Brazil at an Economic Crossroads

Short-term pain for long-term gain?

In September President Dilma Rousseff spoke at the United Nations, indicating that Brazil “will keep on moving on the democratic pathway.” Brazil has indeed made strides down the democratic pathway, but Latin America’s largest country has now reached another critical decision. One path roads leads to more responsible government; the other is a continuation of long-term and ultimately legitimacy-eroding corruption, which could throw the country into a new lost decade akin to the 1980s. The problem for President Rousseff is that this crossroads has been reached on her watch--and it is likely to cost her the presidency.

Brazilian democracy had made considerable progress since the end of military rule in 1985. The election cycle has advanced without interruption, bringing a succession of presidents from the right to the center-left. In 2003, Luiz Inacio da Silva (popularity known as Lula), the head of the Workers Party (PT), won the presidency.

Despite concerns about his leftist leanings, Lula became one of Brazil’s most successful presidents, made significant improvements in pulling people out of poverty, and won back-to-back elections. Lula then was able to help his protégé Rousseff, a former Marxist guerrilla, former chairwoman of the state-owned oil company, Petrobras, and his chief of staff become the country’s first woman president.

While Lula’s two presidential terms brought a sense of Brazil as a country on the move and filled its people with hope for the future, President Rousseff’s first term (2011-2014) was increasingly troublesome. There was a slowing in the country’s economic reforms, loose fiscal policy pushed public debt up to 60 percent of GDP, and in mid-2014 commodity prices began a descent from which they have yet to recover.

At the same time, reforms that injected real authority into the judicial and investigative branches of government uncovered a number of major corruption scandals, the most damaging of which involved Petrobras, high-ranking members of the ruling PT and their political allies, including the current head of the Congress, Eduardo Cunha (a member of the center-right Brazilian Democratic Movement Party or PMDB), who is facing criminal investigations for accepting a $5 million bribe and money laundering.

All of this played back into the country’s expanding middle class, which took its discontent against the government’s dysfunctional nature to the streets. Although President Rousseff was not indicted in any criminal actions, the scandal clearly disrupted the economic policymaking environment. Against this backdrop, President Rousseff was able to win re-election in 2014, but only barely.

Since then, Brazil is grappling with its worst recession since the 1930s, stagflation (that toxic mix of no growth and inflation) looms, and the real, the national currency, remains one of the worst performers against the dollar. Billions of dollars of value have been trimmed from the country’s stock exchange. In late September, the real broke through its all-time low against the dollar.

The currency decline is also raising questions over the ability of Brazilian private sector companies to meet payments in U.S. dollar-denominated debt. To be certain, Brazil does have substantial foreign exchange reserves and it is likely that the government would step in to assist Petrobras repay its debt. However, the same support is not likely for many of the private sector borrowers if they fall into trouble, something that clearly worries global investors.

A reflection of these growing doubts over Brazil’s creditworthiness was the loss of investment grade ratings from Standard & Poor’s in September. It is likely that Moody’s and Fitch, the other two major international rating agencies, will follow. Like many investors, the rating agencies have lost faith in a government increasingly perceived as unable to maintain a coherent policy direction. Real GDP is expected to contract by 3.0 percent this year and could well be in negative territory again in 2016. At the same time, inflation is close to 10.0 percent and unemployment in August was 7.6 percent.

What next for Brazil and President Rousseff? External factors are not constructive as the U.S. central bank is indicating it will be raising rates, which will increase borrowing costs. At the same time, Brazil’s major trading partner, China, has lower growth prospects, which means less demand for Brazilian exports.

President Rousseff needs to demonstrate a more aggressive stance in dealing with the recession and the deterioration in the government’s fiscal picture. While Finance Minister Joaquim Levy is well-respected in international financial circles, the Rousseff cabinet is the repository of different ideas, some of them opposed to austerity. Even the President’s support for Levy’s measures has at times been questionable.

Congress is not likely to be much help. The network of those involved in the Petrobras scandal has widened to entangle a number of its members, which makes the passage of new austerity and tax measures more difficult. At the same time, the government cannot count on much support from the opposition parties, which see the situation as a positive for the 2018 elections.