October 2nd, 2015

As Brazil’s Rousseff reels from crisis, opportunity for reform emerges

by Carlos Eduardo Lins da Silva Brazil is facing its worst […]

Brazil is facing its worst crisis in 70 years. Its economy is mired deep in a recession that will last at least until 2017. The political scene is in disarray, with a president who was re-elected just a year ago now chastened by approval ratings in the single digits. No opposition leader or party is considered a viable replacement for the Workers’ Party, which has held power since 2003.

Fear pervades the business community – not only due to the country’s macroeconomic woes but also because of an anti-graft investigation by federal police that resembles Italy’s ‘clean hands’ investigation of the 1990s. The operation is dramatically reshaping the traditionally venal relationship between large companies and the state in sectors such as construction, energy and transport.

The silver lining is that the democratic institutions Brazil has built since the end of its military regime 30 years ago continue to prove strong and effective. The Public Prosecutor’s Office, the Federal Police Department, Congress, the courts, civil society and the press are all functioning well, while enjoying freedom and independence. The military, under civilian command, is fulfilling its constitutional duties – and it is unimaginable that it would ever intervene in the political process, as was the norm throughout most of the last century.

Negative effects

Brazil’s macroeconomic problems derive mainly from poor decisions taken both by former President Luiz Inácio Lula da Silva, known as Lula, and current President Dilma Rousseff, both members of the Workers’ Party, in the aftermath of the 2008 global financial crisis. Prior to that, from 1994 until the end of 2007, there had been a broad national consensus that macroeconomic policies should be based on strict control of inflation, a floating exchange rate and consistent primary surpluses. These three legs formed the foundation for the Brazilian economy’s extraordinary success and its impressive reduction in poverty over the past two decades.

However, with the financial crisis, President Lula decided to introduce stimulus measures that proved effective initially, but then became progressively more harmful over time. Their negative effects were exacerbated by ‘creative accounting’ methods that used special-purpose funds and subsidies from state-owned banks to pump up surpluses and curb increases in the prices of energy and public services.

This process was particularly intense in the election years of 2010 and 2014 in order to enhance the ruling party’s chances of victory. President Rousseff employed extremely aggressive rhetoric in last year’s campaign, saying that if the opposition won, it would impose a fiscal adjustment that would push the country into recession and lead to widespread hunger.

The day after her re-election, Rousseff picked one of the opposition’s leading economists, Joaquim Levy, as her finance minister. He designed and has been trying to implement a plan to increase taxes and reduce spending in order to achieve the primary surpluses necessary to curb the country’s public debt, which has been increasing at an alarming rate.

At the same time, the unwinding of subsidies (particularly for electricity) coupled with a significant devaluation of the Brazilian real have driven consumer price inflation to near double-digit territory, where it is likely to remain at least until mid-2016. To make things worse, China, the biggest buyer of Brazilian exports, is suffering an economic slowdown, while slumping global commodity prices have hammered the fast-growing agribusiness sector.

Scandal’s taint

The biggest drag on President Rousseff’s administration is ‘Operation Car Wash,’ a joint investigation by the Public Prosecutor’s Office and the Federal Police to uncover corrupt practices between government officials and large private corporations. Initially, the probe focused on Petrobras, the state-controlled oil giant. Later on, the investigation widened to encompass other sectors of the economy.

The Petrobras portion of the investigation has already resulted in the arrest and indictment of about 120 people. Among them are some of the wealthiest individuals in the country, including owners and executives of the country’s most important construction companies (several with significant international operations), as well as key political leaders (members of congress, former cabinet members and former state governors). Currently, the speaker of the Chamber of Deputies (Brazil’s lower house of Congress), the president of the Senate and two members of Ms Rousseff’s ‘kitchen cabinet’ are formally under investigation, though they have not been officially charged.

As yet, no formal accusations have been made against President Rousseff, who chaired Petrobras’ board of directors while serving as minister of energy in President Lula’s administration, when the corruption was alleged to have occurred. Her reputation has nevertheless been severely tainted. Requests for Ms Rousseff’s impeachment have been sent to the Chamber of Deputies, which has not acted upon them. The president is also facing an investigation by a federal audits court over whether her administration’s ‘creative accounting’ methods broke the law. In the end, the cumulative weight of these allegations could force legislators to initiate impeachment proceedings.
President Lula decided to introduce stimulus measures that proved effective initially, but then became progressively more harmful over time. Their negative effects were exacerbated by ‘creative accounting’ methods

Pulling apart

Despite her enormous unpopularity, it is still unlikely that Ms Rousseff will be impeached. The main opposition parties are not united on the issue, and she still has the support of several strong unions and social movements that historically have been loyal to the Workers’ Party. On the other hand, members of her own party have increasingly made her a target because she has adopted economic policies that they have traditionally opposed.

A key actor in the Brazilian political drama is former President Lula, still and by far the country’s most popular leader. Although Lula has also been hurt by the corruption scandals surrounding his party and his administration, he remains very influential.

It was Lula who personally tapped Ms Rousseff (who had never run for public office prior to 2010) for the presidency, and she knows she owes her political success to him. However, as Ms Rousseff began her second term, she attempted to distance herself from her mentor in order to make her own mark on the government. Those moves have pulled the two politicians apart somewhat.

Lula still supports President Rousseff in public. But in private, he has become increasingly critical of her strategy and tactics. In the last couple of months, the former president has often been seen in the capital, Brasilia, conducting meetings with congressional leaders and even with cabinet members, as well as visiting Ms Rousseff herself.

Fiscal pressure

As President Rousseff’s influence recedes, it is Lula who has stepped into the power vacuum, along with Finance Minister Levy (who has won broad autonomy to set economic policy) and Vice President Michel Temer. Mr Temer, who is head of the biggest party in the ruling coalition, the Brazilian Democratic Movement Party (PMDB), may have the most to gain from Ms Rousseff’s troubles. He has already been able to use the threat of Ms Rousseff’s impeachment as leverage to win political and economic concessions, refusing to go along with the president’s plan for cabinet changes until she agreed to support passage of more fiscal adjustment measures in Congress.

This legislation, sent down by the executive in September, must be passed by the end of October to ensure that the 2016 budget is approved and that the government can operate normally. The government needs to post a primary budget surplus equivalent to 0.7 per cent of gross domestic product in 2016, but the budget it sent to Congress had a 0.5 per cent deficit. This means additional spending cuts and revenue must be found to bridge the gap of 1.2 percentage points. Two-thirds of the total will come from new or higher taxes, which politicians are never keen to support.

Ms Rousseff hopes the cabinet reshuffle expected in October will sway some leaders to side with the government. But the public is in no mood to accept more taxes. Brazil’s tax burden already amounts to 36 per cent of GDP, while public services – particularly hospitals, schools and roads – are not known for their quality.

Back from junk

President Rousseff’s efforts to regain investors’ confidence and pull the economy out of recession were further hampered on September 9, when Standard & Poor’s downgraded Brazil’s credit rating to junk status. The Brazilian real plummeted, dipping below US$0.23 on September 24, its lowest value since the currency was introduced in 1994. Long-and short-term interest rates have rocketed, while unemployment surged to 8.6 per cent. Among young people in urban areas, the jobless rate is much higher at nearly 20 per cent.

Even in these dire circumstances, Brazil’s economy is not in danger of collapse, at least in the short term. The country has currency reserves of US$370 billion that can be used to offset capital flight and limit exchange rate fluctuations. The country’s current account deficit is already on track for sustained improvement; the weaker real will only make Brazilian exports more competitive and Brazilian assets more attractive for potential investors.

Other emerging countries reduced to junk status in the past two decades have been able to recover their investment-grade rating quickly: South Korea in only two years, Ireland in two and a half. Even with its problems, Brazil will still end 2015 as the world’s tenth-largest economy, down from sixth in 2009.

Like South Korea and Ireland, Brazil is economically strong enough to recover if it adopts sound policies and implements them effectively in 2016 and 2017. That would allow the country to return to its ‘old normal’ growth rate of about 3 per cent a year by 2018.

Moreover, Brazil’s macroeconomic fundamentals could become even stronger once the necessary adjustments are made. The business environment could be rejuvenated by Operation Car Wash, which represents a dramatic shift in the culture and mores of a country that had been soft on corruption for centuries. The energy Brazil derives from these new circumstances could build impetus for the structural reforms it so badly needs to reach its potential.

Baseline scenario

• President Rousseff is not impeached this year but loses even more power; her survival becomes dependent on Lula and Vice President Temer.

• If unemployment grows dramatically and Ms Rousseff and her allies fall out, impeachment proceedings may be initiated in 2016.

• Social unrest will persist, but will not reach extremes.

• The weaker real will continue to boost foreign direct investment inflows and Brazilian exports, which may become fully competitive with China’s in some markets.

• While the economy will perform better next year, growth will not resume until 2017.

• The ruling Workers’ Party will be soundly defeated in the 2016 municipal elections.

• Newcomers who do well in next year’s local elections may become a force in the 2018 general elections.

Crisis scenarios (less likely)

• President Rousseff’s impeachment or resignation occurs in 2015 or early 2016.

• Lula breaks ranks with Ms Rousseff and openly opposes her.

• Political confrontation turns violent as street uprisings break out.

• Some states or municipalities go bankrupt.

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