Re­al­ity check In Brazil

Financial Mirror (Cyprus) - - FRONT PAGE - 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-tomar­ket 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 short­lived. 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.

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