year on average, with almost half of this market for lower-income housing (families earning less than three minimum wages). According to our calculation, this demand represents a market size of close to USD70bn in sales per year. The publicly traded companies

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launched units worth R$24 bn in 9M10, a 76% increase vs 9M09 and a 290% increase versus 06. We believe that the sector could grow by 15-20% a year for the next 2-3 years.

The main source of funding for mortgage loans is the SPBE (represented by 65% of saving accounts balance and mainly for the middle- and higher-income segments) and the FGTS (worker’s guarantee fund, an 8% mandatory contribution from regular employees’ compensation and mainly for lower-income segments). In 2010, SBPE+FGTS disbursed close to R$75 bn in new mortgages vs R$50 bn in 09 and only R$8 bn in 2004.

Currently the sector is composed of 17 companies with a total market cap of more than USD32 bn and trading close to USD285 mn per day on average. There are also 6 listed Shopping Malls, 2 broker companies and 3 property companies, for a combined market cap of USD15 bn.

Recent news flow: Lower-income demand was boosted in 2009 by the Minha Casa, Minha Vida (MCMV) program, whereby mortgages rates were reduced by 2-3 pp. Of the 1mn units announced, 40% were for families earning less than 3 minimum wages (mw) and 20% for families earning 3-6mw and another 20% for families earning 6-10mw. Caixa Economica Federal is the public bank responsible for administering the program. The home price limit for the MCMV program was recently raised (R$80K to R$170K) depending on the city’s size.

As of December 2010 the program had approved the 1mn units targeted, though only 300k were actually delivered. At the beginning of April 2010 the government announced the second phase of the MCMV program, in which the government expects to build an additional 2mn houses by 2014.

Sector risks: (1) execution risks delivering the strong growth seen in the past few years; (2) availability of mortgage financing in the long term; (3) margin contraction as a result of higher raw materials and labor costs; (4) possibly delayed generation of FCF.

Prospects for the future: We have a positive view on the sector despite the market concerns mentioned previously. Short-term momentum has been impacted by uncertainties regarding macroeconomic policy, especially the rise in inflation and tighter monetary policy. Our top picks in the sector are PDG and MRV,

given their premium execution, attractive valuation and the higher likelihood to surprise with upside potential. PDG is the largest company in the sector and a diversified player, acting in all income segments and with presence in all regions. MRV has the best margins in the sector and currently is one of the only pure lower-income players in the market, having the highest exposure to MCMV. The sector trades at 8.4-9.4x P/E 2011E, representing potential upside of 44-61% to our Dec-2011 target prices.

Table 68: Brazil’s major listed Homebuilder companies Company Ticker Rating Mkt Cap (US$ Million)

Cyrela CYRE3 UW 4,316 Gafisa GFSA3 N 2,992 Rossi RSID3 N 2,476 MRV MVRE3 OW 4,158 PDG PDGR3 OW 6,740 Rodobens RDNI3 N 413 Trisul TRIS3 OW 214 Aliansce ALSC3 OW 1,235

Source: J.P. Morgan estimates and Bloomberg, as of April 11, 2011.

Figure 131: Sector P/E 12 Months

05

101520253035

Jan-

07

May

-07

Sep-

07

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

Jan-

11

Avg 07-Now

Avg 09-Now

Source: J.P. Morgan estimates, company data.

Figure 132: Sector Performance vs. Selic

56789101112131415

0200400600800

1,0001,2001,400

Dec-

07

Apr-0

8

Aug-

08

Dec-

08

Apr-0

9

Aug-

09

Dec-

09

Apr-1

0

Aug-

10

Dec-

10

Apr-1

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Dec-

11

IMOV index Selic target


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Figure 133: Housing Market by Income Segment 31.3

19.2

28.8

22.016.0763

320 275122 46

0.05.0

10.015.020.025.030.035.0

< 3 mw 3-5 mw 5-10 mw 10-20 mw > 20 mw

0

200

400

600

800

1000

Volume (R$ bn) Units ('000) Source: J.P. Morgan estimates, company data.

Figure 134: Listed Companies’ Launches

2.0

4.15.5

13.2

6.7

10.0

6.6 7.0

2.2

4.76.6

9.6

5.4

8.59.9

1Q07

2Q07

3Q07

4Q07

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10


Figure 135: SBPE + FGTS Financing

5.8 4.9 5.5 6.0 6.9 10.316.3

25.2

40.549.7

83.7

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FGTS SBPE


Figure 136: Construction Inflation Breakdown

-2%

3%

8%

13%

18%

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

MaterialsLaborINCC


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Retail

By Andrea Teixeira and team – (212) 622 6735 [email protected]

Retail is still a growth sector in Brazil, as efficient retailers continue to take share from mom & pops and benefit from a benign macro landscape. In Brazil, growth has recently accelerated in apparel and hardlines.

Benign macro landscape long term . . . Brazilian retailers have been benefiting from three main drivers: (1) Income distribution, with ~30 million new people ascending into the middle-income segment. (2) Mid-single-digit real growth in wage mass. (3) Double-digit growth in credit availability.

. . . despite tightening cycle in the short term Highest-growth retailers have been boosting sales through credit. Private label credit cards at lower than market rates have been a major source of growth. While we expect rates to go up by 175bp in 2011 (to 12.5%), credit availability has been improving.

Highest growth categories are discretionary The rising middle-income segment has been consuming items such as electronics and home appliances, items that it could never afford before (approximately 30 million people have been upgraded from less affluent income segments since 2003). Government projects such as “Minha Casa, Minha Vida” have been fostering construction of new homes and therefore boosting sales of appliances and electronics. Brazil will host the soccer World Cup and the Olympic Games in 2014 and 2016 respectively, which are strong purchasing occasions for electronics, besides the typical GDP boost led by tourism and infrastructure investments ahead of these events. Best-in-class retailers are focusing on the middle-income segment and capitalizing on the reduction of tax evasion by smaller players who are being pushed out of business.

Figure 137: Brazil Retail Sales

-20%-10%

0%10%20%30%

40%50%

Jan-

01M

ay-0

1Se

p-01

Jan-

02M

ay-0

2Se

p-02

Jan-

03M

ay-0

3Se

p-03

Jan-

04M

ay-0

4Se

p-04

Jan-

05M

ay-0

5Se

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Jan-

06M

ay-0

6Se

p-06

Jan-

07M

ay-0

7Se

p-07

Jan-

08M

ay-0

8Se

p-08

Jan-

09M

ay-0

9Se

p-09

Dec-

09M

ay-1

0Se

p-10

Furnitures and eletronics Total Retail Sales Supermarkets Sales Apparel & Footw ear Source: IBGE.

Figure 138: Brazil Consumer Confidence

95.0

100.0105.0

110.0

115.0120.0

125.0

Mar

-07

Jul-0

7

Nov-

07

Mar

-08

Jul-0

8

Nov-

08

Mar

-09

Jul-0

9

Nov-

09

Mar

-10

Jul-1

0

Nov-

10

Mar

-11

Source: FGV.

Market fragmented. Top 3 food retailers: 40% share Large retailers have been gaining market share due to access to cheaper capital. Also, smaller players have been pressured to professionalize through required IT systems by the Internal Revenue Service. The tax evasion crackdown has also limited the competitiveness of some mom & pops.

Figure 139: Food Retail Market Share (2009)

Carrefour15.3%

Walmart11.0%

Others59.1%

CBD14.7%

Source: ABRAS.

Consolidation of broadline retailers CBD has 23% market share of electronics and home appliance sales in Brazil after the merger of its Globex and Casas Bahia units. The second-largest competitor is just a quarter of its size (Maquina de Vendas, which is also a result of the merger of private companies Ricardo Eletro and Insinuante.

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Figure 140: Hardline Market Share (2008)

Others65%

CBD*23%

MV*6%

Luiza3%

Pernambucanas3%

Source: Valor Economico.

E-commerce – Scale is key On-line sales are concentrated between two large players (B2W and CBD’s dotcom division, GPA.com). Scale in electronics is key, as more than 40% of sales on line are concentrated in these items. The need for working capital is high given that ~85% of sales are on credit cards.

Figure 141: E-commerce Market Share (2008, 2009)

54%

8%

38%47%

13%

40%

0%

20%

40%

60%

B2W GPA.com Others

2008 2009

Source: CBD.

Among publicly traded Brazilian retailers, most recent IPOs were concentrated among apparel retailers. The largest market capitalization is CBD, which derives 50% of its sale from food, and the rest mostly from electronics, home appliances and furniture. There is no major department store chain in Brazil, after a highly inflationary period in the ’80s and early ’90s pushed most of these companies out of business.

Table 69: Brazil’s major listed Retail / Personal Care companies Company Ticker Rating Mkt Cap (US$ Mn)

CBD PCAR N 10,286 Lojas Americanas ON LAME3 and

LAME4 OW 6,235

Lojas Renner LREN3 OW 4,216 Guararapes GUAR3 N 3,327 B2W BTOW3 N 2,261. Natura NATU3 N 12,244 Hypermarcas HYPE3 N 8,314


Food

By Alan Alanis and team – (1) 212 622-3697 [email protected]

Brazil is a protein powerhouse. It is the #1 beef and poultry exporter in the world. In terms of domestic production/consumption, it is #2 in beef and #3 in poultry.

Table 70: Brazil is top ranked within global protein industry Ranking by volumes Protein Exports Production Consumption Beef # 1 # 2 # 2 Poultry # 1 # 3 # 3 Pork # 4 # 4 # 5

Source: USDA (2011E).

The basic ingredients for this leadership are vast land & water supplies. Plus, it helps that Brazil is the #4 corn and soy producer globally. But in our view, the true differentiating elements are globally ambitious family-run businesses with straightforward access to equity and debt capital markets as well as preferential government financing via the country’s national development bank (BNDES).

Focus shifting to Brazil’s profitable domestic market. Exports have been the main driver for sales volume growth for the Brazilian protein industry since the early 2000s. Toward the second half of the decade, though, a combination of higher domestic prices and a stronger Real reduced the appeal of aggressively pursuing export growth. Nowadays export and domestic volumes grow at par. Companies are increasing efforts to further process and sell branded protein products domestically, which simply as value-added products have better margins than commodity meat exports.

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Figure 142: Exports have flattened as % of total production % of Brazilian protein production exported

0%5%

10%15%20%25%30%35%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Beef Poultry Source: USDA.

Poultry is Brazil’s most consumed protein. Global poultry consumption grew at a 3.4% CAGR in 2000-2010E, more than 5x faster than the flattish 0.6% pace of beef. Poultry consumption also increased faster in Brazil, with a CAGR of 4.7% in 2000-2010E, 2x faster than the 2.2% of beef. Brazilian per capita poultry consumption surpassed that of beef in 2007 to its current 40kg/year. The faster growth pace of poultry can be attributed to much lower prices per kg vs. beef and to cultural/health trends that we don’t see reversing.

Figure 143: Brazil to consume 19mn tons of meat in 2011E % of total volumes

Total Protein Consumption: 19mn tons ('11e)

Poultry45%

Beef41%

Pork14%

Source: USDA (2011E).

Shifting land usage toward agricultural production impacts the beef industry. Meatpackers don’t raise their own cattle. They rely on independent ranchers for their supply. Land for raising cattle could decline by 22% in the next 20 years, with cattle mainly replaced by grains and sugar cane. To avoid falling short of supply, meatpackers must modify how they deal with their cattle raisers. For instance, by purchasing cattle earlier and raising it in feedlots (like in the US), by agreeing on long-term contracts to guarantee the rancher’s returns, and/or by investing in ranching themselves. Most, if not all of the options, suggest a higher cost of doing business for meatpackers.

Figure 144: Brazil’s pastures to decline ~40 mn hectares by 2030E Million hectares

48 8 4

135

174

103

101

62 15 7

5

18

0 340

2030E

2010E

Annual Crops Sugarcane Permanent Crops Cultiv ated Forests Pastures Stock Source: Brazilian Government Strategic Affairs Secretary.

Table 71: Brazil’s major listed Food companies Company Ticker Rating Mkt Cap (US$ Billion)

Brasil Foods BRFS3 OW 16,510 JBS JBSS3 NC 9,522 Marfrig MRFG3 N 3,524 Minerva BEEF3 Neutral 0.46

Source: Bloomberg and J.P. Morgan estimates, as of April 11, 2011.

Beverages


Brazil is the world’s 3rd-largest beer market by volume, after China and the U.S. It consumed 112 million hectoliters in ’09.

Figure 145: World’s Top 8 beer markets by volume, 2009 Million Hectoliters

506064

92105

112249

434

0 50 100 150 200 250 300 350 400 450 500

UKJapan

MexicoGermany

RussiaBrazil

USChina

Source: Plato Logic.

Market dominated by AmBev, a subsidiary of Anheuser-Busch InBev (ABI). AmBev sells +70% of Brazil’s beer volumes and takes +90% of its profit pool. AmBev is the result of a merger of companies (Brahma and Antartica) ten years ago. It later became a subsidiary of Belgium’s Interbrew, which later changed names to ImBev and then to ABI, which currently owns 62% of AmBev. Other Brazilian players include

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Heineken (former Femsa Cerveza) and privately held companies Petropolis and Schincariol.

Figure 146: AmBev’s Beer Brazil Market Share

60%

62%

64%

66%

68%

70%

72%

3Q02 3Q03 3Q04 3Q05 3Q06 3Q07 3Q08 3Q09 3Q10 Source: Company data.

Brazil’s is the 2nd-largest beer profit pool. Thanks to its market share dominance, a +50% on-premise consumption culture, and mainly 600ml returnable presentations, AmBev in Brazil has the world’s highest EBIT margin across leading brewers.

Figure 147: Beer EBIT margin of leading brewer in top markets, 2009E

7%10%

11%15%

17%27%

31%34%

44%

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

UKChina

GermanyJapanSpain

MexicoRussia

USBrazil

Source: Plato Logic, company data, J.P. Morgan estimates.

Per capita consumption up almost 20% last decade. It went from 50 liters in 2000 to the current 59 liters. The outlook is quite favorable for continued growth as the Brazilian consumer continues to benefit from higher wages in real terms and upward economic mobility.

Figure 148: Brazil’s beer per capita to keep gradually improving Per capita beer consumption (liters)

81

61 60 5953

40

50

60

70

80

90

US Europe Mexico Brazil Latin America Source: Plato Logic 2009.

Table 72: Brazil’s major listed Beverages company Company Ticker Rating Mkt Cap (US$ Billion)

AmBev AMBV4 OW 82.4

Source: Bloomberg and J.P. Morgan estimates as of April 11, 2011.

Tobacco


Brazil smokes less than the world average. Roughly 17% of Brazil’s population smokes cigarettes (22% of the men, 13% of the women). This figure is quite low when compared to other developed and emerging market economies, as shown in the following figure.

Figure 149: Global smoking incidence

22%

70%

31%

61%

26%13%

23%

3% 4%

20%

0%

20%

40%

60%

80%

Brazil Russia India China U.S.

Men Women Source: IBGE; World Health Organization.

Smokers are concentrated in the very lowest income segments. Out of all smokers in Brazil, 42% are from households earning less than half the minimum wage ($4k/year).

Figure 150: Smoking is concentrated in Brazil’s lower-income segments % of Brazil’s smoking population by income level

42%

24% 21%13%

0%

10%

20%

30%

40%

50%

Less than 1/2 of theminimum wage

From 1 to 1/2 of theminimum wage

From 1 to 2minimum wages

Above 2 minimumwages

Source: IBGE.

Brazil’s tobacco market is dominated by Souza Cruz, a subsidiary of British-American-Tobacco (BAT) for almost 100 years. Souza Cruz was founded in 1902 and became a 75%-owned BAT subsidiary shortly in 1914. It has historically paid 100% of its net income as dividends. It is currently Brazil’s cigarette leader with 63% market share, almost 5x as large as the

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#2 player Phillip Morris International (PMI). Illegal imports that come mainly from Paraguay account for almost 30% of the Brazilian market.

Figure 151: Souza Cruz market share evolution % of Brazilian cigarette market

58.8% 59.1% 59.2%

60.4%60.9%

62.1% 62.0%62.9%

56%

58%

60%

62%

64%

2003 2004 2005 2006 2007 2008 2009 3Q10 Source: Company data.

Souza Cruz sales and EPS have grown despite higher cigarette taxes and lower volumes. This is thanks to higher prices, better marketing and more efficiency. It is quite surprising for many to see that Souza Cruz sales have grown almost at the same pace as AmBev beer sales during the last decade.

Figure 152: Souza Cruz manages to grow sales and EPS despite lower volumes 2003=100

50

100

150

200

250

2003 2004 2005 2006 2007 2008 2009

Cigarettes Produced EPS Net Revenue Source: Company data, J.P. Morgan estimates.

Government efforts to curb consumption will consider the tax and labor impacts. Taxes represent ~3/4 of a cigarette pack’s price in Brazil. About ~50% of each cigarette pack’s surface is used for cautionary legends. Smoking in closed facilities is already prohibited in Brazil’s main states. Such efforts to curb consumption are most likely to continue. Nonetheless, the government balances its decisions, taking into account the importance of the sector from a labor and tax perspective. The tobacco industry employs ~2.5 million people in Brazil. Federal excise taxes (IPI) from tobacco brought in US$3.3bn in 2009, 7% of national collection and 10% more than all beverages combined.

Figure 153: Federal Excise Tax (IPI) collection R$ million

-

10,000

20,000

30,000

40,000

50,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Nov '10

Tobacco Bev erages Auto Imports Other Source: Brazilian IRS.

Table 73: Brazil’s major listed Tobacco company Company Ticker Rating Mkt Cap (US$ Billion)

Souza Cruz CRUZ3 Neutral 16.18

Source: Bloomberg and J.P. Morgan estimate as of April 11, 2011.

Agribusiness

By Debbie Bobovnikova and team – (1) 212 622-3489 [email protected]

Farming in Brazil began in the Southern region, which has a good climate and relatively good soil, making for easy transition for arriving European immigrants, who brought with them their old world farming know-how. It was not until the 1970s that the savannah (Cerrado) region of central Brazil was proven to be “arable.” Local government research institute Embrapa discovered ways to adapt a temperate crop, soya, to the tropical conditions found in the Cerrado. With that, a new frontier for agriculture opened up. Many farmers left their small and profitable (yet increasingly cramped) farms in the South to seek their fortunes in the “Wild Wild West.” What they found were ideal climate conditions (warm weather, plentiful rainfall) but very poor soil and logistics. Many farmers underestimated the challenges and found themselves heavily in debt. Those that survived continued to grow in scale and adapted to new farming techniques (no tilling, double cropping, etc.). They also invested heavily in correcting the soil through lime and fertilizer.

Today, Brazil is one of the top 5 global agricultural producers in the world, playing a leading role in sugar, soybeans, beef, orange juice and poultry exports. Moreover, it is the only tropical climate to have that honor. It is also one of the most market friendly as heavy government subsidies and regulations were lifted in the 1990s (though some subsidized credit and minimum price auctions remain; the overall contribution to farmer income is well below that found

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in the US, Europe, Japan, etc.). Furthermore, Brazil is uniquely positioned to continue expanding its production due to availability of arable land (which can double or even triple from the current planted area of 47m ha) and water.

Table 74: Brazil Planted Area Breakdown for Annual Crops Cotton 2% Rice 6% Beans 8% Corn 27% Soybean 50% Wheat 5% Other 3% Brazil 100%

Source: Conab.

However, the sector continues to face serious challenges, namely: (1) access to capital; and (2) logistics. This leaves farmers, especially those in frontier regions, heavily dependent on the major trading companies for inputs, financing and commercialization, and leaves farmers in a weak bargaining position and with, often, quite thin profit margins.

The sugar/ethanol sector in Brazil has its roots in the 1970s military dictatorship. The government at that time rolled out an ethanol distribution network and supported the rise of ethanol-only vehicles as a way to decrease dependence on rising global oil prices. In the years that followed, low oil and sugar prices led to a waning in the sector and in ethanol vehicle sales. The sector then got a boost in the 1990s when the government lifted regulations from the sugar industry and then in 2004 when new flex-fuel vehicles were introduced. Still, the government continues to play a role in the sector, setting the minimum ethanol volumes in regular gasoline (at 20-25%) as well as the CIDE tax, which impacts the attractiveness of ethanol vs. gasoline at the pump (in addition to indirectly setting the price of gasoline itself).

The recent rise in foreign capital and corporate farming has done little to change these overall challenges given the sheer magnitude of the sector (large-scale farmers with hundreds of thousands of hectares under management represent no more than ~10% of the planted area in Brazil).

Brazil today is the largest global producer and exporter of sugar (with 50% market share). The industry has seen

large inflows of foreign capital and a buildout of new capacity to meet growing domestic ethanol demand and global sugar demand. The majority (~85%) of sugarcane facilities have the flexibility to produce either sugar or ethanol from the cane to take advantage of price discrepancies. The sector is also trying to develop viable ethanol export markets, though with limited success to date as the most important market, the US, remains closed to Brazilian ethanol.

Despite notable M&A activity in recent years, the domestic sugar/ethanol sector remains quite fragmented, with the top player controlling just 10% of total supply. The majority of players are still family owned, though new foreign players (Indian sugar producers, global trading companies and oil and gas players) are entering. Mills have also increasingly turned to producing cogeneration from leftover cane as a way to boost profits and bring in steady cash flows to balance out the volatility of the sugar/ethanol profits. We have also seen companies partner with fuel distributors in order to gain access to ethanol distribution at the pump.

Figure 154: Sugarcane: Increasingly a Domestic Story x

-200400600800

1,0001,2001,400

10/11E 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21

Domestic Sugar Domestic Ethanol Ex port Sugar Ex port Ethanol Source: J.P. Morgan.

Corporate farming should continue to grow in Brazil and move further into frontier areas. The MAPITO (Maranhao, Piaui, Tocantins states) area should see the most rapid rate of growth, albeit from a small base. Environmental regulations are getting more stringent and at some point will need to be simplified, while foreign land-ownership laws have recently been resurrected and are causing some confusion for existing players. Slowly, logistics issues will start to be addressed, with investments in ports, roads and new rail tracks. For the select few, the capital markets will increasingly be a source of funding.

The sugar ethanol sector will likewise continue to see inflows of capital from the private sector, continuing to fuel M&A. Whether this translates into true

77



consolidation or not depends on the relative speed of M&A vs. the overall growth of the market (Brazil has room to triple the area planted with sugarcane). Revenues will increasingly be diversified as sugarcane-based products will continue to replace hydrocarbon-based ones in new uses such as pharmaceutical, industrial and cosmetics, and will even be used to replicate hydrocarbons themselves as building blocks for the petrochemical sector.

Table 75: Brazil’s major listed Agribusiness companies Company Ticker Rating Mkt Cap (US$ Million)

SLC Agricola SLCE3 OW $1,434 Sao Martinho SMTO3 OW $1,708 ALL Logistica ALLL3 N $5,678 Cosan CSAN3 Restricted $6,207

Source: J.P. Morgan estimates and Bloomberg as of April 11, 2011

Pulp and Paper

By Debbie Bobovnikova and team – (1) 212 622-3489 [email protected]

Brazil is a unique place for pulp production owing to the combination of favorable climate, land and water availability and relative political stability, the latter an important point given 5- to 7-year investment cycles. As a result, Brazil has become a major player in the global pulp market, representing ~15% of global trade in pulp. Pulp and paper exports in turn represent ~15% of Brazil's exports and account for ~650,000 jobs.

A handful of family-run companies have dominated the sector in Brazil since the turn of last century. Brazil’s advantageous climate allowed for rapid tree growth, with eucalyptus plantations reaching maturity in just 7 years compared to 20-30+ years in traditional pulp markets (N. America, Europe, etc.). Advances in forestry yields in the 1970s further improved Brazil’s cost competitiveness in pulp production, making it one of the lowest-price producers globally and leading to Brazil becoming a significant exporter of eucalyptus pulp. Meanwhile, advances in paper production technology have allowed for broader use of eucalyptus grade pulp, which began to replace the traditional softwood type pulp in tissue, printing and writing and even boxboard paper manufacturing.

The growth in the domestic paper market has been unsteady and has resulted in oversupply, which in turn led to a tough pricing environment. As a result, most of

the investments have focused on growing pulp rather than paper capacity. Furthermore, rising land prices have driven pulp projects further from their traditional coastal regions.

The past two decades saw significant consolidation in the sector, in both the pulp and printing and writing paper segments (the corrugated packaging segment remains quite fragmented). Suzano and Bahia Sul merged. Ripasa was bought out by Suzano and VCP. Fibria, the world’s largest market pulp producer, was created through the merger of Aracruz and VCP. Over time, Suzano and IP emerged as the key domestic players in the P&W paper grades while Klabin and Suzano emerged as the leaders of the domestic boxboard segment.

The main drivers in the sector recently have been the emergence of Chinese domestic consumption and the onset of structural decline in demand in the developed world.

Also, a stronger BRL has led to increases in domestic pulp production as well as higher import competition in the domestic paper segment.

Going forward, we expect Brazil to increasingly focus on pulp production which takes advantage of favorable access to raw material. However, we believe paper production will increasingly be based in China, where access to raw materials is limited but access to capital is more readily available.

Table 76: Brazil’s Production Outlook 2010 2020E % Chg CAGR

Pulp mt 14.0 22.0 57% 4.6% Paper mt 9.5 12.6 33% 2.9% Planted Area m ha 2.2 3.2 45% 3.8%

Source: Bracelpa.

Bracelpa expects Brazil to produce 22mt of pulp by 2020, up from 14mt in 2010, a CAGR of 4.6%. Paper production should reach 13mt by 2020 compared to 9.5mt in 2010, a CAGR of 2.9%. As a result, planted forest area should rise to 3.2m ha from 2.2m ha today. Increasingly, that growth is moving to new regions in Brazil – away from the traditional coastal areas. This will require innovative solutions for logistics as well as further development of eucalyptus plantations to adapt to the new regions – namely the Northeast, South and Center-West of Brazil.

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Table 77: Brazil’s major listed Pulp & Paper companies Company Ticker Rating Mkt Cap (US$ Million)

Fibria FIBR3 UW $7,522 Suzano SUZB5 OW $4,195


Roads

By Fernando Abdalla and team – (55) 11 3048-3463 [email protected]

Brazil has the fourth-largest highway system in the world, with over 1.7 million kilometers of roads, of which only about 10% is paved. Highways are the main means of transportation in the country, both in number of passengers moved and movement of freight and goods. It is estimated that annually more than 1.2 billion people travel on Brazilian highways, compared to 140 million traveling via airline. While the South and Southeast of Brazil are well connected by paved highways, the northern region is less so due to the presence of the Amazon rain forest.

The major Brazilian paved highways are operated by private players and therefore have toll stations. The highway system of Sao Paulo is the largest statewide road transportation system in Brazil, with nearly 35,000 km of roads. About 3% of this system consists of federal roads, 33% municipal and 63% state. In the mid-’90s, the government pushed for privatization of state-controlled paved highways in a bid to generate extra revenues.

Currently the three major toll road concessionaires that are publicly listed are CCR, Ecorodovias and OHL Brasil.

Figure 155: State and Federal Concessions

Federal

27%

SP

36%RJ

1%

PR

17%

RS

11%

SC

4%

BA

1%

MG

3%ES

0%

Source: ANTT and J.P. Morgan.

The growth of toll road companies is tied to GDP growth prospects. Traffic has typically grown from 0.9x to 1.3x the GDP growth rate, on average, for the three concessionaires. Overall, strong growth prospects in Brazilian GDP positions the sector to at least keep pace with GDP in terms of traffic and revenue growth in the coming years.

Additionally, given that the toll fares are contractually adjusted by inflation once per year (IPCA, IGP-M or a basket of indexes), the toll road companies are seen as defensive plays in moments of high inflation.

Table 78: Traffic Growth y/y vs. GDP Growth y/y Year CCR OHL ECO GDP 2003 1.10% 0.00% 3.70% 1.10% 2004 5.70% 6.20% 4.50% 5.70% 2005 3.20% 2.50% -0.40% 3.20% 2006 3.80% 2.00% 8.10% 3.80% 2007 5.40% 7.10% 9.20% 5.40% 2008 5.10% 5.50% 2.70% 5.10% 2009 -0.20% -0.60% 3.00% -0.20% 2010 12.10% 13.60% 12.00% 7.50%

Accumulated. 41.87% 41.66% 50.95% 36.05%

Source: Company reports and J.P. Morgan.

The privatization of highways in Brazil started in 1995, with the Brazilian Toll Roads Concession Program and the auction of Ponte Rio-Niterói, current controlled by CCR. At that time, because of uncertainties regarding the macroeconomic environment and the regulatory framework, the average unleveraged IRR of the projects was 17%-18% in BRL.

Nevertheless, the federal auctions held in October 2007 were a landmark for the toll road sector. Average unleveraged IRR in BRL dropped to 8%-9%, reflecting the consolidated regulatory framework and mainly low barriers of entry due to the concession model adopted by the government, which stimulated competition. In our view, there is room for a slight rebound in the IRR for upcoming toll road auctions. The government is transferring the main risks to the private players (as seen in the latest RodoAnel auction, in which companies were responsible for displacement and environmental-related costs), and higher risks demand higher returns.

http://en.wikipedia.org/wiki/Freight

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Table 79: IRR of Toll Roads in Brazil Concession IRR Company Year

Ponte Rio-Niterói 17.00% CCR 1995 NovaDutra 18.00% CCR 1995 ViaLagos 20.00% CCR 1996 Caminhos do Mar 19.90% Ecorodovias 1997 Ecocataratas 16.40% Ecorodovias 1997 RodoNorte 19.00% CCR 1997 AutoBAn 20.00% CCR 1997 Imigrantes 20.60% Ecorodovias 1998 Ecosul 17.60% Ecorodovias 1998 BR-116/SP/PR 8.60% OHL Brasil 2007 BR-381/MG/SP 8.60% OHL Brasil 2007 BR-116/PR/SC 8.70% OHL Brasil 2007 BR-116/376 BR-101/SC 8.00% OHL Brasil 2007 BR-101/RJ 8.00% OHL Brasil 2007 RodoAnel West 9.00% CCR 2008 Ecopistas 10.30% Ecorodovias 2009

Source: Company reports and J.P. Morgan.

Regarding future opportunities, the expected investment in infrastructure in the country may translate into further upside for the toll roads. Brazil is expected to face a strong cycle of investments in infrastructure in the coming years, mostly because of the government’s PAC infrastructure program, the 2014 World Cup and the 2016 Olympic Games. The concessions for urban transportation will likely receive special attention from the government, with expected investment of roughly R$85 billion.

Overall, net leverage of Brazil toll road operators (avg. 1.6x for ’11E) is well below that of developed peers (avg. 4.5x for ’11E). We therefore expect the sector to lever up in the coming years to face the massive investment in infrastructure. If we assume a target net debt/EBITDA of 3x, we calculate that CCR has the highest cash position (R$3.5 billion) while OHL Brasil has the lowest (R$0.9 billion).

Figure 156: Expected Investments in Infrastructure R$ Million

Source: BNDES and J.P. Morgan estimates.

In terms of new highway auctions, on the federal front, the government is expected to host the third round of federal concession auctions this year, which will be divided into two phases and should demand total investment of approximately R$5 billion. The government is expected to privatize 3,663 kilometers of roadways spread among the states of Minas Gerais, Bahia, Espírito Santo, Distrito Federal and Santa Catarina. In the state of São Paulo, the government is preparing a concession package surpassing R$5 billion of investment. The highways to be privatized are the main connections between the city of São Paulo and the state’s coast.

Figure 157: Third Round of Federal Concessions

Rio Grande

do Sul

Rio de Janeiro

Paraná

Mato Grossodo Sul

Bahia

Santa Catarina

Goiás

São Paulo

EspíritoSanto

MinasGerais

1

2

3

4

6

5

Rio Grande

do Sul

Rio de Janeiro

Paraná

Mato Grossodo Sul

Bahia

Santa Catarina

Goiás

São Paulo

EspíritoSanto

MinasGerais

1

2

3

4

6

5

Source: J.P. Morgan and Bloomberg.

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Table 80: Brazil’s major listed Roads companies Company Ticker Rating Mkt Cap (US$ Million)

CCR CCRO3 OW 13,490 Ecorodovias ECOR3 OW 4,773 OHL Brasil OHLB3 N 2,877.6


Transportation

By Fernando Abdalla and team – (55) 11 3048-3463 [email protected]

Air travel is growing rapidly in Brazil. There are more than 4,000 airports in the country, with the majority owned by the government. In 2010, Brazilian airports handled nearly 138m domestic passengers and nearly 16m international passengers. Cargo hauled via air using the airports was nearly 1.12m tonnes. São Paulo-Guarulhos International Airport is the largest airport in Brazil, with a capacity of 20.5 million passengers. In 2010, it ran to 130% of capacity, ferrying 26.7m passengers (23% y/y). Congonhas-São Paulo Airport is the second largest, with capacity of 12m passengers. It ran to 129% of capacity in 2010 (+13% y/y).

The sector has yet to be brought into private hands, along the lines of the privatizations/concessions seen in the roads sector. With the strong growth seen in the past years and the proximity of sporting events such as the World Cup in 2014 and the Olympic Games in 2016, the sector is expected to receive massive investments, from both the government and private entities.

TAM SA (restricted; covered by JPM airlines analyst Jamie Baker) and Gol Linhas Aereas Inteligentes SA (rated OW by Jamie Baker) are the two largest airlines in Brazil. In 2010, the first had 42.8% market share in the domestic market while the latter had 39.5%.

Figure 158: Domestic RPK Growth y/y

-10%

0%

10%

20%

30%

40%

50%

Jan-

07

Apr-0

7

Jul-0

7

Oct

-07

Jan-

08

Apr-0

8

Jul-0

8

Oct

-08

Jan-

09

Apr-0

9

Jul-0

9

Oct

-09

Jan-

10

Apr-1

0

Jul-1

0

Oct

-10

Source: ANAC and J.P. Morgan.

The growth in passenger and freight hauled via air is the main driver of the airports sector. We expect privatization/concession of airports to be the main theme in the space in the near future, with the possible privatization of the airports authority (INFRAERO) to support the ongoing growth.

Nearly 15 out of the top 20 busiest airports in Brazil were running over capacity in 2010. To improve the quality at airports, given the huge growth in air travel that we are witnessing, the government needs to put in more money to upgrade the infrastructure.

Recently, Brazilian Defense Minister Nelson Jobin indicated that the Brazilian government may sell shares in its airport authority, known as Infraero, to support the ongoing growth in traffic and prepare for the 2014 World Cup and 2016 Olympics. Infraero manages 67 airports in Brazil, which together account for 97% of the air traffic in the country. However, only 10 airports, according to the government, are profitable.

Table 81: Brazil’s 5 Busiest Airports in 2010 Airport Passengers (mn) % Chg y/y Capacity (mn) Guarulhos (SP) 26.77 23.20% 20.5 Congonhas (SP) 15.48 13.00% 12 Brasília Intl’ Airport 14.14 15.80% 10 Galeão Intl’ Airport (RJ) 12.22 3.40% 18 Santos Dumont Airport (RJ) 7.8 53.10% 3.2

Source: Infraero data.

São Gonçalo do Amarante, located in the state of Rio Grande do Norte (Northeast region) and currently under construction, is likely to be the first airport to be privatized under Dilma’s administration. The expected investment at this airport should amount to roughly R$600m.

We believe airport privatization could be a growth opportunity for the private players in Brazil, including the toll road companies. Ecorodovias and OHL Brasil have already showed interest in investing in airports. We highlight that CCR is not allowed to invest in airports as one of its controlling groups already has airport operations outside Brazil.

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Electricity and Water

By Anderson Frey and team – (1-212) 622-6615 [email protected]

Brazil’s electricity sector has gone through a restructuring in the past 15 years. Power utilities in Brazil were predominantly state-owned until the late ’90s, when a wave of privatizations kick-started a deep restructuring. Subsequently, a severe energy rationing in 2001 exposed the need for sector expansion and a new regulatory framework, which was created and implemented in the early 2000s, with transparent rules for tariff setting and energy dealing. The industry was also subdivided into three separate segments: generation, transmission and distribution. Currently, the sector’s ownership is composed of both private and state players, and utilities usually have subsidiaries conducting business in all those three segments.

Brazil’s 113GW generation capacity is mostly hydro. The source accounts for more than 70% of Brazil’s installed capacity. Thermo sources (i.e., coal, oil and gas) come in a distant second (26%), which makes the sector less exposed to commodity prices than most global counterparts. This is not expected to substantially change in the future, since the government expansion plans are focused on both large hydro projects and renewable sources (wind, biomass and small hydro), to the detriment of new thermo capacity.

Figure 159: Power Generation Capacity Breakdown by Source Dec 2010, for a total of 113GW

Hy dro71%

Thermo26%

Other Renew able

1%

Nuclear2%

Source: ANEEL.

Government’s influence is still a relevant sector driver. The sector is only partially regulated, and companies can sell energy either in the regulated (i.e., distribution companies, 75% of total demand) or free markets (i.e., large customers, 25%); but in the regulated market, cap auction prices are set by the

government. Moreover, the government is currently revising the legislation that will allow (or not) the renewal of concessions expiring in 2015+. The renewal terms will be a relevant long-term profitability driver for the industry.

Power generation provides expansion opportunities due to strong capacity needs. Electricity demand in Brazil increased at an annual rate of 4% in 2006-10 and is expected to grow at slightly more than 1x GDP for the foreseeable future. This growth should require capacity increases of around 5GW p.a. and opportunities for new investment for utilities. The generation sector is attractive to investors due to its clear and transparent rules, low exposure to commodity prices and stable cash flows from long-term regulated contracts with inflation-hedged prices (the volatility risk in Brazilian generation related to weather is borne by final customers and not utilities). However, since the expansion process is based on new projects selling energy in auctions, high competition for available assets has recently allowed very tight returns for investors.

Figure 160: Electricity Demand and GDP Growth in Brazil In % p.a., estimates from the Brazilian energy research authority

2.3

4.0

5.0 5.0

3.3

4.64.9 4.7

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1995-2002 2002-2010 2010-2015E 2015-2020E

GDP grow th Demand Grow th

Source: EPE.

Electricity distribution and transmission sectors are fully regulated. These are more mature and stable industries with high penetration and more limited growth opportunities, especially distribution. Companies operate under a regulatory environment with (i) market-based regulated returns; (ii) periodical tariff reviews to cover cost inflation and new investments; and (iii) incentives for productivity gains. The downside of operating in a transparent regulatory framework in a fast-developing country is that regulated returns tend to go down over time (mostly due to lower country risk), which is already happening in Brazil.

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Figure 161: Regulatory WACC for Brazilian Utilities over Time In %, in real US$ terms

11.3%9.1% 9.9%

7.2% 7.2%

0%

2%

4%

6%

8%

10%12%

Distrib.2003-2007

Transmis.2005-2009

Dis trib.2007-2010

Transmis .2009-2013

*Distrib.2011-2014

Source: ANEEL. *This is still a preliminary number and might change in the near future.

Cost cutting is the most relevant driver and might lead to industry consolidation. With more limited growth opportunities vs. generation and declining regulated returns, cost cutting remains the best way to improve profitability for regulated businesses in Brazil, especially in distribution, where the margins are lower. The next round of tariff resets will start this year, and we believe that this event might help to accelerate the consolidation of the distribution industry, as companies try to look for opportunities to gain synergies and scale in a sector with still-segmented ownership.

Figure 162: Map of Distribution Companies in Brazil Each color is a different operator


For water utilities, regulation is what matters most. The water sector in Brazil currently presents three major distinct characteristics when compared to power

utilities: (1) there is no centralized tariff regulation. Contrary to power, for which regulation is federal and applies to the entire country, regulation in water is developed by cities and/or states and is still in a very preliminary stage in most cases. Very few companies have a market-based regulatory framework functioning and only a few are expected to be implemented in the next 2 years; (2) most of the sector is still state-owned and the participation of private capital is still incipient. This is most likely a reflection of a poor regulatory environment; and (3) lower penetration rates, especially of sewage collection and treatment. This should support a high capex cycle in the sector in the foreseeable future, as well as high volume growth rates. However, high capex with no guarantee of regulated returns through tariffs can be a hazard for long-term sustainability of the business as companies expand to poorer areas that might require heavy investment for little revenues. Overall, the news flow around the implementation of new state tariff regulations should be the main stock price driver in the near term.

Table 82: Brazil’s major listed Electricity and Water companies

Company Industry Ticker Rating Market Cap (US$ Million)

ELETROBRAS (PN) G/T/D ELET6/EBR.B N 22,076

CPFL ENERGIA G/D CPFE3/CPL UW 13,465

CEMIG G/T/D CMIG4/CIG restricted 12,191

TRACTEBEL ENERGIA G TBLE3 restricted 11,506

COPEL G/T/D CPLE6/ELP OW 7,202

SABESP W SBSP3/SBS N 6,624

CESP G CESP6 N 5,948

AES TIETE G GETI4 OW 5,730

CTEEP T TRPL4 N 5,185

ENERGIAS DO BRASIL G/D ENBR3 OW 3,844

LIGHT G/D LIGT3 restricted 3,663

ELETROPAULO D ELPL4 UW 4,034

COMGAS NG CGAS5 UW 3,240

MPX ENERGIA G MPXE3 N 3,437

COPASA W CSMG3 OW 2,064

CELESC G/D CLSC6 UW 1,202

EQUATORIAL ENERGIA G/D EQTL3 restricted 898.7

Note: G = generation, T = transmission, D = distribution, W = water, NG – natural gas. Source: J.P. Morgan estimates; Bloomberg. As of April 11, 2011.

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Annex 1: Historical Economic Data and Forecasts

Table 83: Main Economic Indicator – Yearly Real GDP %

change oya nsa

Consumer prices - IPCA % Dec/Dec

nsa

Wholesales price - IGP-M % Dec/Dec

nsa

Selic nominal eop % a.r.

Selic nominal avg % a.r.

Selic real deflated by IPCA avg. % a.r.

Exchange rate BRL/US$ eop

Exchange rate BRL/US$ avg

1995 4.2 22.4 15.2 53.1 53.4 25.3 0.97 0.92 1996 2.7 9.6 9.2 27.1 38.1 26.0 1.04 1.00 1997 3.3 5.2 7.7 24.7 23.7 17.6 1.12 1.08 1998 0.1 1.7 1.8 28.4 27.5 25.3 1.21 1.16 1999 0.8 8.9 20.1 25.1 29.0 18.5 1.79 1.82 2000 4.4 6.0 10.0 17.3 19.5 13.5 1.95 1.82 2001 1.3 7.7 10.4 17.2 16.5 8.8 2.32 2.35 2002 1.9 12.5 25.3 19.2 18.4 9.2 3.53 2.93 2003 1.2 9.3 8.6 16.5 23.0 13.8 2.89 3.08 2004 5.7 7.6 12.4 17.8 16.4 8.2 2.65 2.93 2005 3.2 5.7 1.2 18.0 19.1 12.7 2.34 2.44 2006 4.0 3.1 3.8 13.3 15.1 11.6 2.14 2.17 2007 5.7 4.5 7.8 11.3 12.0 7.2 1.80 1.94 2008 5.1 6.0 9.8 13.75 12.5 6.2 2.40 1.84 2009 -0.2 4.3 -1.7 8.75 9.9 5.4 1.74 2.00 2010* 7.5 5.9 11.1 10.75 10.0 3.9 1.66 1.76 2011* 4.0 6.4 9.5 12.50 12.1 5.4 1.60 1.59 2012* 4.0 5.0 na 12.50 12.5 7.1 1.70 1.66 2013* 4.0 4.5 na 10.00 10.5 5.7 1.90 1.80 2014* 4.0 4.5 na 9.00 9.5 4.8 1.95 1.93 2015* 4.0 4.5 na 8.50 8.5 3.8 2.05 2.04

Source: J.P. Morgan. Note: *J.P. Morgan Forecast, a.r.: annual rate, nsa: none seasonally adjusted, eop: end of the period, avg: average.

84



Table 84: Main Economic Indicators – Quarterly Real GDP %

change oya nsa

Consumer prices - IPCA % oya nsa

Wholesales price - IGP-M % oya nsa

Selic nominal eop % a.r.

Selic nominal avg % a.r.

Exchange rate BRL / US$ eop

Exchange rate BRL / US$ avg

04Q1 5.3 6.8 5.9 16.25 16.4 2.91 2.90 04Q2 7.5 5.5 7.3 16.00 16.0 3.10 3.04 04Q3 5.0 6.9 12.0 16.25 16.1 2.86 2.98 04Q4 5.0 7.2 12.2 17.75 17.2 2.66 2.79 05Q1 3.0 7.4 11.5 19.25 18.7 2.67 2.67 05Q2 3.0 7.8 9.0 19.75 19.7 2.36 2.48 05Q3 3.3 6.2 3.7 19.50 19.7 2.21 2.34 05Q4 3.4 6.1 1.9 18.00 18.5 2.34 2.25 06Q1 4.4 5.5 1.1 16.50 17.0 2.17 2.19 06Q2 1.9 4.3 -0.1 15.25 15.6 2.17 2.18 06Q3 4.7 3.8 2.4 14.25 14.4 2.17 2.17 06Q4 4.8 3.1 3.5 13.25 13.42 2.14 2.15 07Q1 5.1 3.0 3.8 12.75 12.92 2.09 2.11 07Q2 6.4 3.3 4.4 12.00 12.33 1.93 1.98 07Q3 6.1 4.0 4.7 11.25 11.42 1.90 1.91 07Q4 6.7 4.3 6.8 11.25 11.25 1.79 1.78 08Q1 7.2 4.6 8.7 11.25 11.25 1.75 1.73 08Q2 7.3 5.6 11.6 12.25 11.92 1.60 1.64 08Q3 6.4 6.3 13.7 13.75 13.25 1.92 1.71 08Q4 -15.8 6.2 11.3 13.75 13.75 2.40 2.29 09Q1 -7.5 5.8 7.4 11.25 12.25 2.32 2.32 09Q2 7.7 5.2 3.5 9.25 9.92 1.96 2.08 09Q3 10.7 4.4 -0.6 8.75 8.75 1.82 1.87 09Q4 10.2 4.2 -1.5 8.75 8.75 1.74 1.75 10Q1 9.0 4.9 0.5 8.75 8.75 1.78 1.82 10Q2 6.5 5.1 4.1 10.25 9.75 1.79 1.78 10Q3* 1.6 4.6 6.9 10.75 10.75 1.70 1.74 10Q4* 3.0 5.6 10.1 10.75 10.75 1.66 1.69 11Q1 3.7 6.1 11.2 11.75 11.42 1.62 1.67 11Q2 3.5 6.8 10.2 12.25 12.08 1.57 1.60 11Q3* 4.3 7.5 9.8 12.50 12.50 1.58 1.58 11Q4* 4.3 6.5 9.7 12.50 12.50 1.60 1.59

Source: J.P. Morgan. Note: *J.P. Morgan Forecast, a.r.: annual rate, nsa: none seasonally adjusted, eop: end of the period, avg: average.

85



Table 85: Debt and Fiscal Indicators 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010F 2011F Debt Stock Total External Debt (USD bn) 214.3 209.5 210.6 214.9 201.4 169.5 172.6 193.2 198.3 197.8 272.2 336.2 Sovereign External Debt (USD bn) 89.8 92.8 110.3 119.8 114.7 87.6 76.3 70.2 67.3 77.1 75.5 75.4 Private Sector External Debt (USD bn) 124.6 116.8 100.3 95.1 86.7 81.9 96.3 123.0 131.0 120.7 196.6 260.8 Total External Debt (% GDP) 33.2 37.8 41.8 38.9 30.3 19.2 15.8 14.1 12.0 12.4 13.2 14.8 Total External Debt (% of exports) 333.2 310.8 301.1 258.8 185.8 127.1 110.5 105.6 87.3 109.4 122.6 133.7 Sovereign Gross Domestic Debt (USD billion) 302.0 304.9 239.7 341.6 418.4 540.7 555.5 803.4 689.5 1,068.0 1,233.8 1,211.6 Sovereign Gross Domestic Debt (% GDP) 49.9 54.1 57.4 50.8 51.8 58.8 50.1 53.6 52.6 58.5 56.3 54.7 Sovereign Gross External Debt (% GDP) 13.9 16.7 21.9 21.7 17.3 9.9 7.0 5.1 4.1 4.8 3.7 3.3 Total Gross Sovereign or Public Sector Debt (USD bn) 411.8 392.4 399.9 400.7 458.2 606.1 621.6 802.6 936.7 1,008.2 1,238.5 1,319.8 Total Gross Sovereign or Public Sector Debt (% of GDP) 63.8 70.9 79.3 72.5 69.0 68.7 57.1 58.7 56.7 63.3 60.0 58.0 Sovereign Debt Service External Debt Service (USD bn) 31.4 12.3 15.7 28.2 26.0 47.7 46.2 21.0 6.5 8.6 11.5 9.2 Amortization (USD bn) 17.7 7.3 11.2 22.1 17.1 34.1 21.1 9.3 2.4 4.9 6.5 4.7 Interest (USD bn) 13.7 5.0 4.5 6.1 8.9 13.6 25.1 11.7 4.1 3.7 5.0 4.5 External Debt Service (% GDP) 4.9 2.2 3.1 5.1 3.9 5.4 4.2 1.5 0.4 0.5 0.6 0.4 Amortization (% GDP) 2.7 1.3 2.2 4.0 2.6 3.9 1.9 0.7 0.1 0.3 0.3 0.2 Interest (% GDP) 2.1 0.9 0.9 1.1 1.3 1.5 2.3 0.9 0.2 0.2 0.2 0.2 Domestic Debt Service (% of GDP) 27.7 17.5 20.2 20.6 17.3 20.2 16.7 15.8 14.5 14.7 14.7 14.0 Amortization (% of GDP) 23.2 11.8 13.4 14.3 12.7 14.5 12.2 10.6 9.3 9.6 9.6 8.2 Interest (% of GDP) 4.5 5.8 6.7 6.3 4.6 5.8 4.5 5.2 5.2 5.1 5.1 5.7 Total Sovereign Debt Service (% GDP) 32.6 19.8 23.3 25.7 21.3 25.6 20.9 17.4 14.9 15.2 15.3 14.4 Sovereign External Debt Service (% of exports) 48.8 18.3 22.5 34.0 24.0 35.7 29.6 11.5 2.9 4.7 5.2 3.7 Private Sector External Debt Service Amortization (USD bn) 21.3 27.9 24.5 22.3 26.1 22.0 23.0 28.5 19.1 27.3 23.2 22.6 Interest (USD bn) 4.2 5.5 6.3 8.2 8.2 8.1 10.1 8.8 9.4 12.0 10.0 11.6 Private Sector External Debt Service (% of GDP) 3.9 6.0 6.1 5.5 5.2 3.4 3.0 2.7 1.7 2.5 1.6 1.5 Total External Debt Service (% of GDP) 8.8 8.2 9.2 10.6 9.1 8.8 7.3 4.3 2.1 3.0 2.2 1.9 Fiscal Finances Headline Fiscal Balance (% of GDP) -3.4 -3.3 -4.4 -4.5 -2.5 -3.4 -3.5 -2.7 -1.9 -3.3 -2.2 -2.8 Public Sector Borrowing Requirements (% of GDP) -29.3 -16.4 -20.1 -22.8 -17.8 -21.7 -17.7 -14.0 -11.4 -13.2 -12.2 -11.3 Primary Fiscal Balance (% GDP) 3.2 3.4 3.2 2.9 3.4 3.9 3.2 3.4 3.5 2.0 3.1 3.1 Government revenue (% GDP) 32.5 33.8 34.6 30.2 31.9 36.6 36.9 37.3 38.2 33.1 33.3 33.8 Nominal GDP (USD bn) 645.0 553.8 504.4 552.5 663.7 881.7 1,089.4 1,366.6 1,651.6 1,592.7 2,064.5 2,275.9 GDP Per Capita (USD) 3,763.2 3,185.2 2,867.0 3,086.7 3,654.8 4,793.0 5,921.2 7,317.3 8,737.9 8,326.6 10,665.1 11,617.8 Real GDP growth (% oya) 4.3 1.3 2.6 1.1 5.7 3.2 4.0 6.1 5.2 -0.6 7.7 4.5 Source: Central Bank, Finance Ministry and J.P. Morgan as of 3Q 2010.

86



Annex 2: Brazil Strategy Dashboard

Market Performance: MSCI AC Performance by Regions, Countries and Sectors in USD

Last 3 monthsGl

obal

North

Am

erica

Euro

pe

EMF

EMF

Asia

EMEA

EMF

Latin

Amer

ica

Arge

ntin

a

Braz

il

Chile

Colo

mbi

a

Mexic

o

Peru

Consumer Discretionary 0.2% 3.2% 2.4% 2.5% 5.8% 4.4% -5.8% -4.0% -10.3% -8.3%Consumer Staples 4.0% 3.7% 6.7% 1.4% -0.1% -1.6% 3.6% 2.0% -0.2% 5.6%Energy 7.7% 7.9% 8.6% 8.7% 6.7% 19.2% 0.8% -17.0% 1.2% -6.2%Financials 1.8% 0.9% 7.3% 1.3% 2.0% 6.6% -0.4% -10.0% -0.6% -1.6% 3.4% 5.7% -12.8%Healthcare 4.3% 5.0% 5.9% -1.1% -1.0% -4.1% 0.0%Industrials 2.1% 4.0% 5.8% -2.0% -1.6% 0.7% 1.3% -1.7% -4.6% 21.1%Information Technology -2.1% -1.5% 8.1% -1.0% -1.3% 0.7% 12.5% 12.5%Materials 2.4% 2.0% 5.2% 0.7% 9.4% 5.4% -8.3% -8.3% -0.2% -9.2% -8.1% -15.4%Telecoms 5.5% 4.0% 8.7% 2.2% -0.1% 4.0% 4.5% -5.6% 19.1% 4.1% 0.9%Utilities 0.9% 0.3% 10.2% 2.4% -1.6% 4.1% 5.7% 8.9% 1.4% -9.3%Region / Country Benchmark 2.5% 2.8% 6.8% 1.9% 2.1% 10.5% -1.1% -9.6% -0.9% -1.2% -1.4% 0.6% -14.6%Change vs dollar -2.1% 5.4% 3.8% 2.5% 3.0% -1.2%

YTD Performance

Glob

al

North

Am

erica

Euro

pe

EMF

EMF

Asia

EMEA

EMF

Latin

Amer

ica

Arge

ntin

a

Braz

il

Chile

Colo

mbi

a

Mexic

o

Peru

Consumer Discretionary 1.8% 4.0% 4.4% 4.0% 9.6% 7.1% -7.1% -5.5% -14.3% -8.7%Consumer Staples 3.0% 4.0% 4.0% 0.0% -0.9% 0.9% 1.6% -1.0% -6.9% 5.7%Energy 10.7% 10.2% 14.0% 11.3% 8.8% 26.8% 0.4% -16.1% 0.7% -5.0%Financials 4.9% 3.5% 14.1% 1.6% 2.9% 9.1% -2.4% -13.4% -2.2% -7.2% 2.7% 3.6% -18.4%Healthcare 5.7% 7.4% 6.1% -4.2% -4.4% -2.0%Industrials 4.7% 6.8% 8.0% 0.0% 1.0% 0.7% 1.1% -0.4% -10.8% 28.2%Information Technology 0.9% 2.3% 12.4% -0.3% -0.5% 8.1% 7.4% 7.4%Materials 2.8% 1.2% 5.7% 3.1% 11.6% 10.7% -4.7% -2.0% -2.9% -3.8% -8.0% -22.4%Telecoms 5.8% 1.7% 11.7% 2.4% 0.3% 5.8% 6.8% -0.8% 27.5% 0.5% 2.1%Utilities 1.6% 1.2% 12.0% 2.9% -3.4% 8.4% 6.9% 14.2% -4.9% -8.5%Region / CountryBenchmark

4.4% 4.8% 9.4% 2.9% 3.4% 15.3% -0.7% -9.9% 0.2% -6.5% -0.1% 1.1% -21.2%

Change vs dollar -2.0% 4.7% -0.9% 4.9% 4.8% -0.5%

Notes Updated as of April 13, 2011Source: Bloomberg, MSCI.

Local currency movements against the dollar : (+) appreciation/ (-)depreciation

Country and sector cross sections in italic blue have outperformed their indices by more than 2%. Shaded areas have underperformed their indices by more than 2%.

87



IBovespa Top 40 Stocks : Consensus Valuation Indicators

Stocks Sector DY ROE P/BV2010E 2011E 2012E 2011E 2012E 2011E 2012E 2011E 2011E 2011E

IBOVESPA 11.9 10.6 9.5 6.9 5.6 12.4% 11.9% 3.8 15.0 1.6Petrobras Pn Energy 7.9 9.2 8.4 6.8 6.6 -13.7% 9.6% 3.1 10.6 1.0Vale Pna Materials 8.9 6.0 5.9 4.6 4.3 49.9% 0.9% 4.0 26.4 1.6Ogx Petroleo On Energy NM NM 50.3 NM 39.6 82.4% 514.5% 0.0 2.4 7.3Itauunibanco Pn Financials 13.0 10.9 9.5 - - 18.8% 14.9% 3.2 22.1 2.4Bmf Bovespa On Financials 15.0 15.6 13.2 14.4 11.6 -3.9% 17.6% 4.2 7.5 1.2Petrobras On Energy 8.9 10.3 9.4 6.8 6.6 -13.7% 9.6% 2.6 10.6 1.1Gerdau Pn Materials 12.8 11.6 8.1 6.2 4.7 10.9% 42.9% 2.4 10.2 1.2Bradesco Pn Financials 12.4 11.0 9.5 - - 12.9% 15.0% 3.3 19.9 2.2Usiminas Pna Materials 13.5 13.1 7.3 9.4 6.8 3.3% 79.4% 2.3 7.5 1.0Vale On Materials 10.0 6.7 6.6 4.6 4.3 49.9% 0.9% 3.9 26.4 1.8Banco Brasil On Financials 8.4 7.2 6.4 - - 15.7% 12.9% 5.5 19.7 1.4Pdg Realt Consumer Discretionary 12.2 7.7 6.8 8.6 7.1 57.9% 13.6% 2.6 20.2 1.6Sider.Nacional On Materials 12.5 9.1 7.9 5.5 4.9 38.4% 14.8% 4.5 32.0 2.9Itausa Pn Financials 11.3 9.2 7.7 11.9 - 22.6% 19.8% 3.7 19.8 1.8Cielo On Nm Information Technology 10.2 12.0 11.9 7.4 7.5 -15.1% 0.6% 7.5 134.2 16.1Cyrela Realt On Consumer Discretionary 9.3 8.3 6.5 8.5 6.5 11.5% 29.1% 2.9 15.8 1.3Gafisa On Consumer Discretionary 10.6 8.3 6.3 7.6 6.0 27.8% 32.2% 2.7 13.2 1.1Redecard On Information Technology 11.0 12.8 12.6 8.2 8.2 -14.0% 2.0% 6.7 102.5 13.2Brf Foods On Consumer Staples 39.3 22.2 15.8 10.5 8.2 76.9% 41.1% 1.0 8.3 1.9Mrv On Consumer Discretionary 10.3 7.9 6.5 7.5 6.3 30.4% 21.5% 2.8 24.0 1.9Fibria On Materials 19.5 14.9 14.6 6.6 6.4 30.5% 2.3% 1.7 4.7 0.7Mmx Miner On Materials 89.2 21.9 19.3 9.8 9.0 NM 12.9% 0.2 12.0 2.6Cemig Pn Utilities 12.3 10.2 8.6 6.0 5.2 20.7% 18.0% 4.6 17.6 1.8Jbs On Consumer Staples 18.6 23.7 15.6 6.7 5.8 -21.8% 51.6% 1.1 3.3 0.8All Amer Lat On Industrials 45.8 30.9 20.9 8.2 7.1 48.2% 47.6% 0.7 6.9 2.1Lojas Renner On Consumer Discretionary 22.4 19.8 16.5 10.9 9.0 13.3% 19.8% 3.0 29.7 5.9Lojas Americ Pn Consumer Discretionary 38.5 29.7 21.4 8.0 6.8 29.5% 39.0% 0.8 33.2 9.9Tim Part Pn Telecommunication Services 37.1 18.3 13.2 4.5 3.8 102.6% 38.8% 2.5 10.2 1.9Rossi Resid On Consumer Discretionary 10.2 7.8 5.9 8.3 6.5 31.0% 31.5% 2.9 16.8 1.3Telemar Pn Telecommunication Services 6.2 8.4 8.0 3.9 3.6 -26.3% 5.0% 9.8 9.2 0.8Bradespar Pn Materials 8.7 5.7 5.8 6.0 6.3 52.2% -2.6% 3.2 29.0 1.7Companhia Brasl.Distb. Pn Consumer Staples 29.2 22.1 15.7 8.3 6.7 31.8% 40.6% 1.1 10.3 2.3Santander Br Unt Financials 10.9 9.4 8.0 - - 16.6% 17.4% 5.8 11.5 1.1Hypermarcas On Consumer Staples 36.5 24.9 18.2 13.5 10.6 46.9% 36.7% 0.7 7.1 1.8Vivo Pn Telecommunication Services 17.2 11.1 10.1 4.3 4.1 53.9% 10.4% 7.2 21.3 2.4Ambev Pn Consumer Staples 19.3 16.9 15.7 9.9 8.9 14.7% 7.1% 5.5 34.5 5.8Eletrobras On Utilities 8.9 8.3 6.9 7.1 6.4 6.9% 20.7% 3.5 4.3 0.4Tam Pn Industrials 9.7 21.2 14.9 6.3 6.3 -54.5% 42.6% 1.6 12.3 2.6Ccr Rodovias On Industrials 27.2 19.8 15.4 8.7 7.3 37.3% 28.6% 3.8 35.2 7.0Ecodiesel On Energy NA NA NA - - NA NA NA NA NA

Source: IBES, Datastream. All estimates are IBES consensus. NM implies negative or large value. NA implies no consensus Data Updated as of 13 Apr 11

PE EV/EBITDA EPS Growth

88



Value: Brazil Sectors Valuation

13-Apr-11 Avg. Current 12m Avg. Current Avg. Current

MSCI Index 5yr Trailing Fwd 2010E 2011E 2012E 5yr Trailing 2010E 2011E 2012E 5yr Trailing 2010E 2011E 2012E 2009 2010E 2011E 2012E

Consumer Discretionary 131 30.1 15.7 10.8 17.4 11.5 9.1 2.3 2.1 2.1 2.3 3.4 3.5 2.3 2.4 2.1 2.0 13.7 13.8 18.3 22.2

Consumer Staples 1195 23.0 21.7 18.4 22.7 19.4 16.1 4.2 2.9 2.7 3.2 3.8 3.2 3.9 4.4 2.7 2.6 17.9 19.4 13.9 16.1

Energy 1742 9.4 10.7 12.5 9.9 12.6 12.2 3.4 1.3 0.9 2.3 2.4 2.5 1.2 1.1 1.4 5.9 22.0 11.2 11.0 48.5

Financials 1235 12.9 12.1 10.7 12.5 11.1 9.7 3.1 2.8 2.5 3.4 3.9 3.0 2.3 2.4 2.0 1.8 17.7 19.3 17.9 18.3

Industrials 240 22.0 22.5 17.7 23.9 19.0 14.7 2.6 3.0 3.3 2.3 3.2 4.3 5.9 6.9 3.6 3.4 46.0 28.7 19.0 23.1

Materials 2738 10.8 9.7 7.9 10.4 7.9 7.6 3.1 1.7 1.2 3.0 3.1 3.3 2.0 2.1 1.6 1.3 13.5 20.5 20.6 16.7

Telecommunication services 202 26.6 9.2 9.0 9.2 9.1 8.9 4.1 6.0 5.7 6.7 7.7 1.5 1.1 1.0 1.3 1.2 20.0 10.5 13.8 13.8

Utilities 433 11.8 11.1 10.2 11.4 10.5 9.5 5.4 5.1 4.9 5.5 6.4 0.7 1.2 1.2 1.2 3.1 9.1 10.5 11.5 33.0

Market Aggregate 229411 11.4 11.7 10.7 12.0 10.9 9.9 3.8 3.3 3.2 3.3 3.8 2.0 1.8 1.8 1.7 2.0 18.7 16.6 15.0 16.0

Value: PE Matrix for Countries and Sectors

12-month forward PE

Bra

zil

US

A

Euro

pe

EM

EM

F E

ME

A

EM

F A

sia

EM

F L

ata

m

Glo

bal

Mexic

o

Chile

Arg

entina

Peru

Colo

mbia

Chin

a

India

Russia

South

Afr

ica

Kore

a

Taiw

an

Japan

Turk

ey

Consumer Discretionary 10.8 11.6 12.3 13.1 15.1 10.0 15.5 25.0 NA NA 13.9 14.9 NA 13.1 16.7 NA 9.8

Consumer Staples 18.4 13.9 17.5 17.7 15.8 14.9 19.8 20.3 NA NA 16.1 24.3 27.1 15.4 17.6 15.7 21.1

Energy 12.5 9.3 9.0 6.7 12.7 9.9 NA NA 10.7 NA 11.9 12.5 6.1 9.6 21.2 9.5 11.2

Financials 10.7 8.9 11.1 10.0 11.5 9.2 15.9 13.3 8.9 NA 10.2 17.4 8.6 10.3 15.1 11.8 9.7

Industrials 17.7 13.3 12.3 10.0 12.2 13.7 NA NA NA NA 11.0 20.4 NA 9.8 10.9 10.8 9.7

Materials 7.9 10.3 10.5 10.7 12.2 7.7 14.5 NA NA 11.4 12.5 10.3 9.9 12.0 12.6 11.4 10.8

Telecommunication Services 9.0 10.3 11.4 11.3 11.6 9.4 11.5 11.6 9.6 NA 11.4 15.3 9.9 11.3 15.2 11.0 10.4

Utilities 10.2 11.6 12.1 10.9 15.8 9.7 NA 14.1 NA NA 15.9 16.7 11.3 NA NA NM NA

Market Aggregate 10.7 7.5 11.3 9.2 12.1 11.7 14.4 16.3 9.4 11.6 11.6 16.2 8.1 11.3 12.5 13.6 10.5

Sector Neutral* 11.9 10.9 11.3 10.6 12.8 10.6 13.8 13.3 11.2 11.7 13.1 16.5 10.9 11.4 15.1 11.9 11.4

Regional and Countries Valuations

13-Apr-11 Avg. Current 12m Avg. Current Avg. Current

MSCI Index 5yr Trailing Fwd 2010E 2011E 2012E 5yr Trailing 2010E 2011E 2012E 5yr Trailing 2010E 2011E 2012E 2009 2010E 2011E 2012E

Brazil* 229411 11.4 11.7 10.7 12.0 10.9 9.9 3.8 3.3 3.2 3.3 3.8 2.0 1.8 1.8 1.7 2.0 18.7 16.6 15.0 16.0

Mexico* 34418 15.6 18.7 14.4 20.8 14.9 13.0 1.8 4.1 4.4 3.2 2.3 2.8 3.8 4.3 2.6 1.8 19.3 19.5 20.5 17.6

Chile* 5526 25.2 16.8 16.3 16.9 16.6 15.6 2.3 3.7 4.2 2.6 2.9 1.9 2.1 2.1 2.1 1.9 13.3 7.7 12.3 12.8

China 71 16.1 13.3 11.6 13.9 12.2 10.5 2.3 2.6 2.5 2.8 3.2 2.4 2.2 2.3 2.0 1.8 15.4 17.4 17.5 18.0

Korea 607 11.5 12.0 10.6 12.4 11.1 9.6 2.0 1.1 1.1 1.3 1.4 1.6 1.6 1.6 1.5 1.3 11.3 14.2 14.2 14.8

Taiwan 312 24.7 14.4 12.5 15.0 13.2 11.2 3.0 3.4 3.2 4.1 4.5 2.0 2.0 2.0 1.9 1.8 7.8 13.8 14.7 16.2

India 777 18.9 19.5 16.2 20.7 17.1 14.2 1.5 1.2 1.2 1.3 1.5 3.9 3.1 3.2 2.8 2.4 13.4 15.6 17.7 18.2

Russia* 1081 12.7 9.5 8.1 10.0 8.3 7.5 1.8 1.5 1.4 1.8 2.1 1.8 1.4 1.5 1.3 1.2 13.4 15.9 16.8 16.5

South Africa* 822 14.3 14.4 11.3 15.8 11.8 10.1 3.0 3.1 2.9 3.6 4.3 2.6 2.5 2.7 2.1 1.9 15.0 17.5 20.0 19.8

USA* 1257 19.0 13.2 11.7 13.7 12.0 10.9 1.8 1.8 1.8 1.9 2.1 2.9 2.2 2.3 2.1 1.9 16.0 17.3 17.9 18.0

Europe* 1199 16.4 8.3 7.5 8.6 7.7 7.1 2.9 3.6 3.5 3.8 4.2 2.3 1.6 1.6 1.6 1.4 17.3 19.4 20.9 21.0

Japan* 527 19.4 15.0 13.6 14.0 NM 11.0 1.1 2.2 2.1 2.4 2.5 1.8 1.0 1.0 1.0 0.9 0.0 8.6 7.7 8.4

Global* 345 18.4 13.6 12.3 14.2 12.3 12.3 2.1 2.5 2.5 2.7 3.0 2.5 1.8 1.8 1.7 1.5 11.1 13.3 14.3 12.5

EMF* 48448 14.3 13.1 11.3 13.7 11.7 10.3 2.4 2.5 2.4 2.8 3.2 2.1 2.0 2.0 1.8 1.7 13.6 15.7 16.4 17.0

EMF LatAm* 75074 13.7 13.4 11.7 13.9 12.1 10.7 2.9 3.5 3.5 3.3 3.5 2.2 2.1 2.2 1.9 2.0 18.5 16.4 15.5 16.0

EMF Asia 701 14.6 14.0 12.1 14.7 12.6 10.9 2.3 2.5 2.5 2.5 2.8 2.0 2.1 2.1 2.0 1.7 13.2 15.4 16.1 16.8

EMF EMEA* 458 14.6 10.9 9.2 11.5 9.6 8.5 2.4 2.6 2.4 3.1 3.6 2.3 1.7 1.8 1.5 1.4 14.6 16.1 17.2 17.2

Source: I/B/E/S, MSCI, JPMorgan.

* Market forecast numbers are derived from bottom-up calculations of each individual MSCI constituents using I/B/E/S estimates. Updated as of

For all other markets and sectors, forecast numbers are derived from bottom-up calculations of each individual MSCI constituents using JPM estimates for covered stocks and I/B/E/S estimates for the rest.

Companies with different yearends are calendarised to December yearends and are free float adjusted for aggregation. Historical numbers are from MSCI.

18.3

13.1

11.4

12.0

11.3

11.3

7.4

38.4

14.5

15.4

12.3

12.1

10.1

13.0

14.5

8.8

10.6

11.8

31.1

NA

15.2

13.7

12.3 NA

NA

NA

NA

31.4

10.9

13.4

P/BV (x) ROE (%)

14.1

14.5

13.4

11.7

13.6

NA

P/E (x) Div. Yield (%)

13.4

14.4

13.5

P/BV (x)

11.3

13 Apr 11

ROE (%)

P/E (x) Div. Yield (%)

89



Brazil Style: Sector Ranks

Sector Ranking by PE Discount to Index* Sector Ranking by Dividend Yield

* History is since 1995.

Sector Ranking By ADTV ( 3months) Sector Ranking by ROE

Source: MSCI, IBES, Datastream, J.P. Morgan. * Historic data from 1995. Updated as of 13 Apr 11

8.0

5.9

3.42.9 2.8 2.6 2.3 2.1

1.2

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Tele

com

s

Relative to History

Relative to Index

90



Technical Indicators

Source: MSCI, IBES, Datastream, CEIC, Bloomberg, EPFR GlobalNote: Bovespa absolute and relative to MSCI EM is rebased to 100 since Jan 03. 13 Apr 11Updated as of

Bovespa Absolute and Relative to EM Index MSCI Brazil Trailing PE

M l i Th il d I d iT k P l d H

Bovespa fair value range*

Phili iR i C h R bli ChilA ti 2004 2005 20042005 20042005 202005 220052004 2005 20042005 20042005 2004 2005 20042005I l 200420052004 2005

MSCI Brazil Forward PE relative to MSCI EM MSCI Brazil Commodities vs Domestics (PE)MSCI Brazil Trailing PB relative to MSCI EM

Bovespa 50 and 200 Moving Day Average EM Composite Valuation Indicator#2010 MSCI Brazil Performance ex Petrobras

05

1015202530354045

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

+1SD

-1SD

0.20.30.40.50.60.70.80.9

11.1

95 97 98 99 00 01 02 03 04 05 06 07 08 10 11

+1SD

-1SD

70

90

110

130

150

170

190

210

50

150

250

350

450

550

650

750

2003 2003 2004 2005 2006 2007 2007 2008 2009 2010 2011

Absolute Relative to EM (36027)

(25818)

(36104)

(57456)

(51902)

(100823)

(78649)

(79551)(120282)

(85703)

10000 40000 70000 100000 130000

PE

PB

DY

BY/EY

BY/DY

4000045000500005500060000650007000075000

Aug 09 Nov 09 Mar 10 Jul 10 Oct 10 Feb 11

Bovespa 50 DMA 200 DMA

4

6

8

10

12

14

16

0

3

6

9

12

15

18

98 99 00 01 02 03 04 05 06 07 08 09 10 11

Brazil Domestics

Brazil Commodities0.2

0.4

0.6

0.8

1

1.2

1.4

95 97 98 99 00 01 02 03 04 05 06 07 08 10 11

+1SD

-1SD

-1.2 -0.9 -0.6 -0.3 0.0 0.3 0.6 0.9

IndiaMalaysiaS. Africa

KoreaBrazil

MexicoChile

TurkeyPolandChina

IndonesiaTaiwan

PhilippinesThailandHungary

RussiaCzech

Cheap Expensive7580859095

100105110115

Jan 10 Mar 10 May 10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11Brazil Brazil ex Petrobras

91



Sector EPS Revisions: Changes in 2011 and 2012 Forecasts

Indonesia 302 211 338 -30.1% 60.4% -10.8%

Turkey 90,953 58,143 91,707 -36.1% 57.7% -0.8%

Malaysia 36 25 40 -29.2% 57.0% -10.0%

Brazil 25,664 15,864 23,354 -38.2% 47.2% 9.9%

Mexico 2,416 1,760 2,414 -27.1% 37.1% 0.1%

South Africa 78 57 74 -26.9% 29.0% 6.0%

Source: MSCI, IBES, Datastream.Note: The charts are rebased to 100 on Feb 2008 for the ease of comparison

Updated as of 13 Apr 11

12 mth Fwd Max Min Current

Current

Peak to Current to

Peak

Trough to

-79.4% 331.7% 12.5%

EPS

Taiwan 28 6 25

Trough

1.6%

Peru 147 52 136 -64.8% 162.5% 8.2%

Argentina 2,664,224

67 161

-63.5% 169.5%973,505 2,623,203

-63.3% 140.9% 13.0%

Korea 46 27 60 -40.9% 120.7% -23.4%

Russia 182

69.7% -19.4%

Colombia 166 80 160

211 347

-52.0% 101.1% 3.6%

China 5 4 6 -26.9%

-20.3%

-25.8% 61.4% -16.5%India 43 32 52

Chile 277

1.1

80.1

45.5

81.0

-23.7% 64.4%

(43.8)

Max

Min

Current

412.6

156.7

263.8

Current to Peak 56.4

Trough to Current 76.168.4

Commodities Domestics

Peak to Trough (62.0)

Brazil


Consumer Discretionary

Phili i

R i

C h R bli

ChilA i 2004 2005 20042005 20042005 202005

22005

2004 2005 20042005 20042005

2004 2005

20042005I l 200420052004 2005

Energy Financials

Materials Telecoms

85

95

105

115

125

Feb 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 Apr 11

2011

2012

Energy Financials

80859095

100105110115120


2011

2012

60

70

80

90

100

110


2011

2012

95

98

101

104

107

110


2011

2012

90100110120130140150160170


2011

2012

708090

100110120130140150160170180190


2011

2012

EM EPS Revision Cycle: Brazil Lagging EM

Brazil Domestics and Commodities EPS Revision Cycle

92



Value: Forward PE for sectors

Source: I/B/E/S, DatastreamNote: This Dashboard aims to show historic consensus forward PE from 1995 with +/- 1 SD bands. * Consumer Discretionary series discountinuous for the period of Sept 2000 - Nov 2002 as EPS was negative. Updated as of 13 Apr 11

Brazil Consumer Staples


Consumer Discretionary*


Energy IndustrialsFinancials

Materials UtilitiesTelecoms

3

6

9

12

15

18

95 97 98 99 00 01 02 03 04 05 06 07 08 10 11369

121518212427

95 97 98 99 00 01 02 03 04 05 06 07 08 10 113

6

9

12

15

18

21

24

95 97 98 99 00 01 02 03 04 05 06 07 08 10 11

0369

1215182124

95 97 98 99 00 01 02 03 04 05 06 07 08 10 110369

1215182124

95 97 98 99 00 01 02 03 04 05 06 07 08 10 110369

121518212427

95 97 98 99 00 01 02 03 04 05 06 07 08 10 11

3

6

9

12

15

18

95 97 98 99 00 01 02 03 04 05 06 07 08 10 1148

12162024283236

95 97 98 99 00 01 02 03 04 05 06 07 08 10 110

3

6

9

12

15

18

95 97 98 99 00 01 02 03 04 05 06 07 08 10 11

93



Value: Dividend Yield for Sectors

Source: MSCI, DatastreamNote: This Dashboard aims to show historic consensus dividend yield. The dotted red line implies Average Dividend Yield for the Sector and grey line Brazil Average Dividend Yield Updated as of 13 Apr 11

Brazil Consumer Staples


Consumer Discretionary


Energy IndustrialsFinancials

Materials UtilitiesTelecoms

0

2

4

6

8

10

95 96 97 98 00 01 02 03 05 06 07 08 102

3

4

5

6

7

8

95 96 97 98 00 01 02 03 05 06 07 08 100

2

4

6

8

10

12

95 96 97 98 00 01 02 03 05 06 07 08 10

0

2

4

6

8

10

95 96 97 98 00 01 02 03 05 06 07 08 100

2

4

6

8

10

95 96 97 98 00 01 02 03 05 06 07 08 100

2

4

6

8

10

95 96 97 98 00 01 02 03 05 06 07 08 10

0

2

4

6

8

10

12

14

95 96 97 98 00 01 02 03 05 06 07 08 100.0

1.5

3.0

4.5

6.0

7.5

9.0

95 96 97 98 00 01 02 03 05 06 07 08 100

2

4

6

8

10

12

14

95 96 97 98 00 01 02 03 05 06 07 08 10

94



Annex 3: Tables

Table 1: Top 6 cities in the world by population .........................................................4 Table 2: Top 5 countries in the world by area .............................................................5 Table 3: Region Details ...............................................................................................5 Table 4: Healthcare Members (2008) ..........................................................................8 Table 5: Education Expenses (2006) ...........................................................................9 Table 6: Gini Coefficient (2007)..................................................................................9 Table 7: Bolsa Família Benefits (values as of 2010) .................................................10 Table 8: Economic Classes: household earnings per month ......................................11 Table 9: Distribution of Economic Classes................................................................11 Table 10: Access to Goods and Services of Different Economic Segments ..............11 Table 11: Travel & Tourism Competitiveness Index.................................................14 Table 12: T&T Competitiveness Index Breakdown (2009).......................................14 Table 13: Global Competitiveness Index (GCI) – 2009-2010 ...................................15 Table 14: Brazil’s classification breakdown ..............................................................15 Table 15: Infrastructure breakdown...........................................................................16 Table 16: 2010 Nominal GDP ...................................................................................16 Table 17: Real GDP Growth – Supply Side...............................................................17 Table 18: Real GDP Growth – Demand Side ............................................................18 Table 19: Real GDP Growth per Region ...................................................................19 Table 20: PAC Investments .......................................................................................20 Table 21: PAC 2 Investment Estimates .....................................................................21 Table 22: MCMV Breakdown ...................................................................................21 Table 23: Ceiling Price for Units under Minha Casa Minha Vida.............................21 Table 24: Government Investment Plan – World Cup...............................................22 Table 25: World Cup Investments (Public and Private) ............................................22 Table 26: Public Sector Investments Plan – Olympic Games....................................23 Table 27: Petrobras Capex 2010-2014 – Distribution by Area ..................................24 Table 28: Consumer Spending Breakdown as a % of Total Household Consumption (2008).........................................................................................................................27 Table 29: Inflation-Targeting System ........................................................................29 Table 30: IPCA Weight per Category and Metropolitan Region (Dec-2010)............30 Table 31: IGP Price Index Calendar ..........................................................................31 Table 32: Brazil Central Bank Chairmen since 1985.................................................32 Table 33: Recap of recent macro-prudential measures ..............................................32 Table 34: Recent History of Brazil’s IOF on Securities ............................................34 Table 35: Main Brazilian Exports (2010) ..................................................................35 Table 36: Top 10 Exports Companies in Brazil (2010) .............................................36 Table 37: Destination of Brazilian Exports (2010) ....................................................36 Table 38: Origin of Brazilian Imports........................................................................36 Table 39: Current Account by Country......................................................................38 Table 40: FDI Distribution per Sector .......................................................................39 Table 41: External Debt in Latin America (2010 estimate) .......................................40 Table 42: Registered External Debt Stock – By Debtor ............................................40

95



Table 43: Breakdown of Expenses of the Brazilian 2011 Budget..............................41 Table 44: Composition of the Stock of Public Debt ..................................................42 Table 45: Investment Grade.......................................................................................43 Table 46: Complexities of the Brazilian Tax System ................................................43 Table 47: Main taxes charged in Brazil .....................................................................44 Table 48: INSS Contribution by Income Level .........................................................45 Table 49: Income Tax Contribution by Income Level for 2011 ................................45 Table 50: BNDES’s Investment Perspectives............................................................50 Table 51: Sector Composition of BNDES Equities Portfolio ....................................51 Table 52: Brazil’s 10 Largest Companies by Market Cap (Dec 2010) ......................52 Table 53: Bovespa by Sector (Dec 2010) ..................................................................52 Table 54: Summary of Corporate Governance Levels for Bovespa Companies........54 Table 55: MSCI Brazil Weighting by Sector .............................................................54 Table 56: MSCI EM index composition by country: Demand Classification............55 Table 57: Market Data and Net Foreign Investment..................................................55 Table 58: Top Ten Brazilian Pension Funds..............................................................56 Table 59: Latin America Private Pension Funds........................................................57 Table 60: Mutual Fund Industry ................................................................................57 Table 61: Brazilian Presidents ...................................................................................59 Table 62: Senate Composition ...................................................................................61 Table 63: Chamber of Deputies Composition............................................................62 Table 64: Governors elected in 2010 .........................................................................62 Table 65: Brazil’s major listed Oil, Gas and Petrochemical companies ....................64 Table 66: Brazil’s major listed Metals & Mining companies ....................................66 Table 67: Brazil’s major listed Financials companies ...............................................68 Table 68: Brazil’s major listed Homebuilder companies...........................................69 Table 69: Brazil’s major listed Retail / Personal Care companies .............................72 Table 70: Brazil is top ranked within global protein industry....................................72 Table 71: Brazil’s major listed Food companies........................................................73 Table 72: Brazil’s major listed Beverages company..................................................74 Table 73: Brazil’s major listed Tobacco company.....................................................75 Table 74: Brazil Planted Area Breakdown for Annual Crops....................................76 Table 75: Brazil’s major listed Agribusiness companies ...........................................77 Table 76: Brazil’s Production Outlook ......................................................................77 Table 77: Brazil’s major listed Pulp & Paper companies ..........................................78 Table 78: Traffic Growth y/y vs. GDP Growth y/y ...................................................78 Table 79: IRR of Toll Roads in Brazil .......................................................................79 Table 80: Brazil’s major listed Roads companies......................................................80 Table 81: Brazil’s 5 Busiest Airports in 2010............................................................80 Table 82: Brazil’s major listed Electricity and Water companies..............................82 Table 83: Main Economic Indicator – Yearly............................................................83 Table 84: Main Economic Indicators – Quarterly......................................................84 Table 85: Debt and Fiscal Indicators .........................................................................85

96



Annex 4: Figures

Figure 1: Brazil Divided by Region.............................................................................5 Figure 2: Brazil’s population .......................................................................................6 Figure 3: Population growth until 2050 .......................................................................6 Figure 4: Average Life Expectancy .............................................................................6 Figure 5: Fertility rate ..................................................................................................6 Figure 6: Population density by state ...........................................................................7 Figure 7: Urban Population as % of Total ...................................................................7 Figure 8: Healthcare Expenditures as a % of GDP (2008)...........................................8 Figure 9: Heath Plan (Insurance) Sector Revenues......................................................8 Figure 10: Illiteracy Rates 2007...................................................................................8 Figure 11: Illiteracy Rate in Brazil ..............................................................................9 Figure 12: Education Expenditure per Student ............................................................9 Figure 13: Gini Evolution in Brazil ...........................................................................10 Figure 14: Income distribution (2009) .......................................................................10 Figure 15: Homicide Rate per 100,000 People (2009)...............................................12 Figure 16: Penitentiary System Deficit ......................................................................12 Figure 17: Evolution of Public Security Investments ................................................12 Figure 18: Federal Police Personnel ..........................................................................12 Figure 19: Tourist Arrivals in Brazil..........................................................................13 Figure 20: Main Travel Destinations .........................................................................13 Figure 21: The most problematic factors in doing business.......................................16 Figure 22: Brazilian GDP Growth .............................................................................17 Figure 23: Economic Growth: Brazil vs. EM vs. G-7................................................17 Figure 24: Latin America GDP..................................................................................17 Figure 25: GDP Components by Expenditure (Demand Side) ..................................18 Figure 26: GDP Components by Sector (Supply Side)..............................................18 Figure 27: GDP per Capita ........................................................................................19 Figure 28: Regional Participation in Brazilian GDP (2008) ......................................19 Figure 29: Emerging Markets Gross Fixed Capital Formation..................................19 Figure 30: Gross Fixed Capital Formation in Brazil..................................................20 Figure 31: Capacity Utilization (% of total installed capacity)..................................20 Figure 32: Public Investment as a % of GDP ............................................................20 Figure 33: Mortgages as a % of total credit ...............................................................21 Figure 34: High Speed Train Total Costs by Sector ..................................................23 Figure 35: Petrobras Domestic Oil and Gas Production ............................................23 Figure 36: Supply-vs-Demand Forecast by EPE........................................................24 Figure 37: Industrial GDP..........................................................................................24 Figure 38: Industrial Production ................................................................................25 Figure 39: Industrial Production by Category............................................................25 Figure 40: Durable vs. Nondurable Goods Production ..............................................25 Figure 41: Retail Sales ...............................................................................................25 Figure 42: Consumer Confidence NSA .....................................................................26

97



Figure 43: Consumption of Furniture, Appliance, Electronics and Computers Index...................................................................................................................................26 Figure 44: Household Ownership ..............................................................................26 Figure 45: Inhabitants per Vehicle (2008) .................................................................26 Figure 46: Consumption Allocation by Region (2008)..............................................27 Figure 47: Unemployment Rate.................................................................................27 Figure 48: Composition of Labor by Type of Job......................................................27 Figure 49: Net Formal Job Creation (Hires – Fires) ..................................................28 Figure 50: Job Creation by Category – 2010 .............................................................28 Figure 51: Real Wage Mass.......................................................................................28 Figure 52: Minimum Wage Evolution .......................................................................28 Figure 53: Inflation Rate since 2006..........................................................................29 Figure 54: IPCA vs. INPC .........................................................................................31 Figure 55: IGP-M and Its Components......................................................................31 Figure 56: IPCA vs. IGP-M.......................................................................................31 Figure 57: Selic Rate vs. Inflation yoy Growth .........................................................33 Figure 58: Exchange Rate..........................................................................................33 Figure 59: Real Exchange Rate..................................................................................33 Figure 60: Interest Rate by Country (end of 2010) ....................................................34 Figure 61: Trade Current (Exports + Imports) ...........................................................34 Figure 62: Trade Balance...........................................................................................35 Figure 63: Total Exports as a % of GDP (2009) ........................................................35 Figure 64: Brazil’s Export Composition by Category (2010)....................................35 Figure 65: Brazilian Monthly Imports .......................................................................36 Figure 66: Imports from China ..................................................................................37 Figure 67: Imports Destination by Regions (2010)....................................................37 Figure 68: Current Account .......................................................................................37 Figure 69: Service Account Deficit Rising ................................................................37 Figure 70: Annual Brazilian FDI ...............................................................................38 Figure 71: Participation of Key Countries in Brazilian FDI ......................................38 Figure 72: Foreign Portfolio Investment in Brazil .....................................................39 Figure 73: Brazil International Reserves....................................................................39 Figure 74: International Reserves by Country (end of 1Q11)....................................39 Figure 75: Federal Government Revenues and Outlays.............................................40 Figure 76: Primary Surplus........................................................................................41 Figure 77: Nominal Deficit ........................................................................................41 Figure 78: Interest Payments .....................................................................................42 Figure 79: Net Public Sector Debt .............................................................................42 Figure 80: Net Public Sector Debt Split into Internal and External Debt ..................42 Figure 81: Average Maturity of Brazil’s Public Sector Local Debt...........................43 Figure 82: Net Debt vs. Gross Debt...........................................................................43 Figure 83: Total taxation as a % GDP .......................................................................44 Figure 84: Brazil Ranks 14 within Countries with the Highest Tax/GDP Ratio (2009)...................................................................................................................................44 Figure 85: Tax Burden by Jurisdiction ......................................................................44 Figure 86: Most Representative Taxes in Brazil........................................................45

98



Figure 87: Credit as a % of GDP ...............................................................................46 Figure 88: Credit as a % of GDP by Country (in 2009).............................................46 Figure 89: Total Credit Growth .................................................................................46 Figure 90: Credit to Individuals .................................................................................46 Figure 91: Total Credit Destination by Debtor ..........................................................47 Figure 92: Breakdown of Consumer Credit per Credit Type.....................................47 Figure 93: Non-performing Loans .............................................................................47 Figure 94: Average Maturity for Consumer Credit....................................................47 Figure 95: Average Spreads for Consumer Loans .....................................................48 Figure 96: Public Sector Credit as a % of Total Credit..............................................48 Figure 97: Household Debt Stock as a % of Annual Income.....................................48 Figure 98: Total Debt Service as a % of Annual Earnings ........................................48 Figure 99: Mortgages as % of GDP ...........................................................................49 Figure 100: Mortgages by Country............................................................................49 Figure 101: FGTS + SBPE Total Mortgage Disbursements ......................................50 Figure 102: BNDES Participation in Credit Rose after 2008 Crisis ..........................50 Figure 103: BNDES Disbursement............................................................................50 Figure 104: BNDES vs. Capital Markets...................................................................51 Figure 105: 15 Largest Stock Exchanges in Terms of Market Cap ...........................51 Figure 106: Bovespa Market Cap ..............................................................................52 Figure 107: Bovespa Index performance ...................................................................53 Figure 108: Bovespa Performance in 2010................................................................53 Figure 109: IBX50 vs. Ibovespa ................................................................................53 Figure 110: Foreign Equity Investments in the Bovespa (Secondary) Market ..........55 Figure 111: Investor Participation in Total Bovespa Volume....................................56 Figure 112: Bovespa Average Daily Traded Volume................................................56 Figure 113: Pension Fund Allocation ........................................................................57 Figure 114: Mutual Funds’ Total AUM.....................................................................57 Figure 115: AUM Breakdown by Category...............................................................58 Figure 116: Fixed Income vs. Equity vs. Multi-Strategy...........................................58 Figure 117: Electorate Divided by Age .....................................................................58 Figure 118: Last 5 Presidents’ Popularity..................................................................60 Figure 119: Brazil’s Energy Matrix 2009 ..................................................................63 Figure 120: Expected Oil Production Growth (CAGR 2009 - 2035).........................63 Figure 121: Simplified map of Brazilian Basins........................................................64 Figure 122: BZ – Main steel-consuming sectors .......................................................65 Figure 123: Vale’s iron ore output has doubled since 2000 and accounts for over 75% of Brazil’s output .......................................................................................................65 Figure 124: Brazil is the 8th major crude steel producer - as of 2010 .......................65 Figure 125: Brazil’s crude steel capacity may reach ~64Mt by 2016 ........................66 Figure 126: Brazilian flat-steel imports have stabilized at high levels ......................66 Figure 127: Deposit Market Share .............................................................................67 Figure 128: Loan Market Share .................................................................................67 Figure 129: Private credit as a percentage of GDP ....................................................67 Figure 130: Total Loans to GDP................................................................................68 Figure 131: Sector P/E 12 Months.............................................................................69

99



Figure 132: Sector Performance vs. Selic ..................................................................69 Figure 133: Housing Market by Income Segment .....................................................70 Figure 134: Listed Companies’ Launches..................................................................70 Figure 135: SBPE + FGTS Financing........................................................................70 Figure 136: Construction Inflation Breakdown .........................................................70 Figure 137: Brazil Retail Sales ..................................................................................71 Figure 138: Brazil Consumer Confidence..................................................................71 Figure 139: Food Retail Market Share (2009) ...........................................................71 Figure 140: Hardline Market Share (2008)................................................................72 Figure 141: E-commerce Market Share (2008, 2009)................................................72 Figure 142: Exports have flattened as % of total production .....................................73 Figure 143: Brazil to consume 19mn tons of meat in 2011E.....................................73 Figure 144: Brazil’s pastures to decline ~40 mn hectares by 2030E .........................73 Figure 145: World’s Top 8 beer markets by volume, 2009 .......................................73 Figure 146: AmBev’s Beer Brazil Market Share .......................................................74 Figure 147: Beer EBIT margin of leading brewer in top markets, 2009E .................74 Figure 148: Brazil’s beer per capita to keep gradually improving.............................74 Figure 149: Global smoking incidence ......................................................................74 Figure 150: Smoking is concentrated in Brazil’s lower-income segments ................74 Figure 151: Souza Cruz market share evolution ........................................................75 Figure 152: Souza Cruz manages to grow sales and EPS despite lower volumes .....75 Figure 153: Federal Excise Tax (IPI) collection ........................................................75 Figure 154: Sugarcane: Increasingly a Domestic Story .............................................76 Figure 155: State and Federal Concessions ...............................................................78 Figure 156: Expected Investments in Infrastructure ..................................................79 Figure 157: Third Round of Federal Concessions .....................................................79 Figure 158: Domestic RPK Growth y/y.....................................................................80 Figure 159: Power Generation Capacity Breakdown by Source................................81 Figure 160: Electricity Demand and GDP Growth in Brazil .....................................81 Figure 161: Regulatory WACC for Brazilian Utilities over Time .............................82 Figure 162: Map of Distribution Companies in Brazil ..............................................82

100



Companies Recommended in This Report (priced as of market close on 14 April 2011) CCR (CCRO3.SA/R$46.10/Overweight), Embraer SA (ERJ/$32.33/Neutral), GOL Linhas Aereas Inteligentes S.A. (GOL/$13.39/Neutral), MRV (MRVE3.SA/R$13.15/Overweight), OHL Brasil (OHLB3.SA/R$65.70/Neutral), PDG Realty (PDGR3.SA/R$9.19/Overweight), PETROBRAS ON (PETR3.SA/R$28.82/Neutral), TAM S.A. (TAM/$19.41/), Vale ON (VALE/$32.65/Overweight)

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

In compliance with Instruction 483 issued by Comissao de Valores Mobiliarios (the Brazilian securities commission) on July 6, 2010, the Brazilian primary analyst signing this report declares: (1) that all the views expressed herein accurately reflect his or her personal views about the securities and issuers; (2) that all recommendations issued by him or her were independently produced, including from the entity in which he or she is an employee; and (3) that he or she will set forth any situation or conflict of interest believed to impact the impartiality of the recommendations herein, as per article 17, II of Instruction 483.

Important Disclosures

• Lead or Co-manager: J.P. Morgan acted as lead or co-manager in a public offering of equity and/or debt securities for PETROBRAS ON, Vale ON within the past 12 months.

• Beneficial Ownership (1% or more): J.P. Morgan beneficially owns 1% or more of a class of common equity securities of GOL Linhas Aereas Inteligentes S.A., PETROBRAS ON, TAM S.A..

• Client of the Firm: CCR is or was in the past 12 months a client of JPM. Embraer SA is or was in the past 12 months a client of JPM; during the past 12 months, JPM provided to the company non-investment banking securities-related service and non-securities-related services. GOL Linhas Aereas Inteligentes S.A. is or was in the past 12 months a client of JPM; during the past 12 months, JPM provided to the company non-investment banking securities-related service. PETROBRAS ON is or was in the past 12 months a client of JPM; during the past 12 months, JPM provided to the company investment banking services and non-investment banking securities-related service. TAM S.A. is or was in the past 12 months a client of JPM; during the past 12 months, JPM provided to the company non-investment banking securities-related service. Vale ON is or was in the past 12 months a client of JPM; during the past 12 months, JPM provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services.

• Investment Banking (past 12 months): J.P. Morgan received, in the past 12 months, compensation for investment banking services from PETROBRAS ON, Vale ON.

• Investment Banking (next 3 months): J.P. Morgan expects to receive, or intends to seek, compensation for investment banking services in the next three months from Embraer SA, GOL Linhas Aereas Inteligentes S.A., PETROBRAS ON, Vale ON.

• Non-Investment Banking Compensation: JPMS has received compensation in the past 12 months for products or services other than investment banking from Embraer SA, GOL Linhas Aereas Inteligentes S.A., PETROBRAS ON, TAM S.A., Vale ON. An affiliate of JPMS has received compensation in the past 12 months for products or services other than investment banking from Embraer SA, GOL Linhas Aereas Inteligentes S.A., PETROBRAS ON, TAM S.A., Vale ON.

• J.P. Morgan and/or its affiliates are acting as financial advisor to LAN Airlines S.A. (NYSE:LFL), in connection with its non-binding agreement to merge with TAM S.A. (NYSE:TAM), as announced on August 13, 2010. The merger will be subject to customary conditions including both parties entering into a binding definitive agreement and satisfaction of conditions, including corporate and shareholder approvals, actions and regulatory approval. This research report and the information herein is not intended to provide voting advice, serve as an endorsement of the proposed transaction or result in procurement, withholding or revocation of a proxy or any other action by a security holder.

• MSCI: The MSCI sourced information is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an 'as is' basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are services marks of MSCI and its affiliates.

101



0

16

32

48

64

80

Price(R$)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

CCR (CCRO3.SA) Price Chart

OW R$52

OW R$44.5 N R$26 N R$31 N R$45

Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.

Initiated coverage Jun 06, 2008. This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst

may or may not have covered it over the entire period.

J.P. Morgan ratings: OW = Overweight, N = Neutral, UW = Underweight.

Date Rating Share Price (R$)

Price Target (R$)

06-Jun-08 OW 30.02 44.50

12-Mar-09 N 21.26 26.00

21-Sep-09 N 30.39 31.00

30-Aug-10 N 39.70 45.00

18-Nov-10 OW 44.28 52.00

0

17

34

51

68

85

Price($)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

Embraer SA (ERJ) Price Chart

OW $18OW $20OW $25N $18 UW $23 N $32

OW $23OW $18OW $23N $27 UW $20 N $35 N $33

OW OW $20OW $16OW $18OW $27UW $18 N $32N $36 N $40


This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst may or may not have covered it

over the entire period.


Date Rating Share Price ($)

Price Target ($)

20-Feb-07 OW 45.98 --

01-Dec-08 OW 14.40 20.00

12-Jan-09 OW 17.40 23.00

23-Feb-09 OW 13.24 18.00

30-Mar-09 OW 13.17 16.00

08-Apr-09 OW 15.44 18.00

04-May-09 OW 18.73 20.00

06-Jul-09 OW 15.99 18.00

03-Aug-09 OW 19.49 23.00

08-Sep-09 OW 22.81 25.00

05-Oct-09 OW 22.57 27.00

30-Oct-09 N 23.45 27.00

02-Nov-09 N 20.25 18.00

06-Jan-10 UW 22.44 18.00

22-Mar-10 UW 24.56 20.00

03-May-10 UW 24.08 23.00

02-Aug-10 N 26.99 32.00

07-Sep-10 N 26.65 35.00

14-Oct-10 N 28.33 32.00

01-Nov-10 N 29.28 36.00

21-Mar-11 N 33.97 40.00

28-Mar-11 N 32.96 33.00

102



0

14

28

42

56

Price($)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

GOL Linhas Aereas Inteligentes S.A. (GOL) Price Chart

UW OW UW

N N UW OW $7.5 N $15.5 N $17 N $20






Price Target ($)

24-Oct-06 N 31.99 -

01-Dec-06 UW 28.46 -

25-Sep-07 N 23.88 -

01-Aug-08 UW 9.97 -

12-Sep-08 OW 9.15 -

29-Jan-09 OW 4.56 7.50

03-Apr-09 UW 3.08 --

09-Nov-09 N 11.80 15.50

05-May-10 N 12.83 17.00

08-Nov-10 N 17.55 20.00

0

15

30

45

60

75

Price(R$)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

MRV (MRVE3.SA) Price Chart

OW R$14.33

OW R$13

N R$14.33 OW R$6OW R$9.33 OW R$16 OW R$23OW R$21


Initiated coverage Aug 01, 2008. This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst




Price Target (R$)

01-Aug-08 N 35.40 14.33

19-Jan-09 OW 11.21 6.00

11-May-09 OW 21.19 9.33

20-Jul-09 OW 29.19 13.00

17-Sep-09 OW 32.40 14.33

15-Jan-10 OW 13.00 16.00

15-Oct-10 OW 18.00 23.00

17-Mar-11 OW 13.75 21.00

103



0

21

42

63

84

105

Price(R$)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

OHL Brasil (OHLB3.SA) Price Chart

N R$64

N R$35.4 N R$17 N R$31 N R$58


Initiated coverage Jun 06, 2008. This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst




Price Target (R$)

06-Jun-08 N 26.49 35.40

17-Mar-09 N 13.34 17.00

13-Nov-09 N 31.20 31.00

30-Aug-10 N 48.00 58.00

18-Nov-10 N 61.10 64.00

0

6

12

18

Price(R$)

Nov

07

Feb

08

May

08

Aug

08

Nov

08

Feb

09

May

09

Aug

09

Nov

09

Feb

10

May

10

Aug

10

Nov

10

Feb

11

PDG Realty (PDGR3.SA) Price Chart

OW R$10

OW R$17

OW R$15 OW R$9 OW R$15 OW R$11OW R$12 OW R$15OW R$14


Initiated coverage Aug 01, 2008. This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst




Price Target (R$)

01-Aug-08 OW 5.88 15.00

19-Jan-09 OW 3.18 9.00

11-May-09 OW 4.96 15.00

20-Jul-09 OW 6.08 17.00

17-Sep-09 OW 6.80 10.00

15-Jan-10 OW 8.16 11.00

05-May-10 OW 8.00 12.00

15-Oct-10 OW 11.00 15.00

17-Mar-11 OW 9.28 14.00

104



0

17

34

51

68

85

102

Price(R$)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

PETROBRAS ON (PETR3.SA) Price Chart

OW R$35OW R$49

OW R$72OW R$42OW R$50.5 N R$43

N R$57 OW R$47 N R$35 OW R$54OW R$51 N R$34


Initiated coverage May 05, 2008. This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst




Price Target (R$)

05-May-08 N 49.00 57.00

27-Jun-08 OW 52.13 72.00

16-Oct-08 OW 25.45 47.00

01-Dec-08 OW 22.59 42.00

21-Jan-09 OW 26.93 35.00

09-Mar-09 N 30.99 35.00

12-May-09 OW 40.88 50.50

08-Jun-09 OW 41.97 49.00

16-Nov-09 OW 43.00 54.00

22-Mar-10 OW 40.55 51.00

03-May-10 N 35.40 43.00

01-Nov-10 N 29.10 34.00

0

13

26

39

52

65

Price($)

Oct

06

Jul

07

Apr

08

Jan

09

Oct

09

Jul

10

Apr

11

TAM S.A. (TAM) Price Chart

UW $14.5

UW N $7.5 N $14

N N N $11 N $11 N $20.5






Price Target ($)

24-Oct-06 N 31.63 -

01-Dec-06 UW 27.88 -

25-Sep-07 N 26.61 -

29-Jan-09 N 7.51 11.00

03-Apr-09 N 6.01 7.50

30-Jul-09 N 12.30 11.00

03-Nov-09 N 14.47 14.00

09-Nov-09 UW 16.05 14.50

14-May-10 N 16.13 20.50

105



0

15

30

45

60

75

Price($)

Sep

06

Jun

07

Mar

08

Dec

08

Sep

09

Jun

10

Mar

11

Vale ON (VALE) Price Chart

OW $23.3 N $31.5 OW $23.4 OW $35.5 OW $39.5OW $47.5

OW $19.8 OW $31.5 OW $30.68 N $24.5 OW $45 OW $42

OW $17.8 OW $27.9 OW $46.1OW $47.5 N $18.5 N $23.5 OW $39.5OW $38 OW $4


Break in coverage Dec 30, 2001 - Feb 12, 2002, and Aug 25, 2005 - Dec 22, 2006. This chart shows J.P. Morgan's

continuing coverage of this stock; the current analyst may or may not have covered it over the entire period.



Price Target ($)

25-Sep-02 OW 10.86 -

22-Dec-06 OW 14.59 17.80

07-Feb-07 OW 16.96 19.80

17-Apr-07 OW 20.95 23.30

09-Jul-07 OW 24.29 27.90

14-Sep-07 OW 27.25 31.50

03-Oct-07 N 32.30 31.50

11-Apr-08 OW 35.82 46.10

02-Sep-08 OW 25.23 47.50

16-Oct-08 OW 11.64 30.68

19-Nov-08 OW 11.09 23.40

20-Feb-09 N 13.60 18.50

03-Aug-09 N 19.73 23.50

08-Oct-09 N 24.41 24.50

10-Dec-09 OW 28.02 35.50

12-Mar-10 OW 30.03 39.50

12-Apr-10 OW 33.95 45.00

04-Jun-10 OW 25.54 39.50

12-Jul-10 OW 25.22 38.00

21-Sep-10 OW 28.51 42.00

22-Oct-10 OW 32.07 47.50

14-Apr-11 OW 32.65 48.00

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] J.P. Morgan Cazenove’s UK Small/Mid-Cap dedicated research analysts use the same rating categories; however, each stock’s expected total return is compared to the expected total return of the FTSE All Share Index, not to those analysts’ coverage universe. A list of these analysts is available on request. The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.

J.P. Morgan Equity Research Ratings Distribution, as of March 31, 2011

Overweight (buy)

Neutral (hold)

Underweight (sell)

J.P. Morgan Global Equity Research Coverage 47% 42% 11% IB clients* 50% 45% 33% JPMS Equity Research Coverage 43% 49% 8% IB clients* 70% 62% 56%

*Percentage of investment banking clients in each rating category. For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on the front of this note or your J.P. Morgan representative.

http://www.morganmarkets.com/

106



Analysts’ Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.

Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of JPMS, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.

Other Disclosures

J.P. Morgan ("JPM") is the global brand name for J.P. Morgan Securities LLC ("JPMS") and its affiliates worldwide. J.P. Morgan Cazenove is a marketing name for the U.K. investment banking businesses and EMEA cash equities and equity research businesses of JPMorgan Chase & Co. and its subsidiaries.

Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation’s Characteristics and Risks of Standardized Options, please contact your J.P. Morgan Representative or visit the OCC’s website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf.

Legal Entities Disclosures U.S.: JPMS is a member of NYSE, FINRA and SIPC. J.P. Morgan Futures Inc. is a member of the NFA. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. U.K.: J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorized and regulated by the Financial Services Authority. Registered in England & Wales No. 2711006. Registered Office 125 London Wall, London EC2Y 5AJ. South Africa: J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. Hong Kong: J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. Korea: J.P. Morgan Securities (Far East) Ltd, Seoul Branch, is regulated by the Korea Financial Supervisory Service. Australia: J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) is regulated by ASIC and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066) is a Market Participant with the ASX and regulated by ASIC. Taiwan: J.P.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Bureau. India: J.P. Morgan India Private Limited, having its registered office at J.P. Morgan Tower, Off. C.S.T. Road, Kalina, Santacruz East, Mumbai - 400098, is a member of the National Stock Exchange of India Limited (SEBI Registration Number - INB 230675231/INF 230675231/INE 230675231) and Bombay Stock Exchange Limited (SEBI Registration Number - INB010675237/INB010675237) and is regulated by Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission. Indonesia: PT J.P. Morgan Securities Indonesia is a member of the Indonesia Stock Exchange and is regulated by the BAPEPAM LK. Philippines: J.P. Morgan Securities Philippines Inc. is a member of the Philippine Stock Exchange and is regulated by the Securities and Exchange Commission. Brazil: Banco J.P. Morgan S.A. is regulated by the Comissao de Valores Mobiliarios (CVM) and by the Central Bank of Brazil. Mexico: J.P. Morgan Casa de Bolsa, S.A. de C.V., J.P. Morgan Grupo Financiero is a member of the Mexican Stock Exchange and authorized to act as a broker dealer by the National Banking and Securities Exchange Commission. Singapore: This material is issued and distributed in Singapore by J.P. Morgan Securities Singapore Private Limited (JPMSS) [MICA (P) 025/01/2011 and Co. Reg. No.: 199405335R] which is a member of the Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (MAS) and/or JPMorgan Chase Bank, N.A., Singapore branch (JPMCB Singapore) which is regulated by the MAS. Malaysia: This material is issued and distributed in Malaysia by JPMorgan Securities (Malaysia) Sdn Bhd (18146-X) which is a Participating Organization of Bursa Malaysia Berhad and a holder of Capital Markets Services License issued by the Securities Commission in Malaysia. Pakistan: J. P. Morgan Pakistan Broking (Pvt.) Ltd is a member of the Karachi Stock Exchange and regulated by the Securities and Exchange Commission of Pakistan. Saudi Arabia: J.P. Morgan Saudi Arabia Ltd. is authorized by the Capital Market Authority of the Kingdom of Saudi Arabia (CMA) to carry out dealing as an agent, arranging, advising and custody, with respect to securities business under licence number 35-07079 and its registered address is at 8th Floor, Al-Faisaliyah Tower, King Fahad Road, P.O. Box 51907, Riyadh 11553, Kingdom of Saudi Arabia. Dubai: JPMorgan Chase Bank, N.A., Dubai Branch is regulated by the Dubai Financial Services Authority (DFSA) and its registered address is Dubai International Financial Centre - Building 3, Level 7, PO Box 506551, Dubai, UAE.

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distributed in Germany by J.P. Morgan Securities Ltd., Frankfurt Branch and J.P.Morgan Chase Bank, N.A., Frankfurt Branch which are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months’ prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivative warrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

“Other Disclosures” last revised January 8, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.#$J&098$#*P

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