Brazil Special Report: Overview

Ascension to investment grade is thwarted by fiscal problems, as well as growth, inflation and rates. A lame duck president looks unlikely to tackle the issues head on.

On the first Friday in January, equity trading volumes in Brazil collapsed to 2% of normal levels and market chaos reigned. The text of a rushed new tax law was so badly worded that banks were unsure whether it applied to share transactions involving foreign money. Investors duly sat on the sidelines.

That story highlights the impact of the government’s December defeat in the Senate over renewal of the CPMF, a major financial transaction tax and central plank of President Lula’s second mandate. Failure prompted a scramble to implement replacement taxes by decree.

The loss was made all the more bitter by the fact that it was a handful of dissident votes from within the pro-government coalition that tipped the balance, says Edmar Bacha, senior economist at Banco Itaú BBA. Quite apart from the humiliation, the hit to the government’s pocket of 40 billion reais per year is serious. The fiscal situation is now much worse than anticipated, he adds.

The government started by seeking to make up the shortfall through new taxes and spending cuts. But realizing that an attempt to raise new taxes might run aground in the Senate and finding reductions, at least on current spending, unpalatable, other easier escape routes are now under scrutiny, says David Fleischer, professor of political science at the University of Brasilia and a political consultant at Brazil Focus.

Finessing the accounts is one solution. The government is looking to take spending on the growth acceleration program, PAC, off the books in a move that could help it meet its primary budget surplus target of 3.8% of GDP, contributing as much as 0.5% to the total, says Bacha. Even so, some contraction may be necessary for the slow-moving PAC, although Fleischer says another round of highway concessions is imminent and a second auction of a hydro electric power station on the Rio São Francisco is slated for May.

Government accountants are meanwhile revising projections to revenues, saying that they expect 10 billion reais to be generated from economic growth, says Tom Trebat, executive director at the Center for Brazilian studies at Columbia University. That looks too optimistic in a year when the global economy is trending down much faster than anticipated.

Growth may slump to as low as 2.0%-2.5% next year, thanks to a full unwinding in credit markets and global knock-on effects, says Walter Molano, head of research at BCP Securities. Fiscal deterioration comes at a time of a rapid deterioration in the trade balance, with imports up 32% last year, driven by a strong real.

These uncertainties and higher global inflation are now feeding into worries about interest rates. As Bacha points out, the government had been counting on a rapid decrease in rates to reduce the deficit. That does not look likely, particularly given Henrique Meireilles’ reputation for resolute hawkishness.

The outcome of all this is likely to be a delay in Brazil obtaining the coveted investment grade. Trebat points out that agencies are more risk averse after miscalculating the extent of the credit crisis, and that tax reform is a prerequisite.
It is not just in the financial sphere that the CPMF defeat is hurting. It has made an already cautious government more dithering and underscores the likelihood that two years of fractious politics will follow. Already, the opposition has gone to the supreme court to try to declare proposals for new financial transaction taxes unconstitutional.

Doubtless, there will be plenty more opportunities for such antics, with municipal elections slated for October. And the campaigning schedule means that there are only another three months of useful time in congress this year, points out Fleischer. That means the faint hope of reforms in tax or labor laws passing have been consigned to the dustbin.

The overall sense of stagnation and shapeless agenda is highlighted by a preoccupation with appointments. Lula seems determined to please all parties to keep squabbling factions of his unwieldy coalition happy ahead of October elections. That is likely to prove difficult, says Fleischer. The PMDB is engaged in a bloody battle internally between senators and deputies who are each rooting for their own candidates. And other parties in the coalition are calling for more spoils.

The contortions of this process are seen in the appointment of the inexperienced but key ally, Senator Edison Lobão, to the highly sensitive position of mines and energy minister. The decision came despite Lobão’s son and suplente, his designated substitute, being investigated for transferring shares to his maid to avoid taxes, as well as alleged corruption in the acquisition of local media.

The depressing reality is that the last two years of Lula’s government may look rather like the last year of the Bush presidency in the US. It will be characterized by growing irrelevancy an opposition that is in the ascendancy and increasingly bolshy, as well as a weakening economy.

The only major difference is Lula’s continuing popularity. That should shield him from the need to enact reform

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