Just last week in Thoughts from the Frontline, we discussed the relative valuations of emerging markets. Any discussion of an emerging market is incomplete without understanding the underlying geopolitical forces that guide behaviors of countries and often predetermine the outcome of events. Today I'm sending you STRATFOR's geopolitical analysis of Brazil, a much-discussed emerging market. This is a long read, but it's the most thorough and enlightening analysis I've seen thus far on how the continent's geography has shaped Brazil's history to date, and the major challenges the the country faces today. Hint: Brazil's biggest problems are an overvalued "real," Mercosur, and an Asian giant (you guess which one...).
For anyone considering an emerging market as an investment choice (or who is simply interested in world affairs), I highly recommend reading STRATFOR's other geopolitical assessments, which they have on all the major players, including emerging markets. You can access these assessments, and all STRATFOR's analysis and updates, when you subscribe. OTB readers can <<get a hefty discount on their subscriptions here>>. Their content is a valuable asset for any investor.
Your now considering samba lessons analyst,
John Mauldin, Editor
Outside the Box
The Geopolitics of Brazil: An Emergent Power's Struggle with Geography
July 14, 2011
Editor's Note: This is the 15th in a series of STRATFOR monographs on the geopolitics of countries influential in world affairs.
Related Special Topic Page
South America is a geographically challenging land mass. The bulk of its territory is located in the equatorial zone, making nearly all of the northern two-thirds of its territory tropical. Jungle territory is the most difficult sort of biome to adapt for human economic activity. Clearing the land alone carries onerous costs. Soils are poor. Diseases run rampant. The climate is often too humid to allow grains to ripen. Even where rivers are navigable, often their banks are too muddy for construction, as with the Amazon.
As the tropics dominate South America, the continent's economic and political history has been problematic. Venezuela, Guyana, Suriname and French Guiana are fully within the tropical zone, and as such always have faced difficulties in achieving economic and political stability, though the discovery of oil in Venezuela improved that country's economic trajectory. Throughout the tropical zones nearly all of the population lives within a few dozen kilometers of the coast. For the most part, however, those coasts are not naturally sculpted to encourage interaction with the outside world. Natural ports — deepwater or otherwise — are few and far between.
There are, however, two geographic features on the continent that break this tropical monotony.
The first is the Andean mountain chain. The Andes run along the continent's western edge, giving rise to a handful of littoral and transmountain cultures physically separated from the continent's eastern bulk and thus largely left to develop according to their own devices. Colombia and Ecuador straddle the tropics and the Andes, with their economic cores not being coastal, but instead elevated in the somewhat cooler and dryer Andean valleys, which mitigates the difficulties of the tropics somewhat. Farther south are the arid transmountain states of Peru and Bolivia. Peru has achieved some degree of wealth by largely ignoring its own interior except when seeking resource extraction opportunities, instead concentrating its scant capital on the de facto city-state of Lima. In contrast, landlocked Bolivia is trapped in a perennial struggle between the poor highlanders of the Altiplano and the agriculturally rich region of the lowland Medialuna.
The combination of mountains and jungle greatly limits the degree to which states in this arc— from French Guiana in the northeast to Bolivia in the southwest —can integrate with each other or the outside world. In all cases, basic transport is extremely difficult; tropical diseases are often a serious issue; there are few good ports; agricultural development is both more labor and capital intensive compared to more traditional food-producing regions; humidity and heat hinder conventional grain production; and the ruggedness of the mountains raises the costs of everything.
Historically, the only way these states have achieved progress toward economic development is by accepting dependence on an external (and usually extraregional) power willing to provide investment capital. Without this, these states simply lack the capital generation capacity to meet their unique and staggering infrastructure challenges. Consequently, the broader region is severely underdeveloped, and the residents of most of these states are generally quite poor. While some may be able to achieve relative wealth under the right mix of circumstances, none has the ability to be a significant regional — much less global —power.
The second exception to the tropical dominance of South America is the temperate lands of the Southern Cone. Here, the summers are dry enough to allow traditional grains to ripen, while cooler weather — especially winter insect kills —limits the impact of disease outbreaks. Unlike the scattered populations of the Andean region, the Southern Cone is one large stretch of mostly flat, moderately watered territory. The bulk of that land lies in Argentina, with significantly smaller pieces in Uruguay, Paraguay and Brazil. The only remaining country on the continent is where the temperate Southern Cone overlaps with the Andean mountain zone: Chile, one of the world's most physically isolated states. It takes longer to fly from Santiago to Lima than it does to fly from London to Moscow, and longer to sail from Santiago to Buenos Aires than it does from New York City to London. Chile consequently does not participate significantly in the politics of the Southern Cone.
In stark contrast to the mountains and jungle that dominate the majority of South America, the Southern Cone flatlands are the best land on the continent. Their flatness, combined with their natural prairies, lowers the cost of construction, and the temperate climate makes them rich agricultural zones. But the real advantage lies in the region's river structure. The Parana, Uruguay and Paraguay rivers combined with the Rio de la Plata — a massive estuary that empties into the Atlantic between contemporary Buenos Aires and Montevideo — are all navigable for a great portion of their length.
Moving goods via water costs about 10 to 30 times less than moving the same goods by truck. Such riverine transport systems therefore generate massive amounts of capital with little difficulty compared to land-transport systems. Collectively, this river network overlaying the agricultural flatlands is known as the Rio de la Plata region.
These rivers are particularly valuable for agricultural regions such as the Rio de la Plata. Wheat, corn, soybeans and the like suffer from a weak value-to-bulk ratio— oftentimes transporting them great distances can only be done at an economic loss. Water transport allows for foodstuffs to cheaply and easily be brought not just downstream but to the ocean and then the wider world. Russia presents a strong contrast to the Rio de la Plata region. Its famines often directly result from the inability to bring foodstuffs to the cities efficiently because its navigable rivers are not well situated — meaning foodstuffs must be transported by truck or train.
The most important geographic fact on the continent is that the Rio de la Plata region's rivers are navigable both independently and collectively via a system of canals and locks. Only the Greater Mississippi River network of North America has more kilometers of interconnected maritime transport options. This interconnectivity allows greater economies of scale, greater volumes of capital generation and larger populations, and it greatly enhances the establishment of a single political authority. In contrast, the separate rivers of the North European Plain have given rise to multiple, often mutually hostile, nationalities. Argentina controls the mouth of the Rio de la Plata and the bulk of the navigable stretches of river. This leaves the Uruguayans, Paraguayans and Brazilians at a disadvantage within the region. (Brazilian power is greater overall than Argentine power, but not in the critical capital-generating geography of the Rio de la Plata region.)
The Brazilian Geography
Most of Brazil's territory does not lie within these Southern Cone lands. Instead, roughly one-third of Brazil's 8.5 million square kilometers is composed of vast tracts of challenging jungle, with the Amazon Basin being the most intractable of all. While there are many potential opportunities to exploit minerals, they come with daunting infrastructure costs.
South of the Amazon Basin lies a unique region known as the cerrado, a vast tropical savannah with extremely acidic soils. However, because the heat and humidity is far less intense than in the jungle, the cerrado can be made economically viable by brute force. The cost, however, is extreme. In addition to the massive infrastructure challenges — the cerrado lacks any navigable rivers— the land must in essence be terraformed for use: cleared, leveled and fertilized on an industrial scale to make it amenable to traditional crops. There is also the issue of distance. The cerrado is an inland region, so shipping any supplies to or produce from the region comes at a hefty transport cost. Brazil has spent the greater part of the past three generations engaged in precisely this sort of grand effort.
Luckily for the Brazilians, not all of Brazil's lands are so difficult. About 600,000 square kilometers of Brazil is considered traditionally arable. While this represents only 7 percent of the country's total land area, that still constitutes a piece of arable territory roughly the size of Texas or France. All of that land lies in the country's southern reaches. But much of that territory lies in the interior, where it is not easily accessible. Brazil's true core territories are less than one quarter of this 7 percent, about the size of Tunisia, straddling the area where the tropical zone gives way to the temperate lands of the Southern Cone. These areas formed the core of Brazil's original settlements in the early colonial period, and these lands formed the population core of Brazil for the first three centuries of its existence. As such, the topography of these lands has had an almost deterministic impact on Brazil's development. Understanding that topography and its legacy is central to understanding what is empowering Brazil to evolve — and hampering Brazil from evolving— into a major power in the years to come.
Two obvious characteristics stand out regarding this core Brazilian region. First, it is semi-tropical, so development in the region faces a somewhat less intense version of the challenges described above for fully tropical zones. Second, and more critical, the Brazilian interior is a raised plateau — called the Brazilian Shield — which directly abuts Brazil's Atlantic coast along nearly the entirety of the country's southeastern perimeter. The drop from the shield to the Atlantic is quite steep, with most of the coast appearing as a wall when viewed from the ocean — the source of the dramatic backdrops of most Brazilian coastal cities. This wall is called the Grand Escarpment, and most Brazilian cities in this core region— Rio de Janeiro, Vitoria, Santos and Porto Alegre — are located on small, isolated pockets of relatively flat land where the escarpment falls to the sea.
The primary problem this enclave topography presents is achieving economies of scale. In normal development patterns, cities form around some sort of core economic asset, typically a river's head of navigation (the maximum inland point that a sizable cargo vessel can reach) or a port or nexus of other transport options. The city then spreads out, typically growing along the transport corridors, reflecting that access to those transport corridors provides greater economic opportunities and lower economic costs. So long as somewhat flat land remains available, the city can continue growing at low cost. In time, nearby cities often start merging into each other, allowing them to share labor, capital, infrastructure and services. Economies of scale proliferate and such megacities begin generating massive amounts of capital and skilled labor from the synergies.
Megacities —such as New York City, Los Angeles, London, Paris, Tokyo, Buenos Aires, Istanbul and Shanghai — form the core of the global economic system. This "standard" development pattern has been repeated the world over. The premier American example is the "megalopolis" region of cities on the American Eastern Seaboard stretching from Washington to Boston, encompassing such major locations as Baltimore, Philadelphia, New York, Hartford and Providence. In Europe, a similar conglomeration contains the many cities of the German Rhine Valley. In both cases, major and minor cities alike merge into an urban/suburban conglomeration where the resources of each location are shared with and bolstered by the others. In all such cases, the common characteristic is the existence of land upon which to expand.
Imperative Four: Challenge the Dominant Atlantic Power
Should Brazil manage to consolidate control over the Rio de la Plata basin the game changes greatly. At this point Brazil is no longer a vulnerable, enclave-based state facing extreme challenges to its development. Instead, Brazil would control the majority of the continent and command broad swaths of easily developed arable land. Instead of cowering in fear of regional naval powers, it would be the dominant regional naval power. With that transformation, Brazil would not see extraregional navies as friends protecting it from Argentina but as enemies seeking to constrain its rise.
Obviously, this imperative will be well beyond Brazil's reach for many decades. Not only is Brazil's navy far smaller than that of states with one-third its population, it is nowhere close to commanding the Rio de la Plata region. Until that happens, Brazil has no choice but to align with whatever the Atlantic's dominant power happens to be. To do otherwise would risk the country's exports and its overall economic and political coherence.
Contemporary Challenges: Escaping the Trap
Contemporary Brazil faces three interlocking problems that pose severe structural challenges to all of the economic stability it improbably has attained: an overvalued currency, Mercosur and China.
As to currency, investor enthusiasm for Brazil's recent stability and theoretical growth prospects has flooded the country with external funding. In addition to complicating always-critical inflation concerns, all that capital is having a demonstrable impact on the Brazilian currency, pushing the real up by more than 50 percent in just the past two years, and doubling it since 2003.
For Brazil's commodity exports — all of which are dollar-denominated — this has no demonstrable impact, but for the country's industrial exports this currency appreciation is disastrous. Because Brazil's infrastructure is inadequate and the country is capital poor, Brazil produces very little that is high value-added; Such industries are the providence of capital-rich, low-transport-cost economies such as Germany and Japan. Instead, Brazil's predominantly low- and medium-value-added industries compete heavily on price. A 50 percent increase in the currency largely guts any price competitiveness enjoyed by Brazil's sheltered industries. The only Brazilian firms benefiting from the mix of impacts are those few high-skill firms that happen to price their products in U.S. dollars, most notably oil firm Petrobras and aerospace firm Embraer — which, while world class by any definition, are not representative of the broader Brazilian economic structure.
Second, Brazil has limited itself with the highly distorting and damaging trade network known as Mercosur. Recall that an oligarchy has long dominated the Brazilian economy, controlling most of the country's scarce capital and enjoying a privileged economic and political position. Unlike most trade agreements — which are negotiated by governments on behalf of the corporate world — Brazil's oligarchic background meant these oligarchs negotiated Mercosur on behalf of the Brazilian government.
This abnormal process radically changed the end result. A normal trade deal removes barriers to trade and exposes companies in all the affected countries to competition from each other. In Mercosur's case, the various Brazilian industrialists were able to block off entire swaths of the economy for themselves, largely eliminating foreign competition. As such, Brazil's industrial sector is shielded from competition with outside forces — and even from most other forces within Mercosur. Add in a 50 percent currency appreciation and Brazil's industrial base is now one of the world's least competitive.
Third, Brazil has allowed competition from the one power most capable of destroying that sheltered industrial base: China. Throughout the past decade, Brazilian governments have sought Chinese investment largely to help alleviate some of the country's transport bottlenecks. The Chinese, hungry for Brazilian resources, have happily complied. But that infrastructure development has come at the cost of granting Chinese firms Brazilian market access, and that access— and even the investment — is damaging the Brazilian system.
At its core it is a difference in development models. The Chinese system is based on ultraloose capital access aimed at maximizing employment and throughput, regardless of the impact on profitability and inflation — about as far as possible from the real plan. This has had a number of negative side effects on the Chinese system, but as regards Brazil, it has resulted in a flood of subsidized Chinese imports.
The China trap is catching Brazil in three ways. The first is direct competition for market share in Brazil. The Chinese yuan is de facto pegged to the dollar, so Brazilian goods are now even less competitive versus Chinese goods on the domestic market (even before one takes into account that Chinese goods are for all intents and purposes subsidized). Second, China is engaging in indirect competition for market share by shipping goods into Brazil via other Mercosur member states— a fact that has prompted Brazil to raise non-tariff barriers that penalize Mercosur partners in an effort to stem Chinese competition. Third, the Chinese are among those international investors whose cash is pushing the value of the real ever upward. With every dollar the Chinese invest into Brazilian commodity production, the real goes just a bit higher and Chinese goods edge out their Brazilian counterparts just a bit more.
Resisting these trends will require some clever and quick policymaking along with a remarkable amount of political bravery. For example, scrapping Mercosur and adopting free market policies would throw the Brazilian market open to global competition. That would decimate Brazil's inefficient industrial base in the short run with the expected knock-on impact on employment, making it a policy the oligarchic and powerful labor unions alike would oppose. But it is difficult to imagine Brazilian industry progressing past its current stunted level if it is not forced to play on a larger field, and weakening the hold of the oligarchs is now at least a century overdue. Two more years of a rising currency and an enervating Chinese relationship will surely destroy much of the progress the Brazilians have painstakingly made in recent decades.
The current president, Dilma Rousseff, is a non-charismatic, no-nonsense technocrat well known for demanding respect and results, a good person to have in office given the nature of Brazil's contemporary challenges. Success in any free market-oriented reforms would require brutal and rapid changes in Brazil's standard operating procedures — changes that would undoubtedly come with serious political risks. The alternative is to continue to pursue protectionist, defensive policies while allowing international forces to shape Brazil rather than Brazil developing the means to shape international forces. This could well be the path Brazil follows. After all, the damage being inflicted by Mercosur and the China relationship are direct outcomes of policies Brazil chose to follow, rather than anything produced by Brazil's geography.
We do not mean to belittle Brazilians' achievements to date. Taming their lands, taming inflation and crafting a series of economic sectors fully deserving of international acclaim are no small feats. But insufficient infrastructure, an ossified oligarchy, a shallow skilled labor pool and the looming question of Argentina continue to define the Brazilian position. The maintenance of that position remains largely beyond the control of the Brazilian government. The economy remains hooked on commodities whose prices are set far beyond the continent. Their ability to supply those commodities is largely dependent upon infrastructure in turn dependent upon foreign financing. Even Brazilian dominance of their southern tier is as much a result of what Argentina has done wrong as opposed to what Brazil has done right.
For Brazil to emerge as a significant extraregional power, Brazilians must first address a lengthy list of internal and regional issues. These include — but are hardly limited to — moving beyond their oligarchic economic system, ensuring that Argentina will never again threaten it and formalizing their dominant position in the border states of Bolivia, Paraguay, and Uruguay. These cannot be accomplished easily, but doing so is the price Brazilians must pay if they are to be the masters of their own destiny rather than simply accepting an environment crafted by others.