Brazilian president forced to backtrack as fiscal pressure grows ever greater

During her re-election bid Brazil's president Dilma Rousseff made great political capital by attacking her country's elite, bankers, The Economist and anyone threatening austerity.

But with four more years in power safely secured, militants from her Workers’ Party are now nervously wondering if she is about to start reaching out to these class enemies as she faces the task of dragging the world’s seventh biggest economy out of recession.

An early indication of attempts to reconcile with the business community – Brazil’s most productive regions all voted for her opponent last month – was a surprise increase in interest rates to 11.25 per cent days after her victory.

That helped calm markets which had plunged on the election result and are worried about inflation, which is still pushing higher despite the recession as the country flirts with stagflation.

But the country's business sector is demanding more. At a conference this week Robson Andrade, the head of Brazil's industry confederation, called for "clear and firm signals" that the government will take further measures to stabilise the economy.

The main area of concern is Rousseff’s fiscal policy and what action she will take to end the worrying erosion in Brazil’s public accounts. Her victory on October 26th owed much to record low unemployment and maintaining the purchasing power of salaries despite the economic contraction.

But the cost of delivering these social achievements is no longer sustainable without damaging the country’s reputation for economic prudence, warn economists.

Price freezes

Wages have been protected by holding inflation in check with a series of price freezes that amount to costly public subsidies. The fiscal problem largely stems from the president’s economic team seeking to prop up the consumer consumption that drove job growth in the last decade with a plethora of tax breaks that have hit its revenues at a time of looser public spending.

Last week, the country posted its worst monthly fiscal deficit since records began. To meet its own fiscal targets it is increasingly reliant on one-off items such as revenues from auctions for 4G phone licenses and oil fields.

“The government faces a severe problem in its fiscal accounts,” says Fernando de Holanda Barbosa Filho, of the Brazilian economics institute at the Getúlio Vargas foundation.

“It will have to make a very strong adjustment but must do it at a time when the economy is poorly and high inflation requires contractionary monetary policy. Next year is going to be very difficult.”

The fiscal deterioration allied to worries about declining transparency of the government’s fiscal reporting has rating agencies warning of downgrades. That could mean a loss of investment grade status which would automatically trigger a rush for the exits by many foreign institutional investors.

That in turn would place huge pressure on the Brazilian real as the country needs capital inflows to cover a growing current account deficit, in part caused by declining prices paid for commodity exports.

Like the rest of South America, Brazil rode the Chinese-driven commodities boom but is now having to adjust to the slowdown in the Asian giant. Local miner Vale, the world's biggest producer of iron-ore, has cut its investment plans in response to a 40 per cent fall in prices. The slowdown in China is not the only external challenge. The tightening in the US as the Federal Reserve ends quantitative easing, threatens to stem the flood of cheap money circling the world hunting for yield, much of which headed for Brazil.

But having campaigned against cuts, it is unclear how much austerity president Rousseff is willing to inflict to get her accounts back in shape. Early rumours that a large austerity package was being prepared have since been talked down.

Her cabinet strongman Aloizio Mercadante warned this week the government was not contemplating any “dramatic cut” in spending saying the priority remained to “maintain jobs and the income of the population”.

Political pain

Part of the problem is any adjustment will produce political pain for the government. It will be reluctant to slash public sector jobs, especially as many are organised in unions that backed the president’s re-election, while tax rises will be unpopular in a country that already pays European levels of taxation but gets very few quality public services in return.

Given the poor state of Brazil’s infrastructure the administration will also be loath to cut investment spending on badly needed public works projects.

Poor infrastructure is blamed by industry for the high cost of production in Brazil which erodes the country’s natural competitive advantages.

President Rousseff’s personal distrust of the business sector was seen in her first term as undermining government attempts to woo investors into putting money in a massive programme to upgrade roads, ports and airports. The initial auctions for concessions to invest in these produced disappointing returns as many investors stayed away, saying caps on returns were too low for the risk being taken on.

But economists from her Workers' Party claim these "one-off" problems have since been overcome. "Now I believe we are ready to move from a cycle of consumer-driven growth to investment-driven growth during the next four years," says Workers' Party economist Marcio Pochmann.

Successful auctions of infrastructure concessions next year would allow the government to raise cash via signing bonuses from winning bidders while boosting investment and spurring job creation, as new operators upgraded facilities which in turn would eventually reduce the cost of doing business in Brazil.

However, these longer-term hopes will not put off the need for more immediate action to shore up the public accounts. The next key indicator of how far the government will go in correcting the country’s economic course will likely be with the president’s nomination of a new finance minister.

The markets want Henrique Meirelles, who ran the central bank during the presidency of Dilma's predecessor Luiz Inácio Lula da Silva. A former BankBoston executive he is impeccably orthodox and strong enough to fight off interference from the notoriously micro-managing president.

Another favourite for the job is Nelson Barbosa, the ministry's former number two. He quit last year, reportedly frustrated at the influence more heterodox rivals had with the president. His return would also reassure markets but could create tensions at the heart of economic decision-making, especially as his former rival in the ministry Arno Augustin is tipped to become a special presidential advisor with an office down the hall from Rousseff's.

Whoever gets the job will have to act fast to restore confidence. In what has become an annual ritual, economists are already downgrading their growth forecasts for Brazil next year and in 2016, with many sceptical that any adjustment will go far enough.

"Brazil's fiscal indiscipline during the past few years will most likely be partially addressed by the administration in 2015, but probably not aggressively enough," warns Morgan Stanley in its latest research note. That, it warns, will prove an "obstacle" to recovery and "could eventually lead to a sovereign downgrade and the loss of an investment grade rating, probably in 2016".

President Rousseff might have run to the left during the recent campaign. But before she has even been sworn in for her second term she is under severe market pressure to tack back to the centre.

Asked about the economy yesterday, president Rousseff said she would carry out some “housekeeping” on the fiscal and inflationary front. But markets will be looking for more drastic action before they are convinced Brazil is ready to return to sustained growth.