The lesson from BrazilAll that glitters is not gold — a lesson that some investors found out too late. Korea’s rich lost big after putting money in the high-yielding government bonds of Brazil, whose sovereign debt rating was relegated to junk status recently by Standard and Poor’s. Their investments are estimated at 5.8 trillion won ($4.9 billion). The downgrade of Brazil’s sovereign debt to junk territory of BB+ has knocked its currency value to a 12-year low. One Brazilian real now fetches for 307 Korean won. Korean investors’ money has been halved as they made the investments when the real hovered at 695 won in 2011. The bonds will be further downgraded amid a renewed sell-off in emerging markets if the U.S. Federal Reserve raises its interest rates for the first time in nearly a decade later this week.
Investment routs are nothing new. Two major financial crises dealt a heavy blow to local investors: the Buy Korea Fund in 1998 following the 1997 currency crisis and the nightmare of Mirae Asset’s Insight Fund in 2007 after the Wall Street meltdown. Despite those painful memories, Brazil’s bonds were too tempting to ignore. Everything was going well for Brazil in 2011 when international oil prices hovered at $115. The largest country in Latin America was one of the frontrunners in the emerging category. Bonds yielding a 10 percent annual profit were hard to resist when low interest rates were a norm elsewhere. Thanks to a bilateral tax arrangement between Korea and Brazil, individual investments were tax-free. That is why 90 percent of the holders of Brazilian government bonds from Korea are individual investors.
Local brokerage houses pocketed the commissions. They strongly recommended the bonds to VIP clients eying a spread of 2 percent to 3 percent. But there was a catch. High-risk currencies like the Brazilian real carry expensive hedging costs, which hovers over 5 percent per annum. If the 10-year bonds are sold before their maturity, the investors would have to pay a commission of more than 3 percent. Due to high foreign exchange risk, the bonds would have to be held for 10 years. Fortunately, local investors were able to avoid heavy losses because they have not placed their money entirely in Brazilian bonds but included them in their investment portfolio.
Investment losses occur mostly because of wrong timing. The Brazilian economy was at its worst in 2002. The real went as low as 4 reals against the U.S. dollar. Yet investors poured into the market placing a bet that newly elected President Luiz Inácio Lula da Silva of the Workers’ Party would bring positive and market-friendly changes to the country. As Lula proved to be competent leader in governance and popular, money from all over the world poured into Brazil. As the country rose to become the world’s eighth-largest economy, the real rose as high as 1.5 against the dollar. Early bettors reaped returns of 560 percent from bond investments and 1,000 percent from stocks.
But they began to ebb out of the market after Brazil slapped a 2 percent Tobin tax on foreign capital investment in 2009 to regulate inflows and outflows of speculative hot money. The tax went up to 6 percent the following year. Foreign capital rushed out as soon as the World Cup Games ended. Brazil ended up scrapping the financial transaction tax in May 2013. Clueless Korean investors joined the party toward its end. Brazil was already being shaken after China, the world’s largest factory, began to slow. The Brazilian economy was hit hard by the shale gas boom in the United States. Korean investors learned another costly lesson.
But their ordeal has not ended. Local financial authorities are poised to tighten regulations to prevent reckless overseas capital investments. They may want scapegoats to set an example. However, Korea’s financial authorities must change their mindset. Korea has already joined the rank of net creditor countries. It posted a current account surplus of $89.4 billion last year. Korea’s benchmark three-year government bonds yield just a 1.66 percent profit. Korea must look outside for investment. Korea’s overseas securities investment hovers at 13 percent against the gross domestic product, sharply lower than 55 percent for the United States and 70 percent for Japan.
Global capital is expected to renew investments in Brazil after two to three years in view of the long-term financial cycle of 10 to 15 years and pending political and economic developments. Local investors must get smarter. One securities company head advises local investors not to trust brokerage houses that only have an interest in commissions. It would be best to watch the movements of state funds like the National Pension Fund or Korea Investment Corporation as they are most experienced in international finance. Following their lead would at least guarantee stable returns of 5 percent.