Publish in Perspectives - Wednesday, January 20, 2016
The Lava Jato investigation is creating a new sense of accountability in the political system in Brazil, here represented by Rio de Janeiro. (Photo: Artyominc)
Brazil now recognizes what it needs to do to emerge as a much stronger country.
BY WALTER T. MOLANO
The outlook for Brazil in 2016 is difficult. The economy is mired in a deep recession, inflation remains high, the currency is weak, interest rates continue to rise, debt levels are moving up and the government needs to implement a painful fiscal adjustment. With such a bleak outlook, President Dilma Rousseff will not have a pleasant second term in office.
The country’s woes can be reduced to two main factors, poor external conditions and the government’s failure to continue with the structural reforms that were left pending after President Fernando Henrique Cardoso left office more than a dozen years ago. There are other smaller issues facing the country. The ongoing Lava Jato investigation has adversely affected the oil and gas sectors, construction and manufacturing. As a result, the investigation has been a drag on the level of economic activity. The resultant political instability has also cast a deep shadow on the country’s business climate, deepening the sense of gloom. Nevertheless, the downturn in Brazil’s tradable sector has been similar to what is affecting other emerging market countries. Furthermore, the increase in U.S. Fed Funds will make it harder for everyone to tap into the international capital markets. Therefore, Brazil’s woes are not unique—they are just a bit exaggerated.
One of the things that make Brazil more vulnerable than many of its peers is its legacy of hyperinflation. Brazil endured one of the worst bouts of hyperinflation at the end of the 1980s and through the first half of the 1990s. Annualized consumer prices rose more than 2,000 percent, laying waste to much of the middle class. In an effort to protect real valuations, the government allowed the introduction of indexation. Unfortunately, this only made things worse by compounding past price increases to calculate future inflation. The result was an uncontrolled acceleration in consumer prices. The Real Plan, which was introduced by Cardoso, broke the cycle of hyperinflation by pegging the currency and introducing a set of major economic reforms.
However, several legacies remained. One of them was the linkage between government benefits and the minimum wage. The linkage was not an issue while inflation declined. The appreciation of the Real during the commodity boom allowed consumer prices to subside. As a result, nominal wages did not grow much. But, last year’s depreciation of the currency, as well as the big increases in utility rates, pushed consumer prices higher and bled into the government’s pension and benefits bill. These two items now account for almost 60 percent of the federal budget. By incorporating payroll and extraneous social entitlements, the line item goes up to 70 percent of GDP. As a result, the government’s primary surplus has become a deficit of 2 percent of GDP. To make matters worse, the SELIC rate could reach 16 percent this year. This explains why the nominal deficit will exceed 10 percent of GDP in 2016, thus pushing up the country’s debt to GDP ratio. The ratio was 68 percent at the end of 2015. It will probably reach 74 percent by the end of this year and will most likely be above 80 percent in 2017. Such debt dynamics will most likely mean lower credit ratings for the foreseeable future.
Fortunately, somethings are improving. The Lava Jato investigation is creating a new sense of accountability in the political system. A generation of young Ivy League-trained lawyers, such as Deltan Dallagnol (Harvard), Carlos Fernando dos Santos Lima (Cornell) and Sergio Mora (Harvard) restored the public’s trust in the judiciary. Not only did they achieve cult status within Brazil, they became the envy of developed countries, particularly Spain, which has been unable to rein in its political class. The corporate sector has also responded well. Under the strain of poor domestic conditions and a lack of access to the capital markets, CEO’s and CFO’s have resorted to streamlining businesses, shedding assets and taking whatever measures are needed to survive.
Still, this is not enough. The government needs to take steps to improve the structural stability of the fiscal accounts. It needs to break the linkage between inflation and benefits. It needs to trim government pensions, and it must improve the coordination between the states' tax systems. It must also resist the temptation of raising taxes. Brazil already has one of the highest tax burdens in the world. The problem is that President Rousseff will not be able to make such difficult changes. Some of these reforms require constitutional amendments and a supermajority to approve. This is difficult for someone who is still fighting for political survival. Although the impeachment initiative is still alive, the opposition lacks the votes needed to oust her. That means that she will continue to plod along for another two years, leaving the country in a vulnerable position. However, Brazil now recognizes what it needs to do to emerge as a much stronger entity—which is the first step in any sustainable recovery.
Walter Molano is head of research at BCP Securities and the author of In the Land of Silver: 200 Years of Argentine Political-Economic Development.