Eitan Urkowitz: This is Eitan Urkowitz at the Peterson Institute for International Economics. Brazil is engulfed in another political scandal that has sparked investor panic and has thrown markets into disarray. Joining me is Monica Debolle, senior fellow at The Institute. Thank you for joining.

Monica Debolle: Thank you.

Eitan Urkowitz: What does this mean for the reforms that President Temer has been trying to push for?

Monica Debolle: So this scandal is actually a spin-off of, well not exactly a spin-off, it's kind of like a continuation of the corruption scandal that has been plaguing Brazil for nearly three years now. But this time it's even bigger than we thought. So at first, let me just use a quick analogy here so that people understand this more clearly.

At first, what seemed to be the big bombshell in terms of the whole scandal was Odebrecht, the construction company that was involved with Petrobras, the oil company in this bribery scheme with politicians, they had their plea bargains, they revealed a lot of information on many politicians and their involvement specifically in all of this. And it seemed like the Odebrecht plea bargain was really the big deal.

Now we have another follow up to this saga that is coming out of JBS. JBS is the meat packer and meat producer, and the world’s largest actually, meat packer and meat producer. It became that large during the PT Government because it did receive a lot of money from state owned bank, BNDS. And that particular company, they have huge U.S. operations, they've been under investigation for a while.

And to kind of think about this, I like to make an analogy with the 2008 financial crisis. So Odebrecht has been, for the Brazilian corruption network, what Lehman Brothers was in the 2008 financial crisis. JBS is AIG. So basically it engulfs the Odebrecht plea bargains and scandals, and has revealed a lot more than the Odebrecht executives have.

It has revealed, in particular, that President Temer has some kind of involvement in the whole corruption that's taking place in the country. And obviously, and this all came out last week, and has completely stalled the reform effort in Brazil as we speak.

Eitan Urkowitz: So what were the reforms that President Temer was trying to push through?

Monica Debolle: So there were three reforms that were very important. One of which was passed last year. That was a spending cap. So the, Brazil's big problem is trying to get a grip on the fiscal accounts going into the medium term, because everything looks very, very unsustainable, including as we speak. Things are still unsustainable. Things have not been fixed.

So part of the strategy to fix the medium term fiscal outlook, the debt trajectory, and so on, was to introduce this spending cap. And this was introduced in December of 2016 as an amendment to the Constitution. The problem is that the spending cap on its own doesn't really do much because a large part of government spending in Brazil has to do with Social Security benefits and pension payments and so on.

So the complimentary reform to the spending cap was a Social Security reform. And this is the big one. This is the one that the Temer government has been trying to pass, and was actually having some success despite it being a very unpopular reform, getting the appropriate level of congressional support in order to approve this reform.

Without this reform the spending cap has no bite, because essentially you know, Social Security is really the big issue that unhinges the fiscal accounts into the medium term. And that reform has actually stalled now because of this latest scandal.

The other reform that doesn't have so much to do with the fiscal accounts, but nonetheless, is needed to sort of unlock productivity in Brazil, is the labor reform. So Social Security and labor reform were the two reforms that were under discussion in the Brazilian congress, and currently they've been frozen.

Eitan Urkowitz: So what are the economic implications of the scandal? Is Brazil headed for another recession?

Monica Debolle: So it all depends on how this scandal actually unfolds. President Temer, at the end of last week, after this, the news broke out of you know, his alleged involvement in, in wrongdoings, he came out very forcefully in two televised speeches basically saying that he would not resign.

A large of the Brazilian media has actually called for his resignation. The population, at large, is very dissatisfied and is also calling for his resignation. His approval ratings in Brazil are currently extremely low, only at seven percent, thereabouts. So he's really lost, with this he's really lost a lot of support. And it seems like his governing base is crumbling at this moment.

Some people have left the government. Some parties have left the government. Smaller parties, but you know, the whole situation is very fluid right now. So the sense is that you know, he probably won't be able to remain as president. But so far he has resisted calls for his resignation. Which has basically thrown Brazil into the kind of situation that it faced back in 2016. In 2016 when the whole Rousseff saga was ongoing, and there was this huge political uncertainty. She had lost govern-ability, but at the same time, she was refusing to resign.

So the outlook here is very dependent on what, what's next. So if there's a swift removal of President Temer in some way or another, and there are a few avenues that can be pursued to remove him from office, presumably one could think that the reform effort could still be salvaged to some extent. And that would obviously, stabilize the economy.

As of right now, because of his resistance and because of his show of resistance towards you know, the possibility of resigning, markets have been reacting very badly. Today the stock market is falling again. The exchange rate is devaluing quite massively. Future interest rates are also very, are you know, the, the yield curves are widening. So there's a general sense that you know, him staying in power is not a solution. He has got to go.

Eitan Urkowitz: So if President Temer does not finish his term in 2018, what are the next steps politically? Who takes over?

Monica Debolle: So here's where we get into very muddy waters, because it's very unclear. The Constitution, the Brazilian Constitution basically says that if the, if Temer is ousted by some means, and there are several, we can get into the weeds but I don't think it's worth it.

Eitan Urkowitz: Mm hmm.

Monica Debolle: If he is ousted, the Constitution says that indirect elections need to be called within 30 days. And the person who does this is the current speaker of the house. So the current speaker of the house becomes the interim president for a period of thirty days, calls these indirect elections. Indirect elections basically means that the caretaker president would be elected by the congress and would be in place until October 2018 when the general elections take place.

That is what the Brazilian Constitution says, and that is probably what would be the best outcome at this point for Brazil. Because this would mean that you could quickly have another government installed, a caretaker government, that could possibly, you know, lead the reform effort and try to salvage a few of these things.

The other possibility is that Temer undergoes a lengthy impeachment process. If he does, it's the same story that we saw in 2015, 2016 with Dilma, it can take months, it's very messy. The country would probably go into a tailspin. In that scenario, we would likely see a recession again in 2017, the fiscal accounts would blow up, markets would become extremely turbulent, it would be a complete mess. That's the second scenario.

And the third scenario is one where he stays, which is very similar to the impeachment scenario because given that he's lost govern-ability, you know, his ability to actually handle the reform effort and actually take things forward is basically exhausted at this point.

Eitan Urkowitz: Thank you, Monica.

Monica Debolle: Thank you.