oil rigThe depth of corruption and scandal at Petroleo Brasileiro (Petrobras) isn’t your typical run of the mill emerging market scam. A conflux of events around the world, built up over decades, fostered the conditions for a defrauding of this magnitude. Post financial crisis, global central bank stimulus, created an environment devoid of scrutiny, resulting in robust emerging market capital inflows, largely untied to the merits of structural reform. Investors were encouraged to take risks, and the BRICS were beneficiaries of exceptionally loose, if not misguided, capital flows. Today, we behold the end result of the grand EM experiment, and unfortunately, the results are appalling. The extent of economic mismanagement has been spectacular, with all BRIC governments, to varying degrees, failing the opportunity to modernize. Economic malaise got masked by capital flows and the ability for governments to tap debt capital market. History continues to prove the impossibility of EM economic alchemy, for countries that fail to develop a sophisticated, globally relevant, corporate sector.

Irrespective of the above, Brazil’s Petrobas scandal is special. The far-reaching nature, and vast number of taxpayers, investors, analysts, and governments who got duped, is unprecedented. A brief review of the drama, followed by thoughts on the implications:

The fraud at Petrobas ranges back to 1994, spanning two Brazilian presidential administrations, Luiz Inacio Lulu de Silva, and Dilma Rousseff (it appears highly likely that both leaders were aware of the corruption). The essence of the scheme relates to Petrobras management awarding contracts to a cartel of companies overcharging Petrobras for business. The suppliers/contractors earned inflated profits and created a series of ghost companies to funnel money for kickbacks to Petrobras management and Brazilian politicians. Players involved earned tens, or in some cases, hundreds of millions of dollars. Petrobras is still unable to precisely quantify the fraud with estimates of misappropriated funds ranging into the billions (USD). The NYT published a colorful piece covering how much of the kickbacks came in the form of watches, wine, helicopters, and prostitutes. Indictments have been pervasive through the Brazilian government, all ranks of Petrobras management, and the top 6 (all of them) Brazilian construction firms.

At one point, in 2010, Petrobras was the 4th largest company by market capitalization in the world.

Lulu was recently called in for questioning on Petrobras. Dilma Rousseff, the current socialist Brazilian president (the Iron Lady), was chairwomen of Petrobras during a period overlapping the fraud. Rousseff denies any knowledge although there are forces calling for her impeachment. Joaquim Levy, the market oriented Finance Minister has threatened to resign based on an inability to implement reform. On September 9th, Standard & Poor’s downgraded Brazil’s sovereign credit rating to junk. Brazil has some serious issues.

With the nature of Brazil’s growth miracle revealed, through shocking scandal at its most globally preeminent firm, questions naturally arise as to whether the rest of the Brazilian corporate sector engaged in similar practice?  “Operation Radioactivity” relates to another fraud/kickback scheme at  Brazil’s largest utility, Electrobras. So far, the top energy firm, top utility, and top 6 construction firms are all being implicated or investigated for fraud/corrupt business practices.

An investor knee-jerk reaction is to seek out depressed EM assets when the night is darkest. CJF takes the other side of this view, with the emphasis that cheap ≠value. There is no way to accurately determine the cheapness of domestic assets in Brazil, China, or Russia based on flawed controls, financial reporting, accounting, and corporate governance. Investors seeking end-market exposure to the BRIC economies are best served investing in high quality, developed market equities with large businesses in the emerging markets. These stocks are depressed too.

Brazil is in deep recession while running a current account deficit close to 9% of GDP. Inflation is too high, political and central bank leadership in flux, and the currency is down 30% relative to a year ago. There is no easy way out, and the economy will only recover after cleaning up corruption, changing governments, implementing structural reforms in the corporate sector, experiencing a longer duration recession, and seeing the currency weaken further. For EM countries without the ballast of a robust corporate sector, there is little ability to immediately stimulate the economy without massively inefficient capital allocation (stimulus) and more waste.

The pervasive economic issues in China and Russia are thematically similar. The companies in these countries are the products of statist governments, bureaucracy, and graft. It isn’t surprising that flaws are becoming apparent in a period of global deleveraging at the start of a US rate-hike cycle. The S&P 500 will ultimately weather the storm much better than EM equity markets, but large parts of the S&P are exposed to EM.

Investors should brace.

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  1. Kidchowda on September 15, 2015 at 10:50 am

    KJF, how does the rise of Korea and its development into mature economy fit in to your formula? Though not as statist as Russia, China or Brazil, they Chaebols are not entirely disimilar from a giant state-owned enterprise as one might see in China. I guess my point is, that the corporate sector that you point to as the lynchpin of healthy growth may take forms other than the US model. BTW, good point that cheap does not necessarily equal value. Seems basic, but it’s worth repeating. Keep up the great posts KJF!

  2. crackerjack on September 15, 2015 at 8:04 pm


    This is a good analogy. While Korea has shown great flashes, and been truly innovative within technology and auto, I think Korea has been partially successful developing a modernized corporate sector. The Chaebols and sprawling nature of many conglomerates are rather inefficient corporate structures.

    When you take the top 100 companies in the world, the US would have between 80-90. Korea would certainly have a few (Samsung, Hyundai-Kia).


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