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FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Brazil’s Geopolitical Imperatives

Politics / Brazil Aug 12, 2011 - 06:30 AM GMT

By: John_Mauldin

Politics

Diamond Rated - Best Financial Markets Analysis ArticleContinued from Part 1 here.

Geopolitical imperatives are broad, strategic goals a country must pursue if it is to achieve security and success. These are non-ideological paths determined by the geography of a given country and by the geography of its neighbors. Geopolitical imperatives typically nest: The second imperative is dependent upon the first imperative, the third upon the second, and so on. This is not the case for Brazil, however.


Since Brazil occupies such a difficult geography, it has traditionally been a weak state that has lacked the resources and institutional capacity to greatly impact the world around it. Its first three imperatives reflect this. As such, the order in which those imperatives might be attained is largely determined by the constellation of forces in Brazil’s near abroad — factors for the most part beyond the Brazilians’ ability to manipulate — rather than any decision-making process in Brasilia. Brazil can only push to achieve these imperatives as circumstances beyond its control allow.

Imperative One: Protect the Coast

The Brazilian southern coast contains the country’s core territories. However, the ruggedness of that coast and the disconnected enclave nature of the core territories mean that infrastructure linking the coastal territories will not ensure mutual defense. The only way Brazil can protect its core itself is to cultivate a naval force of sufficient strength to deter would-be predatory powers. Without such a navy, Brazil would shatter into a series of (most likely mutually hostile) city-states. And without a navy any Brazilian exports are utterly at the mercy of more maritime-oriented entities.

But Brazil is capital poor and cannot afford such a navy. Historically, this has led Brasilia to seek alliances with whatever the dominant Atlantic power has happened to be in order to hold the traditionally more powerful Argentina in check. In the first half of the 19th century, the Brazilians sought out a favorable relationship with the British. But the deeper expression of this imperative came from Brazil’s enthusiastic embracing of the United States’ Monroe Doctrine. Nearly alone among Western Hemispheric powers, Brazil expressed enthusiasm for the American neo-colonial policy of barring European states from the Western Hemisphere, largely because it could not stand up to those powers without assistance.

Even today, Brazil’s navy is unable to patrol the Brazilian coastlinereliably beyond the Brazilian core territories. Thus, Brazil maintains close— if not exactly friendly — relations with the United States both to ensure that America never views Brazil as a state of concern and as a hedge against other potential threats.

Imperative Two: Selectively Expand into the Interior

Developing (or outsourcing) a navy is one means of protecting Brazil’s core. Another is to expand that core into new areas not so exposed to a hostile navy. In this, Brazil faces several challenges. The coastal enclaves are not large enough to generate their own economies of scale, so reaching inland requires the expenditure of massive resources Brazil simply does not have. As such, Brazil’s inland expansion has been halting, slow and piecemeal and driven by an often badly coordinated mix of government, oligarchic and foreign interests. The obvious target for this expansion is into the subtropical and temperate regions of the country’s south, not the tropical zone of the north.

However, the farther these new territories are from the coast, the more integrated they will naturally become into the capital-rich lands of the Rio de la Plata region to the south. Ironically, in achieving strategic depth and a better economic position, Brazil risks its territory becoming more fully integrated into its neighbors, as opposed to the Brazilian core.

In this challenge, however, also lies an opportunity. When the economies and populations of Brazil’s interior regions are small, they naturally gravitate toward Argentina’s sphere of influence. But as they grow they eventually reach a critical mass in terms of influence, which brings us to the third imperative.

Imperative Three: Expand into the Rio de la Plata Region

The solution lies in increasing Brazilian influence to the south so that those territories ultimately answer to Brazilian economic and political decision-making. Like the first two imperatives, this requires decades of slow efforts to make any progress. It has only been in the past generation that Brazil has created enough capital to encroach into the Argentine-Brazilian buffer states of Bolivia, Paraguay and Uruguay. Brazil has invested heavily into Bolivian energy and agriculture. Most Bolivian foodstuffs are now sold to or through Brazil to the outside world. Natural gas — responsible for by far the largest component of Bolivian state income— is under the direct management of Brazilian state-owned energy company Petroleos Brasileiros (Petrobras). In Paraguay, Brazilians have migrated in significant numbers and are the dominant investors in the economy —particularly in electricity, as the two are partners in the Itaipu Dam. Brazilian (and Argentine) cash fuels Uruguay’s vibrant financial sector, and Brazilian-born Uruguayan citizens now own a majority of Uruguay’s farmland.

The next logical question — something the normally nonconfrontational Brazilians are currently struggling with — is what to do once economic control has been seized but political control is not yet in place. Here the Brazilians come up against an odd cultural barrier: Nonconfrontation is hardwired into the Brazilian psyche. Even today, with the Brazilian economy growing and Argentina continuing to struggle, there exists a belief in government circles that Brazil needs to concentrate on striking an equilibrium with Argentina, with perhaps the inclusion of even Chile in a trilateral balance of power in the region (the Chileans for their part want little to do with the Southern Cone and even less to do with the Argentine-Brazilian balance of power).

For all practical purposes, Brazil has already secured dominance in the three buffer states— Uruguay, Bolivia and Paraguay are all but economic satellites of Brazil— but in light of Brazil’s historically passive foreign policy these states rarely shirk from demanding better terms out of Brasilia. Uruguay charges steep fees on Brazilian cargo. Paraguay recently was able to triple the cost of electricity produced by the Itaipu Dam, Brazil’s single-largest source of electricity, and routinely receives financial aid from Brazil and Mercosur. The Bolivian government regularly confronts Medialuna landowners who for all intents and purposes are fully integrated into the Brazilian economy, and it has not been shy about its attempts to nationalize energy assets owned by Brazilian interests. If Brazil is going to make its gains stick, at some point it will need to devise a strategy for formalizing its control of the buffer states. That means, among other things, learning to be less accommodating.

There also looms a much more significant — potentially bruising — competition. Brazil cannot be truly secure until at the very least it controls the northern shore of the Rio de la Plata. That requires significant penetration into Paraguay and de facto control of Uruguay and of select pieces of northern Argentina. Were that to happen, Brazil’s interior would have direct access to one of the world’s most capital-rich regions. The marriage of such capital generation capacity to Brazil’s pre-existing bulk will instantly transform Brazil into a power with global potential.

But not before. Without these territories, the Southern Cone balance of power remains in place no matter how weak Argentina becomes. So long as Argentina can exercise functional independence, it persists as a possible direct threat to Brazil, constrains Brazil’s ability to generate its own capital and exists as a potential ally of extraregional powers that might seek to limit Brazil’s rise.

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.

John F. Mauldin
johnmauldin@investorsinsight.com

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

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Copyright 2011 John Mauldin. All Rights Reserved
Note: John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Plexus Asset Management; Fynn Capital; and Nicola Wealth Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. ("InvestorsInsight") may or may not have investments in any funds cited above.

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