Armínio Fraga Neto, president of Brazil’s central bank, spends hours poring over the fine print of the country’s financial regulations, exasperated by how excessive red tape burdens the Brazilian capital markets.

Over-regulation discourages foreign portfolio investment in Brazil and contributes to the country’s high interest rates, which rose to 45% at the height of last year’s devaluation crisis.

Fraga is convinced that dealing with nitty-gritty microeconomic and regulatory issues can be just as important as devising grandiose macroeconomic plans, an unusual stance for a senior government official.He believes that efficient markets must complement solid macroeconomic structures.

However, many of his predecessors at the central bank were academics with little understanding of life in the markets and failed to fully grasp this insight. Fraga, though, is an experienced investment professional keenly aware of the sometimes pernicious effects of over-regulation. He took over at the central bank last March after working for six years as a managing director at Soros Fund Management in New York.

Last year Fraga began his deregulation crusade by introducing changes in the fixed income markets to improve transparency and liquidity.

They are making the domestic debt markets more efficient and attracting more foreign capital.

Now Fraga is ready to begin hacking at the thicket of rules governing the equity markets.

The central bank and the government’s CVM securities commission are working to eliminate a regulation that prevents foreigners from investing directly in the markets. They currently can only invest in equities through funds under a mechanism known as Anexo IV. The commission and central bank called for comment from the markets on the proposed new rules prior to submitting any changes to the National Monetary Council, the country’s main financial policy-making body. In future, foreign investors would basically be subject to the same rules as resident investors.

“The new rules are going to permit foreigners to invest directly in the stock exchange here,” says Manoel Féliz Cintra Neto, chairman of the Bolsa de Mercadorias&Futuros in São Paulo. ” This would give contracts more liquidity.”

Brazil’s equity markets are suffering a severe loss of liquidity as trading in the most popular Brazilian shares shifts to New York.

The re-introduction last year of a 0.38% tax on financial transactions that substantially increased the cost of trading in Sao Paulo accelerated the migration of equity trading to the US. Although the São Paulo Stock Exchange’s Bovespa index rose almost 70% in US dollar terms last year, daily trading on the market averaged $347.6 million in 1999, a 39% drop from 1998. In 1997, daily turnover averaged $767.4 million.

Dwindling business has forced the Rio de Janeiro Stock Exchange to propose merging with the rival São Paulo market, which now trades 85% of Brazil’s stocks, to create a single national market with greater liquidity.

Although international fund managers welcome the changes they are not overwhelmed. “I think it is good, not great what Brazil is doing,” says David Herro, portfolio manager at Chicago-based Oakmark International. “It is positive because they continue to take steps to make their markets more open and transparent. All else being equal, this will lower the market’s risk premium.”

However, Herro also warns that looser controls would allow greater inflows of short-term international capital, often blamed for accentuating market turbulence. “It will gush in when times are good and gush out when they are bad,” he says. This could also affect the stability of the wider economy, by putting pressure on the exchange rate.

Fraga said late last year that he would also push to make the real fully convertible, abolishing the last of Brazil’s currency and capital controls. This followed the government’s decision to allow the currency to float after the real collapsed last year. The exchange rate is now set mainly by market forces rather than by government decree, although the central bank does intervene to smooth out oscillations.

Convertibility, not to be confused with Argentina’s rigid currency board system known by the same term, might aggravate volatile currency flows. However, it would also be another sign to investors that the government is committed to modernizing Brazil’s financial system and opening the economy to international markets. Convertibility could also help keep interest rates down by further improving access to hard currency by Brazilian companies, banks and individuals and ease access by foreigners to local financial markets.

“Making the real convertible would be interesting to us. It would give the foreign exchange market more liquidity, thereby yielding more liquidity in our dollar future contracts,” says Cintra. However he doesn’t believe that a convertible real is imminent. “The project may not become a reality. The government has more urgent [economic reform] priorities.”

Finance Minister Pedro Malan’s decision to appoint José Luiz Osório de Almeida Filho as the new CVM chairman may also signal government interest in reforming the equity markets. He takes over from Francisco da Costa e Silva who is quitting after six years in the post. Unlike Costa e Silva, who is a lawyer, Osorio is a hardened market professional and investors hope he will be more effective than his predecessor in promoting deregulation and defending the interest of investors.

Osório ran the government’s privatization program as managing director of BNDESPar, the equity finance arm of national economic development bank BNDES. Prior to joining BNDESPar in January 1999, Osório was executive director and president of Lehman Brothers do Brasil. His career also includes stints in Boston and on Wall Street.

Alfredo N. Rizkallah, chairman of the São Paulo Stock Exchange, says the changes are long overdue. “These rules have existed since 1991. The market has changed a lot.

International transactions have changed a lot.

We need rules that are a lot simpler in order for the investor to feel more comfortable.

Today almost everything is done electronically, you have to change rules that require a lot of documentation.”

Rizkallah says deregulation would also help the exchange develop its Internet trading system. “We have some 40,000 visits a month from the United States. I believe that 20% of these could be from potential clients.”

Unlike other countries, where every brokerage develops proprietary transaction systems, the Sao Paulo market has a single online system linking 15 brokers through the Internet. In principle, individual investors can trade at the same bid-offer spreads that are offered to large investors.

Protecting Minority Shareholders
Perhaps of greater interest to institutional investors are government promises to tighten regulations protecting the rights of minority investors. International fund managers say abuse of minority investors by controlling shareholders has contributed to the decline in Brazilian and other Latin exchanges.

The patience of individual and institutional investors is wearing thin. Brazil’s first shareholder revolt broke out in December 1998 after JC Penney, the US retailing company, acquired Lojas Renner in December 1998.

Advised by Credit Suisse First Boston Garantia, the company held a tender auction shortly after to buy up the company’s outstanding stock at R$25 (then equivalent to $19) per lot of 1,000 shares.

Minority shareholders felt the terms were so harsh that they lobbied the CVM to act. The commission subsequently tightened up its takeover rules to protect minority investors, but regulations are probably still too weak.

“Brazilian capital markets are still far from providing a fair environment to minority shareholders,” says Eleonora Antici, head of equity sales at BBA Icatu, a São Paulo brokerage.

Rizkallah was a large investor in Lojas Renner, but even he sounds plaintive. “What can you do if there is a change in control and nobody knows the [sale] price? In international markets, you have hostile bids or competitive bids and everyone knows the price,” he says.

Ary Oswaldo Mattos Filho, a São Paulo corporate lawyer and former CVM chairman, says more active shareholders and not tougher rules may be a better solutiuon. However, there are limits to what Fraga can achieve. Perhaps the greatest drags on Brazil’s financial system and capital markets is the .38% tax on financial transactions, which has contributed to raising transaction costs. But the tax, pushed through Congress with great difficulty last year, is a vital source of additional revenue for the government to stave off further financial instability.