A matter of interest rates

I am CFO of Lakeland Industries Inc., which acquired a Brazilian company in 2008. I have been intimately involved with the Brazilian operations ever since, and I would like to comment on the excellent article “Business Basics in Brazil” (Nov. 2011, page 34). In the section addressing exchange rate risk, the interview subjects point out that “[t]he most common contracts are future, forward, options and swaps. Operations with derivatives can be done through major banks.”

While it is absolutely true that these contracts are readily available, the subjects do not address the cost of these forward contracts. The cost of a forward foreign exchange contract is mainly determined by the interest rate differential between the two country currencies. At the time of closing in 2008, I had extensive discussions with the FX (foreign exchange) departments of several major U.S. banks, and my Brazilian people had similar discussions with several Brazilian banks about a net investment hedge. All returned the same answer: Due to the interest rate differential, the hedging cost is prohibitive. Nothing has since changed the dynamics.

In hedging against the Canadian dollar, euro, etc., the interest rates in each country are fairly comparable, and the forward rate in a hedge contract may not be very different from the spot rate plus a few basis points for the bank. Whoever takes the long position in Brazilian reais to offset the short position we would need in a hedge is essentially committing to pay a fixed amount in a period fixed by the contract. This requires essentially borrowing in the local currency to avoid the bank’s assuming FX risk itself. Over the last three to four years, there has been at least an eight-point differential, which means it would cost more than 8% per year just to stay even with a hedge. We decided over the long term it would make more sense just to keep our long position.

If there are any borrowing needs, if it is done in Brazil in BRL-denominated debt, this will also act as a natural hedge.

Another comment I would have is that, while the interviewees clearly mention corruption as an issue in doing business in Brazil, I believe it is far more pervasive than implied by the article and is the single biggest obstacle my company faces in doing business in Brazil. The problem is magnified for a U.S. company that has to comply with the Foreign Corrupt Practices Act and Sarbanes-Oxley Act while competing against Brazilian companies that clearly see corruption as part of doing business. But, this is probably an interesting topic for an entire article.

Having said that, I want to affirm that my company’s management believes firmly Brazil is a great market and is heavily committed to our future in Brazil. We have just finished a major expansion, which doubled our manufacturing capacity, and purchased additional land adjacent to our property for future expansion.

Gary Pokrassa, CPA

Ronkonkoma, N.Y.

Interviewees’ reply: We would like to thank Mr. Pokrassa for his time and positive commentary on our article.

His additional statement regarding forward contracts is correct. Their cost can be high due to the interest rates’ differential between Brazil and other countries. The cost of swap operations in Brazil is not comparable to similar operations in other countries such as the United States, Canada and the euro zone. Although inflation rates in Brazil are under control, banks are still imposing high interest rates, as they are very conservative in credit concession and are working with large spreads. The fact is that the cost of money in Brazil is very high for businesses or individuals.

In our article, we also mention the impact of the “Brazil’s Cost,” a term that includes corruption, and we refer to a study issued by the Brazilian Association of Machinery and Equipment Producers, which found that Brazil’s Cost raises the price for agricultural and machinery products by 36%, on average, when compared to the United States or Germany. We agree with you that this probably would be a good topic for a whole other article.

Eduardo Pestarino

Regional Executive, The Americas, at Crowe Horwath International

Buenos Aires, Argentina

José Bendoraytes

Managing Partner, Horwath Bendoraytes Aizenman & Cia., member of Crowe Horwath International

Rio de Janeiro