The Brazilian Political Crisis Lessens Chances of Economic Resolution

Monica de Bolle (PIIE) and Tamim Bayoumi (PIIE)
December 14, 2015 4:45 PM

Market euphoria over the prospect of a Brazilian presidential impeachment is likely premature—and belies global investors' apparent lack of familiarity with Latin American politics.

The latest developments in Brazil predicate big political changes but not necessarily major economic ones. Impeachment proceedings initiated by the Lower House in recent days may yet lead to President Dilma Rousseff's ouster in 2016, but major economic challenges will remain. The increasing likelihood of a credit rating downgrade, as signaled by Moody's recently, would strip Brazil of its investment grade rating alongside an earlier S&P downgrade and add to the turmoil facing the country in the coming year.

The last few weeks have revealed the extent of Brazil's rapidly evolving political crisis: the rupture between Vice President Michel Temer and President Rousseff, the start of an impeachment process in the Lower House, as well as the first arrest in history of a sitting senator—none other than the government's leader of the Senate. These developments underscore the unpredictability that the country is mired in. The special commission recently formed by pro-impeachment members of the House may have sealed Rousseff's fate, and many have already begun to speculate about what a post-Dilma government would be able to achieve. This may be somewhat premature. The Supreme Court has yet to rule whether aspects of the process itself are constitutional, including whether this commission should prevail.

Brazil's latest economic indicators show the depth of the country's problems: GDP is expected to contract by about 4 percent this year, marking the worst recession since 1990; inflation should exceed 10 percent by year-end despite falling activity; the government has already announced that it will post a primary fiscal deficit of 2 percent of GDP this year; and the nominal deficit should end 2015 near 10 percent of GDP, while the gross debt-to-GDP ratio is projected to rise to 70 percent this year, from 65 percent in 2014.

Since Brazil's inflation has increased substantially over the last two years, a better way of calculating the fiscal burden utilizes the operational deficit concept: According to this definition, adjustments to the interest bill associated with high and rising inflation should be excluded from the deficit measure to properly reflect the excess of expenditures over revenues. The operational deficit in Brazil currently stands close to 3 percent of GDP. At this rate, gross government debt could mount to 90 percent of GDP by the end of 2017, underscoring Moody's recent decision to review the country's ratings. It also highlights the sizeable fiscal adjustment that needs to be engineered in the midst of collapsing activity and rising unemployment.

In the current toxic political environment, any advancement on fiscal adjustment is unlikely. In fact, as 2015 has demonstrated, Brazil's political stalemate and its devastating impact on business and consumer confidence have aggravated the economic imbalances largely created by a sequence of bad policy decisions over the last several years. Policy mismanagement and Brazil's version of so-called "state capitalism"—the increasing intertwinement of private- and public-sector interests via the concession of subsidized credit from public financial institutions under obscure conditions—have not only brought the economy to its knees but have served to amplify corruption at all levels of the political and business establishments.

The graft scheme originating at Petrobras, the state-owned oil company, and the ever-widening course of the investigations are reminiscent of Italy's "Clean Hands" ("Mani Pulite") operation of the 1990s. In that case, traditional political parties were dismantled, and several arrests and indictments dealt a severe blow to the business community. The operation also led to a long period of political paralysis and economic stagnation, as uncertainty about the future reduced confidence. This is the real risk to Brazil coming out of recent events.

It is too early to draw conclusions about how a similar scenario might materialize in Brazil, but one thing should be clear: Whether impeachment leads to the ouster of Rousseff or not, the investigations will continue, more arrests will be made, further wrongdoings will be revealed, and the political stalemate will continue at some level. That might be just enough to prevent the major economic reforms Brazil so desperately needs.

By Monica de Bolle and Tamim Bayoumi.