Reality check In Brazil

By Arthur Kroeber

After a year of terrible news, Brazilian markets rallied last week on the surprise news that former president Lula Ignacio da Silva had been forcibly hauled in for questioning by investigators plumbing a vast and fetid corruption scandal. The basic charge is that Lula’s Workers’ Party (PT) funnelled government financing and inflated contracts to construction firms in exchange for campaign contributions. On the hope that Lula’s brief detention presaged his arrest and the fall of his hand-picked successor, the widely despised president Dilma Rousseff, equities gained 8% in two days and the beaten-down real jumped by more than 5%.
The enthusiasm is premature. We reported a year ago that Brazil was headed for hard times, and if anything things have turned out even worse than we expected. GDP contracted by -3.8% in 2015, and the median forecast for 2016 is another slide of -3.5%, with some predictions as low as -5%. The cumulative fall in investment spending in 2014-16 is likely to hit -27%. Brazil is facing its worst growth slump ever—worse even than the Great Depression or the hyperinflation years of the late 1980s.
Despite the gloom, there is not yet much evidence of a crisis mentality. Several factors explain the relative calm. First, the broad population has not yet suffered as much as headline GDP would suggest: the labour market remains relatively tight and unemployment has risen only marginally so far. At the bottom of the scale, income remains supported by the social welfare schemes established by the PT.
Next, the debt and payments situation is deteriorating, but does not pose an immediate threat. Foreign reserves stand at around $350 bln, and external liabilities have remained stable at modest levels. The financial system is secure. Thanks to high interest rates, Brazilian banks enjoy the widest interest margin in the world (over 7%). And they face no funding stress: the ratio of private sector credit to bank deposits is still under 100%. Obviously, bank profits will fall as asset quality deteriorates over the next couple of years. But there is little chance of a financial blowup.
The big problem is government debt, which now stands at a not-so-bad 67% of GDP but is on track to surge by about 10pp a year. This is not a matter of countercyclical fiscal stabilisers kicking in during a downturn; it is the consequence of years of spending incontinence. The main culprit is an absurdly lavish set of perks for civil servants, including enormous pensions and free air tickets home every weekend for bureaucrats working in Brasilia. Any hope for a sensible rebalancing of fiscal policy went out the window last December when finance minister Joaquim Levy resigned after less than a year in office and was replaced by former planning minister Nelson Barbosa, who promises to be more compliant to Rousseff’s political needs.
Most likely, the fiscal can will be kicked down the road. Government debt could hit 90% of GDP by the time the next presidential election rolls around in autumn 2018. But the government will still probably find a way to pay its bills. There has been some quiet talk of the International Monetary Fund providing some pre-emptive fiscal support, but given the Rousseff government’s complete loss of credibility such aid will not come until after she leaves office.
Finally, and rather surprisingly, foreign investors have not cut their exposures as much as you would expect given the 50% depreciation of the real in the last 18 months and downgrades of Brazilian debt to junk. One reason is that fixed-income investors who are not subject to mark-to-market accounting (notably Japanese institutions) have now lost so much money on paper that they have little choice but to stay invested and hope to make up some ground.
In short the economy is in terrible shape, but there is no obvious trigger for a crisis that could force a new course. The only potential game-changer is political: namely the chance that Rousseff could be forced from office before the end of her term in December 2018. A week ago this seemed unlikely; with Friday’s dramatic move against her patron Lula, the odds of an untimely exit rose sharply.
There are three scenarios for such an exit. One is that Congress moves ahead with impeachment proceedings, which are already in their early stages. The credibility of this process is undermined by the fact that the speaker of Congress, who must authorize the impeachment, is widely known to be one of the most corrupt people in Brazilian politics. And in any case, a successful impeachment would simply hand the presidency to the vice-president, so it is unclear whether it would change much.
A second scenario is that the independent Electoral Court nullifies Rousseff’s 2014 re-election on the grounds that the voting process was corrupted. If the court makes such a ruling before the end of this year (i.e. in the first half of Rousseff’s term), a fresh election would automatically occur. If however it waits until next year, Congress would appoint an interim president to serve until the next scheduled election in 2018. Again, it is hard to see this resolving the country’s political paralysis. The final possibility is that Rousseff, facing either of the first two scenarios, simply resigns.
Financial markets would cheer Rousseff’s ouster, as they did Lula’s detention. But the absence of any coherent opposition leadership would make the celebrations short-lived. However bad the PT’s governance may be, there is at the moment no organised alternative. This is why Rousseff managed to get re-elected despite her personal unpopularity, economic weakness, and voter exhaustion after 12 years of PT rule. Even if she gets kicked out this year and new elections are held, the next government might prove no more competent.
The deeper problem is that Brazil has a dysfunctional political system that runs on corruption. Elections to Congress are by proportional representation, with no minimum vote-percentage threshold to qualify for seats as in most European countries. Voters must opt for an entire slate of candidates for their state, so they often have no idea who they are voting for and elected members have no accountability to their constituents. About 30-odd parties are represented in Congress, most with no agenda other than to collect bribes for their votes on legislation. Until this system is reformed there is not much hope for sustained improvement in fiscal responsibility or economic vitality.