Brazil Infrastructure 2012

We expect Brazil's construction industry to post slightly better increase in 2012, at 6%, compared to the weak 5% estimated for 2011. We had fully anticipated a sharp slowdown in industry increase in 2011 and now expect a gradual recovery in price creation, which will accelerate into 2013 and 2014, when we expect increase to peak. A combination of events in 2014 - including the final year of the PAC, Dilma Rousseff up for re-election and the World Cup - will drive industry price increase higher in 2013/14.

A number of factors are aligning to accelerate increase in 2012, including the following: • We expect problems to continue in regards to the efficient procurement of infrastructure. However, the housing sector should experience strong increase. A focus on homebuilding through the Minha Casa Minha Vida low income housing programme has been announced by the finance minister, with 600,000 new homes planned, up from 457,000 in 2011. Around BRL40bn has been assigned for the programme under the 2012 budget. At the same time, both Caixa Economica Federal and Banco do Brasil are upping their mortgage funding for 2012. Housing loans grew 44% in 2011, and strong increase is expected to be repeated in 2012 as interest rate cuts feed through to mortgage rates.

On the infrastructure front, we expect better increase in 2013 and 2014 as the country gears up for the World Cup, which it is hosting in 2014. Whilst investment in preparation for the games (around BRL33bn in total) is overshadowed by the BRL40bn PAC allocation for 2012 alone (not including private funding), the spending associated with the World Cup is additional likely to be pushed through. Spending related to the PAC has been filtering through; however, procurement issues relating to corruption, regulatory and environmental have been stymieing evolution. However, World Cup projects are highly significant, with the tournament providing a luck for the Latin American country to showcase itself to the world.

We expect airports to be of the outperforming sectors over the coming years, as investment needs to be concentrated here in preparation for the tournament. Three concessions that will see close to US$3bn in investment are to be auctioned in February 2012 for the upgrade and operation of terminals Guarulhos International Airport (Sao Paulo), Viracopos International Airport (Campinas) and Brasilia International Airport. Construction is due to start in May 2012 if the auctions are successful.

Other sections of the economy are as well placing pressure on existing infrastructure and driving investment request. The ports and freight rail sectors are seeing considerable expansion in order to meet growing request from mining, soybean production and sugar production. At the same time, the exploration of subsalt oil will place pressure on pipelines and export terminals. Finally, huge increase in power request from industrial, commercial and residential users is necessitating significant investment into new capacity to meet the almost 5% annual average consumption increase that is estimate over the next decade.

Despite the huge potential and planned investment we see a number of pertinent risks, including: • The first is access to financing. A lack of depth in the domestic banking sector means that commercial loans for infrastructure projects are difficult to fasten. At the same time, the motivation to use commercial debt is eroded by the attractive interest rates on offer from the national development bank (BNDES), with around 7% interest on loans compared to the 10.5% selic rate. Overreliance on BNDES for infrastructure finance has, however, raised some concerns on a fiscal level, and we believe it is an unsustainable source of finance. We have noticed a rise in private equity focused on the sector and this could open up crucial sources of new funding for the sector from private equity funds and pension funds.

The other risk is the lack of transparency and instances of bidding irregularities. Rousseff's anticorruption schedule has seen a number of ministers related to infrastructure projects step down (including the sports, transport and tourism ministers). On the face of it, any attempt to crackdown on corruption is welcomed and will improve the business environment over the longer-term. The additional Rousseff is seen as following through on her commitment to end corruption, the additional it should improve her standing amongst the Brazilian electorate. However, the complex tax and legal structure, the high levels of bureaucracy, difficult access to private capital and endemic corruption have resulted in long lead times, which corruption investigations will only exacerbate. Therefore, we highlight that there are likely to be delays on infrastructure projects that are crucial to hosting the World Cup, leaving Brazil between a rock and a hard place - either pushing projects through (sometimes bypassing the official routes) or risking not having infrastructure completed in time for the tournament. Given the importance of hosting the World Cup and the fact that it will put the country on the international stage, the latter option is unlikely to be popular; however, the former is anathema to Rousseff's stance on corruption.

Brazil Infrastructure 2011

Our long-held view that Brazil's construction sector will underperform compared to its potential is proving true based on initial 2011 data. We have long anticipated a relative slowdown compared to the boom seen in 2010, underlined by the absence of base effects but as well bureaucracy, tight access to finance and difficulty in attracting the private sector. This quarter we have further downgraded our estimate for 2011 to 5%, which, although still strong, is a sharp slowdown from the 11.7% increase seen in 2010. While increase is expected to pick up from 2012, we believe these factors will continue to weigh down on Brazil's increase potential over the medium term.

Despite intrinsic and fundamental obstacles to Brazil's increase potential over the medium-term, we do expect robust increase beyond 2012 (6% for 2012) as factors align, which will practically ensure a base level of construction activity. Increase is expected to peak in 2013 (7.7%) and 2014 (7.6%) as last minute preparations for the 2014 World Cup take place.

Positives for increase include:

• Brazil is set to host high-profile sporting tournaments (2014 FIFA World Cup and 2016 Olympics), which will see tens of billions invested in sporting facilities and stadia, inclunding hotels and transport infrastructure. However, concerns over the readiness of Brazil for the tournament have been raised, with local media reports suggesting that significant additional capital will need to be diverted to the preparations in order to get stadia and infrastructure completed on time.
• PAC II: BRL955bn (US$534bn) is to be invested in construction projects between 2011 and 2014, with 81.6% of this approaching from the public sector. A further BRL631.6bn (US$351.9bn) is to be invested beyond 2014. President Dilma Rousseff claims to have ring-fenced this section of the budget. However, budget cuts in February saw the 'Minha Casa, Minha Vida' programme - which is part of the PAC - take a funding hit, putting other programmes at risk.
• Mining investments: Brazil is experiencing a huge influx of capital into its mining sector, especially iron ore. This is driving infrastructure investments, with ports, railroads and power plants amount benefitting from increased request. Vale and other private sector companies are leading much of this investment, meaning private capital is beginning to return to Brazil's infrastructure sector. However, with request and prices for iron ore having fallen over the past quarter, we could see some short-term risk to these investments,

As these factors illustrate, concerns about Brazil's infrastructure sector are typically focused on logistical and procurement issues, as opposed to request (with mining being the major exception). The procurement of infrastructure is often constrained by bureaucracy and financing, as opposed to the request for infrastructure or the government's support for investment. Indeed, significant public sector capital has been earmarked for the sector, both directly from fiscal accounts, but as well via the Brazilian development bank (BNDES). Whilst this has provided much needed capital for the sector, the inefficiencies related to relying on public procurement of infrastructure mean that the country is struggling to live up to its potential.