Some countries might greet the takeover of critical infrastructure by a Chinese state-owned company with vocal concern. Yet whether because of the holiday season, or just a relaxed attitude toward foreign investment, Brazilians hardly blinked at the announcement on December 23 that China’s State Grid Corporation would assume control of electricity transmission lines to Rio de Janeiro, Sao Paulo and Brasilia.
The US$1 billion investment gives State Grid a lease of 30 years to operate 3,000 kilometers of power lines linking the cities. It is China’s largest investment in Brazil to date, and is expected to generate roughly US$110 million annually for the firm.
“It’s a very exciting deal for both sides,” said Charles Ho, director of China coverage at Standard Bank (SBK.JSE) in Brazil, who worked on the deal. ‘From a Brazilian perspective, it’s the first deal where Chinese companies are not only buying the asset, but they’ll be managing it afterward.
“And from the Chinese perspective, it shows how open the Brazilian government really is. For a Chinese company to invest in the power infrastructure – there’s nothing more critical to the infrastructure of a country. [State Grid] got all the approvals and the whole thing happened pretty smoothly.”
Such cooperation may be a harbinger of many deals to come as the Sino-Brazilian relationship evolves beyond trade in commodities and manufactured goods.
In April 2009, China overtook the US as Brazil’s largest trade partner. As a country blessed with some of the most extensive natural resources in the world, Brazil has benefitted enormously from China’s seemingly insatiable demand for commodities.
Charles Tang, chairman of the Brazil-China Chamber of Commerce and Industry (CCIBC) in Rio de Janeiro, notes that income from the export of commodities to China has allowed Brazil to retire most of its foreign debt and accumulate US$250 billion in reserves. This has helped to shield the country from the worst effects of the global economic downturn.
These commodities also make Brazil one of the few countries to have a sizeable and growing trade surplus with China. China’s accelerating demand for commodities helped push the value of Brazil’s exports to China up to US$38 billion in 2010 from US$20 billion in 2009. This trend is likely to continue: According to forecasts by the Economist Intelligence Unit (EIU), commodities may drive trade relations between the two countries for the next 10 years.
EIU’s senior Asia editor in Beijing, Duncan Ines Ker, explained that this dynamic is largely due to China’s urbanization and infrastructure development, as well as its urge to diversify supplies of key resources, particularly iron ore.
“Iron ore is at the cutting edge of China’s strategy in Brazil, because the next five to 10 years are going to be a very intensive period in Chinese construction of infrastructure and real estate,” he said.
China consumed an estimated 618.6 million tons of imported iron ore in 2010. While this figure represented a 1.6% dip from 2009, it is widely expected rebound sharply in 2011.
And while Australia has historically been the primary supplier of ore for the Asia-Pacific region, a 2007 tussle between state-owned Aluminum Corp of China (ACH.NYSE, 601600.SH, 2600.HK) and Australian mining giant Rio Tinto (RTP.NYSE, RIO.LSE, RIO.ASX) – in which Rio shareholders and the Australian government effectively killed a proposed US$19.5 billion acquisition – prompted Beijing to at least attempt to diversify its iron ore supplies.
“There is a clear national strategy to diversify, though it may not be explicitly announced,” said Ines Ker.
That strategy works out nicely for Brazil; its largest export is iron ore. The country boasts 19.7 billion tons of the commodity, giving it the world’s sixth-largest reserves. In 2009 Brazil exported US$7.8 billion worth of iron ore to China – approximately 24.6 million tons every month.
Most iron ore is sold through Vale (VALE.NYSE, VALE3.Euronext, 6210.HK, VALE3.BOVES), Brazil’s largest mining company and the world’s biggest by market capital. Vale recently listed on the Hong Kong Stock Exchange to establish an Asian presence.
A few days before Vale’s depository shares went on sale in Hong Kong in early December 2010, the company also announced plans to invest US$24 billion this year to fund aggressive capacity expansion. Most of that expansion will be geared toward meeting increasing demand from China, which Vale projects will outstrip supply over the next few years.
Farming the savanna
Brazil’s iron ore exports to China are followed closely in value by its exports of agricultural products. The country has made tremendous leaps in agricultural productivity since the 1973 founding of EMBRAPA, a state-owned company devoted to agricultural technology research.
EMBRAPA has transformed Brazil from a net importer of food into the world’s top exporter of coffee, sugar, orange juice, chicken and beef, with plans to surpass the US as the world’s top food exporter by 2025. Exports of processed food represent higher margins for Brazil than many of its less successful industrial products. Endowed with plentiful arable land, the country is keen to further exploit its agricultural prowess.
“Brazil is well-placed to be perhaps the largest bread basket in the world,” said Tang of the CCIBC. “It presently cultivates less than 80 million hectares, has 200 million hectares of grazing land and can introduce another 140 million hectares without encroaching on the Amazon rainforest.”
At first glance, this advantage might not seem to count for much. China’s most stringent self-sufficiency laws concern grains: 95% of its needs must be produced domestically.
“Self-sufficiency in grains is not going away anytime soon,” says EIU’s Ines Ker. “The opening of China’s agricultural market is likely to be slow and gradual, as the sheer size of demand has a big impact on prices.”
Ines Ker said that Brazil can overcome these restrictions by moving further up the value chain to focus on processed food. As Chinese consumers become wealthier, processed products like beef and corn are finding a larger customer base.
Particularly popular are soybeans and soy products, critical components of the animal feed required to meet China’s rising demand for meat products. The commodities represented over a quarter of Brazilian exports to China from January to November in 2010, totaling about US$7.1 billion.
“China is already a huge market for agricultural exports, and fast-growing domestic demand will further boost China’s reliance on imports in the long run,” said Thilo Hanemann, research director of the New York-based Rhodium Group.
Moreover, Hanemann observes that over the next few years Chinese policymakers are expected to make great efforts to increase domestic productivity in agricultural production. This could provide competition for Brazilian agricultural producers, but it could also present an opportunity for established Brazilian firms to sell their expertise and technology.
Even so, the prospect of future competition over agricultural exports ties into broader fears among many Brazilians that their economy is becoming reliant on commodities exports, and that China’s demand for its resources could prove volatile.
In a May 2010 report, research consultancy Capital Economics argued that China’s commodities demand over the last few years represented an unusual and unsustainable trend. Demand has been galvanized by the country’s accession to the WTO in 2001, and more recently by a government stimulus package geared toward commodity-guzzling infrastructure investment.
Mark Williams, Capital Economics’ senior China economist, argues that as the country’s economy gradually changes to a focus on dome
stic consumption, Latin American countries will no longer be able to rely on Chinese commodity demand to drive growth in the long term.
“China is much more energy-intensive than other economies at the same point of development, and so its decline could be relatively steep,” said Williams.
Fortunately, Sino-Brazilian trade seems to be expanding beyond commodities.
“There are three phases in which Chinese companies come to countries like Brazil,” said Ho at Standard Bank. “The first phase is Chinese companies basically trying to cut the middlemen out by coming to Brazil and buying directly from the source.”
Ho says that the second wave is more strategic in nature because Chinese firms are coming to establish a manufacturing presence in Brazil or acquire an existing asset.
The third phase is firms coming to support existing Chinese operations, and includes banks, lawyers, accountancies and other service providers.
Chinese investments in Brazil seem to be moving beyond Ho’s first phase and into the second. In August 2010, China surprised the world by emerging as Brazil’s top direct foreign investor, up from 29th just one year earlier. Fueled by cheap government-led financing, China’s state-controlled enterprises (SOEs) have taken a keen interest in Brazilian assets.
These SOEs initially targeted the country’s metal and oil industries. In early October Sinopec (SNP.NYSE, 600028.SH, 0386.HK) announced a US$7.1 billion alliance with Spanish firm Repsol (REP.BMAD) and Brazilian oil giant Petrobras (BPR.NYSE, PETR3.BOVES). Wuhan Iron and Steel (600005.SH) has become the largest shareholder in Brazilian mining company MMX, and has signed a deal to invest US$5 billion in a steel mill in Rio State. Chinese sovereign wealth fund CIC also has a share in Vale, and more Asian investment is expected after Vale’s listing in Hong Kong.
As indicated by State Grid’s investment in Brazil’s electricity distribution network, SOEs are also beginning to move beyond resource acquisitions into high-profile infrastructure projects. Other such investments include a possible deal in the works for a high-speed rail line connecting Sao Paulo and Rio de Janeiro, and Sany Heavy Industry’s (600031.SH, 0631.HK) announcement in February 2010 that it would build a plant in Brazil to produce heavy construction equipment.
Protecting the nation
These deals are encouraging, but Chinese firms still face obstacles to investment in Brazil.
The furious pace of commodities exports has driven up the value of Brazil’s currency, hurting exporters. Popular concerns have also increased the risk of protectionist measures against Chinese firms in the country. In late December, Brazil increased import tariffs from 20% to 35% on a list of toys, openly acknowledging that the move would affect Chinese exports. Brasilia is also limiting Chinese investment in certain areas, particularly in agricultural land.
“We do see [protectionist measures] more,” said Rodrigo do Val Ferreira, chief representative at the Shanghai office of Felsberg e Associados, a Brazilian law firm. “About a year ago there was a very clear strategy from the Brazilian government to initiate a lot of the investigations at the same time. Brazil became one of the world leaders in the amount of investigations against Chinese products.”
Perhaps because of these tensions, China is taking pains to make its presence less conspicuous.
“China has learned the lessons from the epic Rio Tinto failure, so Chinese investors in Brazil will keep a low profile and avoid situations that could put them in the spotlight or cause political friction,” said Hanemann.
Protectionism is not the only concern for Chinese firms in Brazil. Burdensome regulation, high taxes, and a bloated and inefficient bureaucracy all hamper growth.
“Brazil is quite expensive because of labor laws, because of taxation,” noted Ferreira. While Brasilia is working to make matters easier for foreign investors and companies, major reforms including labor and tax reform haven’t yet been passed.
“Even many Brazilian businesses couldn’t wait for [these reforms], so they decided to source in China to gain competitiveness,” Ferreira said.
Most damaging to business prospects is Brazil’s vastly underdeveloped infrastructure. When Chinese firms go to Brazil, they typically find infrastructure a larger obstacle than acquiring a product, according to Ho. “Brazil’s infrastructure is in need of huge amounts of investment in almost every respect,” he said.
Paradoxically, this very underdevelopment may actually be the best investment opportunity for Chinese firms in the country. The Brazilian Development Bank (BNDES) expects Brasilia to spend US$185 billion on infrastructure between 2010 and 2013. In preparation for international sporting events alone, the country will invest some US$20 billion in infrastructure for the 2014 FIFA World Cup and US$50 billion for the 2016 Olympics. With extensive experience built from vast infrastructure projects, China’s firms have much to offer, and they are spurred on by diminishing returns and an increasingly regulated market back home.
Ho says this sets the stage for an encouraging trend. He contrasts the distorting effects of short-term trade, which encourages ever more resource exports, with the more balanced nature of long-term investments.
“With longer-term equity investments you have to commit longer to the country, and get to understand the country. It really brings the two together.”
That is why Ho sees the State Grid deal as just the beginning of a rush of China-financed infrastructure projects in the Latin American country.
“It’s going to happen,” said Ho. “The returns in Brazil are just too high.”