When you hear "Brazil" this month you'll likely think of Ronaldo and Ronaldino leading the national soccer team on a possible repeat of the World Cup in Germany, but the Brazilian Mercantile & Futures Exchange (BM&F) has performed economic miracles worthy of Ludwig Erhard.
In its 20 years of operation, during which it absorbed two other exchanges, BM&F has not only survived, but thrived, becoming a million-contract-per-day behemoth by turning every quirk of their nation’s economy to their advantage (see “Emerging markets: The next generation,” June 2005).
This month’s Expo Trader Brazil conference in Sao Paulo is further testament to BM&F’s success, but it also reveals some of the exchange’s shortcomings. Flavio Lemos, one of the conference organizers, says more than 400 people have already registered for this year’s event, with roughly 80% coming from Brazil and just 3% from the United States. Of those attending, 25% are retail traders, with the remainder being spread among pension funds, brokers, teachers and professional asset managers.
Missing are potential commercial hedgers, less than 15% of whom take advantage of BM&F for hedging purposes. What’s more, although BM&F is a member of Globex, only three of its contracts trade electronically all the time: the mini Bovespa stock index futures, the mini dollar/real cross and live cattle. Lemos blames the low commercial participation on the slow shift to electronic trading.
BM&F’s neighbor, the Sao Paulo Stock Exchange (Bovespa), Latin America’s largest stock market, was also slow to go electronic, but finally closed its trading floor last year.
Despite some innovative derivatives-based financing projects in Argentina (see “Emerging markets: The next generation,” June 2005), the Mexican Derivatives Exchange (MexDer) remains Latin America’s only other derivatives success story in terms of standardized, retail-oriented futures contracts. In less than a decade, MexDer has built up its average daily volume, largely thanks to the dollar/peso contract, but also because U.S. investors have found it easier to access their products than they have Brazil’s products.
“One interesting difference between BM&F and MexDer is that there are no taxes for foreigners to make direct trade on MexDer, but there were in Brazil until a couple of months ago,” says Ricardo Amorim, Head of Latin America Strategy for West LB. “As a result, trades that would go to BM&F ended up in Chicago.”
MexDer lists only financial products, and BM&F’s most successful products also are financials, but both countries have been impacted by the China-driven commodities boom. In Mexico’s case, however, the better verb is “whacked.” Although Mexico’s exports of raw commodities to China have increased, the country’s exports of manufactured products to the United States have decreased (see “Losing ground,” below), due to Chinese workers’ ability to deliver finished VCRs for less than the cost of the material that goes into them.
But for the most part, commodities have proven a windfall for all Latin American countries regardless of government (see “Exports on the rise,” below). “Even someone like [Venezuelan president] Hugo Chavez, whose policies are clearly market-unfriendly, is seeing excellent market performance in his country because of oil prices and external conditions,” Amorim says, pointing out oil accounts for more than 25% of Venezuela’s economy and more than half of government receipts, not to mention 85% of exports. “Oil revenues are up over three-fold in Venezuela since the oil market took off,” he says.
But most governments aren’t just sitting back and letting the tide do the work. Brazil, for example, has been using the cash flowing in from commodities to buy back crushing short-term debt and replacing it with longer-term debt denominated in its own currency, the real (see “Paying it down,” below). “This substantially reduces both its short-term interest burden and the forex risk,” Amorim says. “For traders, it means increased liquidity on BM&F’s dollar/real swap and DDI contracts.”
It’s a global phenomenon among emerging markets, and the result is a narrowing of the spreads between emerging market bonds and U.S. Treasuries. The risk premium on J.P. Morgan’s Emerging Markets Bond Index Plus, for example, dropped to a record low of 1.82% against U.S. Treasuries in late April.
But Amorim warns of what he calls “Chavez Risk,” namely, “the risk that Chavez might change laws and legislation at his will and adopt market unfriendly policies that negatively impact investor’s interests in Venezuela.”
After May Day, he may want to add “Morales Risk” to the lexicon. That’s when Bolivian President Evo Morales not only kept his campaign promise to nationalize the country’s oil and natural gas industries, but did so in the most alarming way: by ignoring congress and issuing a presidential decree for the military to grab oil and gas processing facilities before owners could shut them down in protest.
If Brazil had a natural gas futures contract, you can imagine where it would have traded the next day, for although the country recently declared oil independence, they still get most of their natural gas from Bolivia via a pipeline run by Petrobras, which in turn is owned by the Brazilian government but has entered into joint ventures with China’s state-owned oil company. Morales’ move came less than a week after Bolivia, Venezuela and Cuba signed the so-called Peoples’ Trade Agreement (PTA) to oppose the Free Trade Agreement of the Americas (FTAA). Brazilian President Luiz Inácio Lula da Silva nominally offered cheerleading to the PTA, but his country remains a signatory to the FTAA, a lesson in separating rhetoric from policy.
Brazil, Argentina, Uruguay and Paraguay all belong to the Southern Common Market (Mercado Común del Sur, Mercosur), which is being touted as a precursor to a Latin American Union. Uruguayan President Tabare Vazquez, however, recently declared the association “useless” because the larger countries, namely Brazil and Argentina, consistently have their way with the little guys. So he announced Uruguay will leave Mercusur and has opened talks with that little country to the north: the United States.
Brazil, Uruguay and Chile, which has Latin America’s most stable economy, have not headed down the slippery slope of nationalization, although all of them are nominally run by old-line “leftist” governments. The presidents of Columbia and Peru have also signed trade agreements with the United States, though they are still unratified, and Ecuador also is negotiating with the United States.
Chavez’s response has been to pull Venezuela out of the Andean Community of Nations, with Bolivia following close behind.
BATTLE OF THE BEANS
Soybean futures should be a no brainer for Brazil because the country supplies vast quantities of beans to China, but most Brazilian beans are still priced at a premium or discount to the Chicago Board of Trade (CBOT) contract, despite being of a different grade.
“Brazil is the second-largest global producer of soybeans and the largest global exporter,” Amroim says. It is a huge exporter of soybeans to China, and the BM&F has a cooperation agreement with the Dalian exchange,” says Amorim. “But the cost of transaction is higher in Brazil than it is in Chicago.” Specifically, he says, taxes and inefficiencies on the Brazilian side make it more expensive to hedge there than Chicago.
The BM&F contract has attracted a semirespectable volume of 4,000 contracts per day, infinitely more than the CBOT’s South American bean contract, which the last time we checked had a volume of zero and open interest of just 22 contracts, but nowhere near the CBOT’s flagship bean contract. That could be a function of the BM&F contract’s design: it seems to be a domestic product marketed to an international user group. With a contract size of 27 tons (an average truckload in Brazil) and delivery being FAS (Free Alongside Ship), the buyer has to clear all the goods for export, as opposed to the CBOT contract, which is FOB (Free On Board) and puts the export clearance burden on the seller.
“The Brazilian bean contract is really a farmer or elevator contract because it conforms to truckload size,” says Ann Berg, a former CBOT board member now working as a consultant to emerging market exchanges. “This is hard for an exporter to use because export business is conducted in metric tons and is based FOB, not in-store, which is what FAS essentially means.” And then there’s the distance of transport. “You have a lack of railroads, bad motorways and the two main ports are at the south of Brazil, while the soybean plantations are in the Midwest,” Lemos says. But, as the numbers show, the CBOT Brazilian contract is even more of a dud. “The load-out rate is a killer on that one,” says Berg. “If you are unloading 2,000 tons per day, it takes 15 days to get a 30,000 ton vessel loaded, and those days sitting in port could add roughly $5 to $7 per ton to the cost of loading the ship, or about 15¢ per bushel per month.”
WHAT TO TRADE
No matter how you ultimately evaluate Chavez Risk and Lula's ability to act as a hedge against it, there is no shortage of products that tap Latin American volatility. The Chicago Mercantile Exchange's Brazilian real and Mexican peso contracts have been posting respectable volume this year and several currency platforms also make liquid markets in those crosses.
And there are plenty of Latin America-based Exchange-Traded Funds (ETFs). The iShares MSCI Brazil Index Fund and the iShares MSCI Mexico Index Fund, for example, have soared throughout the past year (79% and 59%, respectively). But be forewarned, they are not for the weak of heart, both plunged more than 5% in a single April week for no discernable reason.
MexDer has not yet been recognized by the U.S. Securities and Exchange Commission, so its contracts are not technically available to U.S.-based retail traders. That leaves BM&F as the only Latin American game for U.S. traders. The most actively traded contracts are the interest rate products (730,000 average daily volume), the real/dollar cross (250,000) and the Ibovespa stock index (40,000), which has just made the shift to electronic trading.
Both Mexico and Brazil are facing presidential elections later this year, Mexico on July 2 and Brazil in two rounds, first on Oct. 3, and then on Oct. 29. These follow Chile, where President Ricardo Lagos’ center-left coalition kept its majority in the lower house but has lost its Senate majority; Costa Rica, where President Óscar Arias nudged out Ottón Solís by a 1.2% margin; and Peru, where a runoff election will be held on May 28, the same day as Colombia.
Mexican President Vicente Fox isn’t running for re-election, and his successor as Partido Revolutionario Institucional (PRI) candidate, Felipe Calderon Hinojosa, is in a tight race with former Mexico City mayor Andres Manuel Lopez-Obrador. “A victory by Lopez-Obrador and continuous loss of U.S. market share to China could prove a bonanza for traders who are short MXN and long local rates,” Amorim says.
Most observers say Lula is pegged to win re-election, and the Brazilian Central Bank will stop cutting rates before the election. But Amorim says future rate cuts might be smaller than recent ones and will continue at least until the election. "Macroeconomic policies have been very effective and market-friendly under the Lula administration, microeconomic policies much less so," says Amorim. "He is the strongest candidate to win the elections, but not a lock."
Indeed, his popularity has dropped and he has been rocked by a campaign financing scandal. “Geraldo Alckmin, the former governor of the state of Sao Paulo, also has decent chances,” Amorim notes.
The wild election year rounds out with Ecuador in October and Venezuela in December, and all that uncertainty could lead to a wild ride for futures markets. “Both BM&F and MexDer can be very attractive for U.S.-based retail traders,” Amorim says, “but they also both need to dedicate effort to making themselves familiar.” And that’s a lesson they can learn from their soccer team.