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Emerging Markets Research | Americas

Is Brazil’s balance sheet sustainable? 28 February 2011

We argue that the best way to think about BRL’s long-term prospects is to look at Foreign Exchange Research & Strategy
the relationship between Brazil’s negative net asset position and the outlook for Contributing Strategists
its future trade balances. Our results show that the implied growth rate of the
trade balance at current BRL levels already likely discount future additional Tony Volpon
export earnings from the “Pre-sal” oil finds. +1 212 667 2182
tony.volpon@nomura.com

Last year (see ‘Brazil: A “perfect storm” for BRL?’) we argued that the situation in
Brazil bears remarkable similarities with what it faced in the 1970s. Then, such Sercan Ozcan
as in the current situation, commodity prices were rising strongly. Then, such as +1 212 667 9827
sercan.ozcan@nomura.com
in the current situation, monetary policy in the developed world was exceptionally
loose, and global inflation was rising. Then, like currently, Brazil had rapid
economic growth and a strong investment cycle driven by foreign investments
This report can be accessed
and a growing current account deficit. electronically via:
www.nomura.com/research or on
Bloomberg: NOMR <GO>
These historical similarities should be a concern because of what followed:
eventually monetary policy in developed countries tightened strongly, commodity
prices crashed and Brazil, like many other countries, was unable to pay its
foreign debt. The 1970s boom was followed by the 1980s debt crisis and a “lost
decade” for Brazil and many other less developed countries.

While the historical parallels between today and the 1970s merit close attention,
there are also important differences. We would pick out two as being the most
relevant: first today, unlike the 1970s, Brazil has a flexible, market-based
exchange rate regime (albeit lately it has become heavily managed). Second,
and most importantly, unlike in the 1970s, where foreign liabilities were mostly
US dollar-denominated debt obligations, Brazil is currently accumulating mostly
BRL-denominated liabilities with no fixed payment terms, such as equity and
foreign direct investments.

This last difference is key because it means that any eventual crisis will likely be
resolved by changes in the level of BRL and asset prices, and not become a debt
crisis. Like many European countries are currently discovering, if economic
perspectives disappoint, liabilities denominated in the local currency pass on the
risk to the holder of the asset through lower exchange rate values. When a
country has a fixed exchange rate and debt liabilities, it bears the whole burden
of adjustment unless the debt is restructured.

Thinking of BRL as a “growth stock” - the net asset position

The difference in liability structure means that unlike in the 1970s any eventual
disappointment in Brazil will likely be resolved through a lower value for BRL. In
fact, in our July piece, we argued that another helpful way to think about Brazil is
to compare it with a “growth stock”: Brazil’s growing current account deficit can
be viewed as heavy external investments in a company with present negative
cash flows, but excellent future earnings prospects. Current valuations should be
justified ex-post if, in the future, the country sees rapid growth in “earnings”.

We have taken a closer look at this parallel through examining Brazil’s net
investment position. Specifically, though Brazil has a flexible exchange rate, BRL
is non-deliverable, and so all inflows into and out of the country have to be
registered at the Central Bank of Brazil (BCB). This allows the BCB to calculate
the economy’s net asset position: claims that Brazilians hold as assets abroad
and claims that foreigners have on Brazil (Figure 1).

Nomura Securities International, Inc.

See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures
Nomura | FX Insights February 28, 2011

Figure 1. Net international asset position

1,400 US$ bn US$ bn -800

1,200 -700
Assets (lhs)
Liabilities (lhs) -600
1,000
NAP (rhs inverted) -500
800
-400
600
-300
400
-200
200 -100

0 0
2004Q1
2004Q2
2004Q3
2004Q4
2005Q1
2005Q2
2005Q3
2005Q4
2006Q1
2006Q2
2006Q3
2006Q4
2007Q1
2007Q2
2007Q3
2007Q4
2008Q1
2008Q2
2008Q3
2008Q4
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
2010Q4
Source: BCB.(http://www.bcb.gov.br/?SERIEPIIH)

Not surprisingly, the BCB estimates Brazil’s negative net asset position at
US$657.6 billion as of September 2010. The implication is that, extending our
“growth stock” analogy, external investors have put US$657 billion into Brazil,
and expect a return on these investments.

But while equity valuation theory claims that this return will be through higher
earnings, what is the correct metric in the case of Brazil? One way is to look at
the balance of payment data, specifically the “income and services” line, which
reached US$70.6 billion in 2010 (Figure 2). Indeed, there is, as one would expect,
a strong relationship between the amount paid by Brazil in income payments
(dividends, profit remittances and interest payments) and the net asset position.
During the financial crisis when BRL fell by over 50% in nominal terms from
August 2008 to the beginning of 2009 net asset position improved from minus
US$635.1 billion in Q2 2008 to minus US$278.8 billion in Q4 2008, with income
and services remittances falling from US$16 billion to US$11.8 billion for these
quarters. Not only did the crisis decrease earnings on local assets, but as BRL
fell during the crisis, it became more expensive to repatriate investment earnings
in hard currency, leading to smaller remittances.

Figure 2. Net asset position vs Income and services payments

US$ bn US$ bn
-2

-200
-7

-400
-12

-600
-17 Net asset position (rhs)

Income and Services (lhs)

-22 -800
Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10

Note: We detected a very strong statistical relationship between the net asset position and the sum of
income and services payments by running a simple linear regression with the quarterly data since
2004. The regression results in the following equation:
Net Asset Position = 28.59 x Income and Services -104.46 (R-squared = 72.75%)
Source: BCB.

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Nomura | FX Insights February 28, 2011

Trade balance - the correct metric for measuring future returns

We believe the level of income and services payments in the balance of

payments is not the correct metric for measuring the return that foreign investors
expect from their assets in Brazil. The reason is similar to that on equity valuation
literature: should one look at earnings or dividends? Continuing with our analogy,
the income and services line in the balance of payment may be seen as being
equivalent to earnings, but the trade balance would be dividends. Earnings, like
the income line in the balance of payment, will depend on various factors, and
can be financed by issuing more securities, but in a commodity export economy
such as Brazil, the only real, ultimate source of foreign currency is its trade
balance.

This is especially true when one imposes a “transversality” or “no Ponzi scheme”
condition on the valuation exercise. Although in equilibrium the net asset position
has to be equal to the present, expected value of all earnings derived from these
investments in Brazil, ultimately the need to pay these earnings to foreign
investors means that these earnings will, over time, have to be met by the
country’s ability to generate hard currency, and in the case of commodity
exporting Brazil that ultimately comes down to the trade balance. Thus while
actual remittances can, in the short term, be financed by further borrowings and
investment inflows or by running down “current assets” (like the BCB’s foreign
reserves), in the future if the liability position does not to asymptotically go to
infinity Brazil must run positive trade balances to meet its obligations. Thus,
under a correctly specified transversality condition, the exchange rate is in
equilibrium when the net asset position is equal to the discounted, present
value of future trade balances.

The exchange rate as the “price” that brings stocks and flows into balance

Why elect the exchange rate as the variable that makes the net asset position, a
stock quantity, equal to the trade balance, a flow value? In any general
equilibrium exercise one would have to compute a full range of asset prices
beyond the exchange rate, but the exchange rate is clearly the most important
price involved as it affects both sides of the equality. Specifically, for example,
any negative change in the expected return of assets held by foreigners would,
with a lower BRL, simultaneously lower the value of these assets (the negative
net asset position would fall) and, at the same time, help compensate the
expected lower value of future trade balances by changing the relative price of
exports in relation to imports (diminishing the fall in the ex-post trade balance in
hard currency terms).

What happened in 2008 demonstrates the correct dynamics between these

variables. With the onset of the financial crisis commodity prices fell and export
demand collapsed. The quick adjustment higher of the exchange rate both
lowered the value of assets owned by foreigners in Brazil (see Figure 1) and, at
the margin, improved the expected trade balance despite the fall in commodity
prices. Although in crisis conditions all kinds of overshoots are possible, the
exchange rate moved in the right direction to equalize the net asset position to a
lower present value of the trade balance. Subsequently, as China’s successful
implementation of countercyclical policies helped support commodity prices, BRL
began once again to appreciate and the value of assets held by foreigners in
Brazil rose.

Having established the exchange rate as the price that brings both quantities into
line, and using the net asset position as reported by the BCB, we still need some
method to measure the expected net present value of the trade balance.

Once again taking a page from equity valuation literature, we propose to simplify
this task by using the well known Gordon Growth Model (Dividend Discount
1
Model, in general) :

1
Damodaran, A., 2002. Investment Valuation. 2nd edition. Wiley Finance, New York, NY, 322-348.

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Nomura | FX Insights February 28, 2011

Here the present value of the trade balance PV(TB) in the current period is equal
to trade balance in the next period, divided by r-g, where we interpret r as the
discount rate of the trade balance and g as the constant growth rate for the trade
balance.

We choose to use this model for two reasons. First and most obviously, because
it is much easier to calculate than the full future expected value of the trade
balance. Second, if the level of g needed to bring the present value of the trade
balance is, for example, unrealistically high, it would point to a likely need for a
lower BRL some time in the future. That is, a very high g would be evidence of
a “speculative bubble” in the exchange rate, which could only hold by
2
breaking the long run transversality condition.

For PV(TB) we will use the net asset position, which is US$657.6 billion at an
exchange rate of 1.6873 for the end of September. For TBt+1 we will use three
distinct values. First, the expected trade balance for 2011, which according to the
latest Focus survey is equal to US$10.03 billion. As the Gordon model is usually
used in literature to determine sustainable, terminal growth rates, we also look at
the average value of the trade balance of US$30.4 billion since 2001, when the
commodity boom started, and the average value of US$27.6 billion since 2006,
3
the year the trade balance reached its highest level.

For calculating r we will again use our analogy to a “growth stock”. r in our case
is the required return for the investments held by foreigners in Brazil. But to
determine this return we have to look at the expected return of the different items
making up the asset and liabilities positions. That is, by calculating the expected
returns to the assets and liabilities, using this flow number divided by their
respective stock quantities will give us r. We illustrate this in the table below
(Please see Appendix I for a discussion of the return assumptions used):

Figure 3. Foreign assets and liabilities of Brazil vs estimated expected returns

(US$ mn) Sep-2010 Expected Return
Assets 548,090 6.7%
Direct investment abroad 166,337 18.4%
Portfolio investments 13,500 3.7%
Other investments 92,835 3.7%
Reserve assets 275,206 0.8%
Derivatives 214 3.7%

Liabilities 1,205,691 16.5%

Foreign direct investment 436,922 22.1%
Portfolio investments 608,511 14.2%
Investments in shares 386,733 17.1%
Fixed income securities 221,777 9.2%
In the country 122,584 12.8%
Abroad 99,194 4.7%
Other investments 156,611 10.3%
Others 3,647 10.3%

2
Kamihigashi, T., 2000. Necessity of transversality conditions for infinite horizon problems. Available
at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=233633.
3
Damodaran, A., 2009, Ups and downs: Valuing cyclical and commodity companies. Available at
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/papers.html#commodity

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Net Asset Position -657,601

Expected return on assets 36,558
Expected return on liabilities 199,387
Expected net payment on NAP -162,829
Expected Return on NAP 24.76%
Source: BCB; Nomura.

By using our return assumptions, we calculate that the average return for the
assets of Brazilian held abroad is 6.7%, while the return to assets held by
foreigners in Brazil is 16.5%. This large difference is basically driven by the fact
that a large portion of the foreign assets held by Brazilians, 50.2%, are low-
yielding reserve assets held by the BCB. This large difference is very important,
as it means that Brazil will have to generate much larger future trade balances to
meet the difference. BRL valuations are challenged by both the size of the
negative net asset position and the disadvantageous spread between assets and
liabilities. This result contrasts, for example, with the United States, whose
largest liabilities are low yielding Treasuries against higher yielding assets
abroad (mostly equities and foreign direct investments). In the case of the United
States, the positive return differential in its favor means it could run a negative
trade balance forever without breaking any transversality condition.

Applying these returns to the asset and liability positions generates a US$162.8
billion net expected return to the net asset position of foreigners in Brazil (a
US$36.6 billion return on assets held by Brazilians abroad versus a US$199.4
billion return on assets held by foreigners in Brazil). We would note that the
US$162.8 billion return on foreigners’ net assets in Brazil against the US$70.6
billion income and services remittances in the balance of payments imply that
foreigners “retained” and re-invested US$92.2 billion of their earnings. Given the
outstanding net asset position of minus US$657.6 billion, this generates an
r of 24.8%. We calculate the needed g for our r given out three measures of the
trade balance:

Figure 4. Growth rate calculation under different trade balance assumptions

TBt+1 = 2011 estimate TBt+1 = Average since 2006 TBt+1 = Average since 2001

TBt+1 10,030 TBt+1 27,636 TBt+1 30,409

NAP 657,601 NAP 657,601 NAP 657,601
r 24.76% r 24.76% r 24.76%
g 23.24% g 20.56% g 20.14%
Source: Nomura.

As we show, different starting values for the trade balance do not change the
calculated needed growth rate by much, though as below shows the implied
equilibrium BRL rates are very sensitive to changes in g.

Given the uncertainty in determining the correct values for r and TB in our model,
we calculate a table of g values for a range of r going from 20.0% to 27.5% and
for TB going from US$10 billion to US$30.4 billion. We also plot the relationship
between g and r given different values of TB. This exercise generates values of
g that range from 15.54% to 26.0%.

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Figure 5. Sensitivity analysis of g Figure 6. g and r relationship for different TB assumptions

27% g

25%
TB t+1
23%
10,030 27,636 30,409
20.00% 18.5% 15.8% 15.4% 21%
22.50% 21.0% 18.3% 17.9%
19%
r

24.76% 23.2% 20.6% 20.1%

25.00% 23.5% 20.8% 20.4% TB t+1 = 10,030
17% TB t+1 = 27,636
27.50% 26.0% 23.3% 22.9%
TB t+1 = 30,409 r
15%
20.0% 22.5% 24.8% 25.0% 27.5%

Source: Nomura.

Before we discuss the feasibility of these g values, we will transform them into
BRL-equivalent values for ease of exposition. Given the non-linear nature of the
calculation (small changes in the denominator can generate large changes in the
results), we will deal with a range of g values between 17.9% and 23.5%. We will
also deal with the case of an initial trade balance equal to the US$10 billion
expected for 2012. Given these parameters, we can determine the present value
of the trade balance. We can then calculate what BRL will make the present net
asset position equal to the present value of the trade balance.

To do this we use two methods. First, we calculate item by item the percentage
shift in asset and liability values given changes in BRL. Thus, for example, in the
case of a devaluation of BRL the asset position of Brazilians abroad does not
change (as it is denominated in USD), but the value of assets held by foreigners
in Brazil falls (as they are denominated in BRL). We calculate what BRL is
needed to reduce the net asset position until it is equal to the present value
of the trade balance. We also, alternatively, run a regression of changes of BRL
on the net asset position (see Appendix II for details). Both methods give broadly
similar results.

Figure 7. Method 1: Estimating the changes in Assets and Liabilities by item

4.50 BRL
Sensitivity analysis of BRL
4.00
g
3.50
17.9% 20.6% 23.5%
3.00
20.0% 2.0966 N/M N/M
22.5% 3.1477 1.9814 N/M 2.50
2.00
r

24.8% 3.6596 3.0186 1.4950

25.0% 3.7009 3.0935 1.6873 1.50
g=17.9%
27.5% 4.0422 3.6695 2.9600 1.00
g=20.6%
0.50 g=23.5% r
0.00
20.0% 22.5% 24.8% 25.0% 27.5%

Source: Nomura.

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Nomura | FX Insights February 28, 2011

Figure 8. Method 2: Modeling Net asset position using regression

5.00 BRL
Sensitivity analysis of BRL
4.50
g 4.00
17.9% 20.6% 23.5% 3.50
20.0% 2.0096 N/M N/M 3.00
22.5% 3.0464 1.9153 N/M 2.50
r

24.8% 3.7692 2.8946 1.5367 2.00

25.0% 3.8386 2.9815 1.6834 1.50
g=17.9%
27.5% 4.5085 3.7857 2.8286 1.00
g=20.6%
0.50 g=23.5% r
0.00
20.0% 22.5% 24.8% 25.0% 27.5%

Note: Please see Appendix II for further information on the regression model.
Source: Nomura.

Looking at these results, we see that equilibrium BRL near the current rate
implies that the trade balance will have to grow strongly. Specifically, for BRL at
1.687 both methods imply a constant growth rate of the trade balance of
23.2% from current levels.

Is this growth rate feasible? Looking at the yearly variation of the trade balance,
Brazil achieved higher levels of growth than 23.2% from 2003 to March of 2006,
when the yearly trade surplus reached its highest level, US$45.9 billion (Figure 9).
Thereafter, despite strong commodity prices, even stronger domestic demand led
to fast import growth and the trade balance has fallen, and currently it is negative
18.6% on a y-o-y basis.

Figure 9. Trade balance: y-o-y change in 12-month moving sum

350% y-o-y
300%

250%

200%

150%

100%

50%

0%

-50%

-100%
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Source: Bloomberg,Nomura.

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Conclusion: BRL should become an oil play

What conclusion can we reach about BRL and Brazil’s net asset position? We
would argue that:

1. The large difference in returns between assets owned by Brazilians and

assets owned by foreigners in Brazil, of almost 10% per year, generates
a bigger challenge in terms of future positive trade balances than would
be implied by just looking at the negative US$657 billion asset position.

2. As Brazilian domestic demand is still growing above potential supply, we

would expect the trade balance to remain under pressure for the next two
years at least. Given the fact that the Brazilian economy is savings
constrained (savings to GDP is only 16.4%) and that Brazil will likely go
through an intense period of infrastructure investments means that the
current account deficit will probably stay high (we expect 3% of GDP for
2011 and 2012) leading likely to an increase in the negative net asset
position assuming a favorable environment for EM economies.

3. The 23% growth rate in the trade balance may not seem daunting as
Brazil’s trade balance has grown by as much in the past. One can argue
that the results above do not provide evidence of a speculative bubble in
BRL. Nonetheless a “perpetual” 23% growth rate in USD terms is still an
aggressive implied growth path, especially given the fact that the trade
balance will likely remain under pressure for the next few years. In our
view, the current levels of BRL and strong investment flows into
Brazil suggest that the market already discounts the expected
increase in commodity exports when the “Pre-sal” oil finds are
developed, which could make Brazil a major oil exporter. It is
difficult to justify the current level of BRL given already high prices
and production levels for Brazil’s existing metal and agricultural
exports. Alternatively, the market could be forecasting a large decrease
in domestic demand suggesting a downward path in import growth, but
we view this as unlikely (even though we expect domestic demand to
grow more in line with supply over time). Only the addition of export
revenues from the “Pre-Sal” will possibly push export earnings to growth
levels justifying the already large and growing negative asset position
and the high level of BRL.

4. Thus we see over the long run risks around BRL tied to the success of
the investments currently being made in the oil sector, and thus BRL
should be, going forward, increasingly correlated with oil prices. As we
shown in our recent BRL model (See “What are commodity prices telling
us about BRL?”), BRL levels are driven by a mix of risk indicators and
metal prices (iron ore being Brazil’s largest current export). Oil’s
importance should rise over time, and perhaps eventually replace the
effect of metal prices.

5. Although BRL levels look to be set by metal and oil prices, our results
show that any disappointment in terms of trade balance growth rates,
when translated into a lower BRL, quickly lowers the net asset position.
In fact, our regression shows that a 1% move lower in BRL lowers the
negative net asset position by 1.9%. Thus any disappointment in future
export performance might lead to a lower BRL, but given the high
elasticity of the net asset position to BRL it is very unlikely that it would
lead by itself to any kind of meaningful rise in credit risk. Thus while
Brazil’s growing negative net asset position will make future export
performance key to maintaining or improving current levels of the
currency, the structure of the assets owned by foreigners, mostly
denominated in local currency and with “state-dependent” returns (direct
investments and equity equaling US$822 billion against US$221 billion in
fixed income securities) means that while valuation for BRL may already
be aggressive (if not “bubble-like”), we would argue that our results show
that the market’s perception of credit risk from this perspective may be
too high at present. In effect Brazil’s position is quite conservative, as it is

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long low yielding USD assets against risky, long BRL positions held by
foreigners.

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Appendix I: Estimation of expected returns

Assets:

 Direct investment abroad:

 5-yr average ROE for Vale peers: 18.4%
 We use two metrics to estimate equity returns: return on equity and
market return for public companies. For direct investments we believe
return on equity to be a better estimate of expected return than the
market return. Direct investments are subject to major risk factors that are
not usually captured in the return expectation for public investments.
These include liquidity risk, additional regulatory risk and completion risk
for brownfield/early stage projects. Moreover, diversification of the
idiosyncratic risks argument cannot be fully applicable for companies
investing directly as they generally cannot diversify adequately.
 Most Brazilian investments abroad are in the commodities sector and
driven by few major companies like Vale. Hence, we believe Vale’s 5-year
average return on equity can be used as the average expected return, as
it reflects the returns for a period of international expansion.

 Portfolio investments:
 10 yr US treasury rate: 3.65%
 98% of portfolio investments of Brazilians are in fixed income securities,
which are dominated by securities of developed economies including the
US. Therefore, we believe a benchmark interest rate seems appropriate
for the expected return. Although the average duration is likely to be less
than 10 years, we assume the 10-year US Treasury rate as the expected
return to compensate for the higher interest rates in the securities of other
countries and corporates.

 Other investments:
 10 yr US Treasury rate: 3.65%
 Other investments comprise mainly trade credit (65%) and currency and
deposits (26%). In essence, these items are fixed income instruments
and we believe a benchmark interest rate would be appropriate for the
expected return. Trade credit tends to have a higher return than
government securities, while currency and deposits usually have lower
returns. These two effects are likely to offset each other to some extent.
Therefore, we assume 10-year US Treasury rate as the expected return.
 Reserve assets:
 2 yr US Treasury rate: 0.78%
 These are central bank reserves, which are predominantly held in short-
term US Treasuries. Hence we assume 2 year US treasury rate as the
expected return.
 Reserve assets:
 10 yr US Treasury rate: 3.65%
 This is a very small portion of assets, which we believe include mostly
fixed income derivatives. We assume the long-term US Treasury rate to
be an appropriate rate.

Liabilities:

 Foreign direct investment:

 Public equity investment + 5% risk premium: 22.1%
 Direct investment should justify a higher return as we discussed above
due to the additional risks it assumes. Considering the return on equity
and market return value in developed markets and comparing the public
equity returns with private equity returns, we believe a 5% risk premium
on top of the public equity returns is justified for direct investments in
Brazil.

 Investment in shares:
 MSCI Brazil index average return since 1988: 17.08%
 Investments in public equity markets should have a long-term expected
return based on the historical performance of the market. We use the

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MSCI Brazil index as a proxy for the Brazilian equity market and calculate
the annual return historically. Although this return expectation may seem
high, we believe it may be justified given the extra risks of capital controls,
exchange rate and regulation.

 Fixed income securities in the country:

 10 year Brazil government BRL bond yield: 12.84%
 Most fixed income investments are in government securities denominated
in BRL.

 Fixed income securities abroad:

 10 year Brazil government USD bond yield: 4.70%
 A majority comprise long-term government securities denominated in
USD.

 Other investments:
 Estimated average corporate bond yield: 10.27%
 90% consists of loans to entities other than the monetary authority and
includes both BRL and USD denominated debt. Taking into account the
BRL and USD borrowing rates for Brazilian government, BRL and USD
breakdown of other investments, credit spreads and the type of Brazilian
borrowers that can access international markets, we estimate an average
borrowing rate of 10.27%.

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Appendix II: Method 2: Modeling net asset position using regression

We modeled the changes in net asset position by using the changes in USD/BRL.
We first transform data by taking the natural logarithm of each series. Therefore,
the resulting model approximates the percentage change in the net asset
position given a certain percentage change in the USD/BRL.

Method 2: Modeling net asset position using regression

Regression Model:

DLOG(-NAP) = C(1)+C(2)*DLOG(BRL)

Eviews estimation output:

Dependent Variable: DLOG(-NAP)
Method: Least Squares
Date: 02/17/11 Time: 08:21
Sample (adjusted): 2004Q2 2010Q4
Included observations: 27 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

C -0.0044 0.0131 -0.3334 0.7416
DLOG(BRL) -1.8699 0.1625 -11.5081 0.0000

R-squared 84.12% Mean dependent var 0.0341

Adjusted R-squared 83.49% S.D. dependent var 0.1619
S.E. of regression 0.0658 Akaike info criterion -2.5337
Sum squared resid 0.1082 Schwarz criterion -2.4377
Log likelihood 36.21 Hannan-Quinn criter. -2.5052
F-statistic 132.44 Durbin-Watson stat 2.1793
Prob(F-statistic) 0.0000

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Appendix III: “Pre-sal” oil potential of Brazil

In 2007, Petrobras announced the discovery of Tupi field, which has been
renamed Lula, with approximately 5 to 8 billion recoverable reserves of light oil.
This was the first indication that Brazil would be one of the leading oil producers
globally in the coming years.

These reserves are widely referred to as “pre-sal” (pre-salt in English) reserves.

The pre-salt expression refers to an aggregation of rocks with potential to
generate and accumulate oil. These rocks lie below a thick layer of salt, which is
as much as 2,000 meters thick. The “pre” expression is used as these rocks were
deposited through time before the salt layer. The total depth of these formations
is around 5,000 to 7,000 meters from the surface.

The oil found in this region has low sulfur content and low acidity, which indicates
a high quality reserve with a high market value.

Brazil’s pre-salt region is located approximately 170 miles off the Atlantic coast.
The area extends from the Esprito Santo state to Santa Catarina state across
800 km (497 miles) with an average width of 200 km (124 miles).

The proven oil reserves of Brazil stood at 14.25 billion barrels in 2010 according
to the national oil regulator ANP (Agencia Nacional do Petroleo, Gas Natural e
Biocombustiveis). The proven reserves increased 10.65% versus 2009, the
biggest increase in eight years since 2002. Total reserves, which also include
probable and possible reserves, soared 34.57% to 28.47 billion barrels.
Offshore reserves, mostly pre-salt reserves, make up about 95% of this figure.

ANP estimates an aggregate of around 50 billion barrels of oil in the pre-salt

region. A study by Hernani Chaves and Cleveland Jones of the Rio de
Janeiro State University estimates a much more optimistic 123 billion
barrels of reserves for the region.

Petrobras, the Brazilian state-controlled oil company, controls almost 85% of all
the drilling activities in the region. A law signed late last year declared the pre-
salt reserves to be state property and stipulated that they will be explored and
developed by consortiums in which Petrobras will have a minimum 30% stake.
Petrobras is planning to invest US$108.2 billion to develop offshore oil
fields until 2014. To this end, Petrobras raised US$70 billion in 2010 in the
largest ever equity issuance globally.

(Please see Petrobras – Initiation of coverage – Recapitalisation to unlock quality

resource base for further discussion.)

Pre-sal region map

Source: Petrobras.

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Nomura | FX Insights February 28, 2011

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