Brazil’s “dream team” faces an economic nightmare

Fiscal Policy ▶ Investors are expecting miracles from the acting president ▶ “You’re having to do this ... exercise with a very weak economy”

Investors are bullish on Brazil. The country’s Bovespa equity index is up almost 19 percent this year, while the real has gained 13 percent against the dollar. One big reason for the rally: President Dilma Rousseff has stepped aside as she awaits an impeachment trial, which has allowed Vice President Michel Temer to take over as acting president.

The financial community expects Temer, a member of the Brazilian Democratic Movement, to pursue more market-friendly policies than Rousseff, who hails from the Workers’ Party. Goldman Sachs, in a research note to clients, dubbed his economic cabinet, led by Finance Minister Henrique Meirelles and Economic Monitoring Secretary Mansueto Almeida, the “dream team.” “The political transformation in Brazil is creating huge investment opportunities,” says Jan Dehn, the head of research at Ashmore Group, an emergingmarkets investor.

Yet the list of problems Temer and his team must tackle is daunting. In the first three months of 2016, gross domestic product shrank 5.4 percent year-on-year, extending a recession that began in 2014. The unemployment rate is 11.2 percent, its highest since at least 2012, and the central bank is struggling to tame inflation, which is running above 9 percent this year. “Markets are getting ahead of themselves,” says Desmond Lachman, a former deputy director at the International Monetary Fund who’s now at the American Enterprise Institute. “You’re not going to find a silver bullet.”

The new government has also already been tarred by scandal. Budget Minister Romero Juca was forced to step down in May over allegations he wanted to block a probe into graft and money laundering. Fabiano Silveira, the minister of transparency and control, resigned the same month after local press published a recording of a conversation in which he criticized the graft probe known as Carwash and offered advice to a politician under investigation.

A priority for Temer and his advisers is reining in a budget deficit of 603.7 billion reais ($179 billion), which amounts to more than 10 percent of GDP. That’s the second-highest level in the Group of 20, after Saudi Arabia. The administration has proposed putting a cap on federal spending, throttling back the costly government pension system, and withdrawing money from Brazil’s sovereign wealth fund to pay for government operations.

Making a significant dent in the deficit won’t be easy. Cut discretionary spending, and there’s the risk of a backlash from an already frustrated electorate. Raise taxes, and the recession could deepen. Privatize government companies? Beware the wrath of the unions. And any attempt to reform social security will take decades to have an impact on the nation’s balance sheet.

Lachman says that to put the economy on a healthy path, Temer needs to trim the deficit by at least 5 percentage points of GDP, plus address such long-term issues as social security, all without further depressing growth. “You’re having to do this whole exercise with a very weak economy,” he says. “If the politics are very difficult now, how much more difficult are they going to be in a few months’ time if the economy keeps sliding?”

Temer must also grapple with a mounting national debt, which climbed to 4 trillion reais last year—67 percent of GDP. Interest payments hit 464 billion reais in 2015. Debt is on course to top 80 percent of GDP within two years, according to Lachman.

While Brazil has foreign currency reserves of $376 billion, such high debt levels are worrisome for a country that missed foreign debt payments in the 1980s and received an IMF bailout in 2002. “Economies really suffer” when emerging-market governments accumulate too much debt, says Koon Chow, a London-based strategist at Union Bancaire Privée. “They tend to have more turmoil,” he says, “and asset prices are more volatile.”

The bottom line The acting president has little room to maneuver as he tries to revive the Brazilian economy.