Last updated: 16:53 / Tuesday, 24 November 2015
Schroders’ Report

A Very Brazilian House of Horrors

A Very Brazilian House of Horrors
  • The corruption scandal at Petrobras and allegations over accounting irregularities in the last president election’s campaign and government finances leave Dilma Rousseff weakened even as the economy continues its tailspin
  • Rumors of finance minister Levy resignation on mid-October prompted downward pressure on Brazilian asset, and fueled volatility in the markets
  • Brazilian corporate investment is moribund, consumers are crushed by their debt burdens, government spending is squeezed by attempts at fiscal consolidation, and inflation has continued to climb

With China hogging the emerging markets limelight in recent months, it has been easy to lose track of developments elsewhere. With China worries calming now, it seems a good time to review just how bad things have become in Latin America’s biggest economy. President Dilma Rousseff has suffered a series of painful setbacks since her election victory last year, and in many ways is now in political exile despite being nominally in power – approval ratings signal how rapidly the situation has deteriorated (chart 10). The corruption scandal at Petrobras and allegations over accounting irregularities in her campaign and government finances leave the president weakened even as the economy continues its tailspin. The combination of political and economic paralysis has seen a wave of growth and credit downgrades for Brazil, and it is hard to see a rapid turnaround. According to Schroders, it could be years before Brazil recovers meaningfully.


The Petrobras scandal (commonly referred to as the Lava Jato, or ‘Car Wash’), has continued to spread, contaminating larger and larger swathes of the corporate and political sectors in Brazil. It has now reached Dilma’s current political nemesis, Eduardo Cunha, speaker of the Lower House.  Unlike much of the scandal to date, this revelation presents a possible boon to Dilma. Cunha is spearheading attempts to impeach the president, and his removal from office would provide an opportunity for Dilma to rebuild relations with the lower legislature. One tentative olive branch, in the form of a cabinet reshuffle which ceded more political power to the party of vice president Temer – the PMDB - appears to have backfired by angering other smaller parties in coalition with the PMDB, which were not included in the largesse. They have now splintered from the PMDB, creating a more fractured Lower House which will be even more difficult to reconcile. The reshuffle, which removed a key ally of the president, also leaves Dilma increasingly isolated within her own government, with former president Lula steadily building control in what some have dubbed a virtual regency (though Lula holds no position of power de jure, he remains influential within the ruling party and popular in Brazil at large). There are concerns that Lula’s next step will be to push for the removal of finance minister Levy, who has bought the government what little fiscal credibility it has. Rumors of his resignation on Friday 16th October prompted downward pressure on Brazilian assets but have since been quashed – likely reflecting assurances from Dilma to Levy that the government would continue to back his fiscal consolidation efforts. This drive by Lula is also likely a result of the Lava Jato scandal, which has begun to implicate family members. Political analysts at Schroder’s Eurasia Group suggest that Lula’s only chance of avoiding prosecution would be if he could portray the investigations as an attempt to undermine the left, and that to do this he needs to reinvigorate his traditional electoral base. Attacking fiscal consolidation is one way to do this. It was mentioned above that the rumors around Levy fueled volatility in Brazilian assets. More generally, the backdrop for all of this power broking has been an increased likelihood of impeachment for Dilma, forcing the concessions discussed above. This has generated a good deal of volatility across Brazilian markets, with participants seemingly hoping for an impeachment and fresh government.


Is this justified?

Dilma is increasingly powerless and under siege from enemies and allies alike. The corruption scandal is engulfing an ever growing share of the political class and ensuring political energies are focused upon the investigation rather than reform efforts or fiscal consolidation, while those politicians so far untainted are currently deeply unhappy with Dilma – in part because they are being egged on by the Lower House speaker, Cunha. As things stand it is difficult to see how Dilma can lead Brazil out of the mire. Even if Cunha is forced to step down due to the corruption allegations he faces, it is not certain that the new speaker will be any more amenable – there is a strong incentive for the main coalition party, PMDB, to push for impeachment. Vice president Temer, of the PMDB, would then assume the presidency. Though good for the PMDB, this would not necessarily be good for investors, given the exposure of that party to the Lava Jato scandal - so more of the same political paralysis.  What would be a good outcome? One possibility is that Dilma’s re-election is declared void. The country’s highest court has authorized an investigation into the president’s re-election accounts, following revelations that kickbacks from a construction firm were paid into the campaign’s coffers. If compelling evidence is found that serious electoral violations took place and were significant enough to impact the race for the presidency, the election result could be revoked. Though obviously a disruptive event, this would clear the way for a more market friendly, and scandal free, government to be elected. They would find they had plenty to do.

The undead economy

Activity continues to flatline, with corporate investment moribund in the wake of the Lava Jato scandal, consumers crushed by their debt burdens (chart 12), and government spending squeezed by attempts at fiscal consolidation. Yet despite this, inflation has continued to climb, in hideous parody of a booming economy. The Brazilian zombie economy, lifeless and yet animated, is enough to make policymakers hide behind the sofa.


Is there any hope for Brazil?

Certainly, the current trend is a negative one, as reflected by the recent S&P and Fitch downgrades, which take the country’s sovereign debt within a whisker of junk status, driven by concern over the fiscal consolidation process. Schroders has written many times, too, on the supply side issues plaguing the economy, contributing to the persistent inflation problem, and the ‘Dutch disease’ inflicted by the multi-year commodity boom, which drove up unit labor costs and rendered Brazilian industry uncompetitive. On the fiscal and supply side concerns, there is little hope for immediate relief. The political situation all but guarantees a lack of productive legislation until a new government comes to power, unencumbered by corruption allegations and infighting. However, market forces are beginning – if only by a war of attrition – to generate an improvement in other metrics. For example, unit labour costs (chart 13) have finally begun to decline as unemployment builds, which ought to lead to an improvement on the trade balance, as seems to be happening (chart 14).

All in all, Brazil’s horror story is far from its final act, but perhaps a glimmer of hope is becoming apparent on the very distant horizon. There can though be no painless resolution; perhaps the best case scenario is an early exit for Dilma followed by new elections that allow a purging of the rottenness seemingly embedded at the political core and a new energy with which to pursue reforms.