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A case study in Brazil's economic troubles

By Brian Winter

SAO PAULO (Reuters) - A good example of why Brazil's economy is floundering can be found in a surprising place -- a seaside city in southern Scandinavia.

Stavanger, Norway-based investment fund Skagen says it has lost about $200 million since August because of Brazilian President Dilma Rousseff's latest intervention in her country's economy -- a plan to force companies to slash electricity rates.

Rousseff says the plan is needed to cut costs for Brazil's struggling factories and other consumers. The collateral damage has been huge, as the prospect of dramatically lower profits has wiped more than $15 billion off the book value of Brazilian power companies, including Eletrobras , in which Skagen holds a large equity stake.

The episode is one of several heavy-handed moves by Brazil's left-leaning government that have scared investors because of their unpredictability, said Kristian Falnes, the portfolio manager of Skagen's global fund.

"We're not the only ones being hurt," Falnes said by telephone from Norway last week. "There's a lot of distrust in the Rousseff government because of cases like this."

Data released last Friday suggested that distrust is taking a heavy toll. Investment in Brazil declined for a fifth straight quarter between July and September, dooming the overall economy to a meager expansion of just 0.6 percent during that period -- half what financial markets had expected.

Latin America's biggest economy is now expected to grow only about 1.3 percent this year, likely the worst performance among the BRICS group of big emerging markets that also includes Russia, India, China and South Africa. Even developed economies are, on average, expected to grow faster than Brazil in 2012.

Rousseff and her economic team blame their troubles on the global crisis. They say worries about government activism are misplaced, and predict a recovery is around the corner.

Nonetheless, it has been a hard fall back to earth for an economy that just two years ago grew at a 7.5 percent clip and seemed set for a long run of prosperity as it prepared to host the 2014 World Cup soccer tournament and 2016 Olympic Games.

A PLAN TO GET THE ECONOMY GOING AGAIN

The story of how Skagen got wrapped up in Brazil's struggles is complex, but familiar in many ways to investors in the country's banks, oil firms, auto industry and currency market.

Earlier this year, as Brazilian manufacturers were mired in a severe funk, Rousseff decided to try to resolve some of their long-standing complaints. Among them was electricity rates, which were the third-highest in the world by one measure, behind only Italy and Slovakia.

Drawing on her past as an economist and a former energy minister, Rousseff helped design many aspects of the plan herself, settling on two main courses of action.

One was to cut federal taxes and fees on electricity. The other was to use the upcoming expiration of several power concessions as leverage. If companies wanted to renew their contracts to operate dams and electricity distribution networks, they would have to agree to a major cut in rates - with a goal of cutting the average price to consumers by 20 percent.

The cut in rates is set to take effect early next year. Rousseff says no existing agreements are being broken, and that companies are free to not apply for the new concessions if they so desire. But many of the companies had built their long-term business plans around broadly similar rates -- and some would see their income plunge if they did not renew.

"We thought that after the concessions expired, there would be new auctions," Falnes said. "(We thought) there would be some kind of free-market price for this and not forced prices and forced terms."

With Eletrobras, which made up about 4 percent of Skagen's $17 billion global portfolio, the situation is even thornier.

As is true of many Brazilian companies, the government is the controlling shareholder. So when the company's board voted early on Monday to renew the concessions, as expected, the government was essentially voting for its own plan.

"This completely ignores the interests of minority shareholders," Falnes said. "You can view this as a form of nationalization or expropriation of property."

Falnes says it may be impossible for Eletrobras to turn a profit in the long term under the new concession terms, even if it undertakes heavy cost-cutting. Many others agree, driving the company's shares down 55 percent since details of the plan began to leak in August despite a government offer to compensate power companies for some of their losses.

"With these new tariffs, I don't think the most efficient electrical company can make money," Falnes said. "It's possible that saying yes to this proposal is saying yes to lose money for the next 30 years."

THEY SHOULD HAVE KNOWN BETTER?

Many officials in Rousseff's government - and even some people in the business world - believe that Skagen and other electricity investors have no real right to complain.

Eletrobras' prospectus for shareholders clearly warns about the perils of investing in a company in which the government is calling the shots.

Skagen itself is no stranger to risk, as illustrated by a video on its corporate website that explains its investment strategy. "We search for companies that are undervalued, underresearched and unpopular," a narrator says. "Where some people see only clouds, we see a glimmer of sunshine."

Government officials say margins in the electricity industry were unsustainably high, especially considering that most of Brazil's electricity comes from relatively cheap hydroelectric dams. They say the government was obligated to step in and act in a way that will create far more winners - all 190 million Brazilians - than losers.

"These companies were making promises they were never going to be able to keep," said one senior Brazilian official, speaking on condition of anonymity. "There is going to be a period of transition for them now."

"We're not going back on this," the official added.

The problem, from private investors' point of view, is that the list of companies that have had their business models up-ended by Rousseff goes way beyond the electrical sector.

In the past year or so, Rousseff has enacted measures to weaken Brazil's currency by about 27 percent; push interest rates to an all-time low of 7.25 percent; and cajole private-sector banks into lending more and at lower rates.

She has also doled out tax breaks to struggling sectors such as automakers, winning their affection but also prompting complaints from other companies who feel left out. Meanwhile, Rousseff has used the government's stakes in companies such as Petrobras and Vale to push them toward decisions that will stimulate Brazil's industry at-large, rather than just their own bottom lines.

Officials say all those measures have a noble intention: to bolster the short- and long-term health of the economy. They are bewildered that Skagen and other companies have compared Brazil to countries in Latin America that are openly hostile to private capital, such as President Hugo Chavez's Venezuela.

Nevertheless, the economy's struggles suggest that investors are not buying into Rousseff's initiatives - at least for now.

The Bovespa <.BVSP> share index has fallen about 15 percent since she took office in January 2011, trailing other stock markets around Latin America. Rousseff's intervention in banks helped cause the financial services sector to contract 1.3 percent in the third quarter - which, along with falling investment, was the main explanation for Brazil's weak growth.

The list of unhappy investors keeps growing. Skagen has, in fact, been burned at least twice -- it is also a Petrobras shareholder. Falnes said his company was not naive, but simply believed it could trust Brazilian governments after a decade of investing here under Rousseff's ideologically similar predecessor, Luiz Inacio Lula da Silva.

"We were quite happy with corporate governance during Lula. We saw much less government interference then," he said.

Falnes says the fund has not taken any legal action against the government "yet" on the Eletrobras case, but would consider all options.

"I can understand the need for lower electricity bills," he said, "but of course we are not happy with paying the bill."

(Additional reporting by Brad Haynes, Editing by Todd Benson, Kieran Murray and Andrew Hay)

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