Why investors aren’t pricing political risk properly

In many respects the plan is working to perfection. Brazil’s business class wasn’t particularly discreet about its desire to get In many respects the plan is working to perfection.

Brazil’s business class wasn’t particularly discreet about its desire to get rid of former president Dilma Rousseff and replace her with a government that would restrain out-of-control government spending, bring in market-friendly reforms and get the economy growing again.

Michel Temer, Rouseff’s vice-president, certainly did not prevaricate in leading the rebellion, finding as he did reasons enough to co-opt personal ambition with a loftier goal of national good.

A constitutional amendment followed his inauguration in August last year that freezes public spending in real terms. Even if the World Bank published a report on it that could be summarized with an emoticon of raised eyebrows, the markets loved it. ‘Fiscal discipline’ had been written in very large letters.

This, along with other symbolic noises, was enough to lead to a swift fall in the risk climate, reflected by lower credit default swap spreads and lower debt premia. The Bovespa rallied on this risk adjustment – particularly the banks. All was becoming right with Brazil.

But this superficial improvement is very misleading. One core problem with this turnaround narrative is that the economy hasn’t actually followed suit. GDP growth in the fourth quarter of 2016 was still -0.36%, the eighth consecutive quarterly decline.

Some leading indicators suggest positive growth may return in the first quarter of 2017, but even if it does, it will be from such a low base and will be so weak that it will not feel like a recovery to ordinary Brazilians.

The still-growing unemployment numbers will be a greater influence on consumer sentiment and they are not expected to stop rising until the second half of this year at best. The constitutional amendment to headline spending was the easy part. Politicians love symbolism and there was a collective impulse to sign up to an aspiration of fiscal discipline. The hard part, however, comes next. To freeze spending, there need to be real cuts to social security expenditure and, in particular, pensions.

That these reforms are necessary is clear to anyone familiar with Brazilian debt dynamics and demography. The entitlements are far too generous.

But it is easy to take the macro view as an economist or journalist. To take away long-held pension rights from poor and middle-class Brazilians is something else.

Are these individuals going to be placated by pointing out that without reforms and new minimum retirement ages, social security spending will be higher than 18% of GDP by 2060?

They won’t say: ‘Fair enough’, even if you point out that the working population will peak in 2030 and the elderly will surpass the young by 2050.

No, they’re more likely to say: ‘You’re taking away what now?’

And the ability to force through these measures will come down to the government’s political support and political capital. And here comes the problem. It has very, very little.

Rousseff was weakened by spectacular economic failure as much as her inability to forge political ties within her coalition, and was left stranded as the plotters made their move.

The following municipal elections were a disaster for her political party, the PT.

The results gave short shrift to those who argued that the people viewed her ousting as a coup d’état. But that is not to say Temer reaped a political reward from getting her out of the Planalto. He didn’t. A recent poll showed his personal approval rating at 24%.

Temer’s unpopularity is not surprising: he was tainted as vice-president, and many view his decision to act as self-preservation. The ‘Lava Jato’ corruption investigations were (and still may be) moving closer to him personally and many of his political allies. The whole political class in Brazil is tarred with corruption, the irony being that Rousseff was one of the very few in a position to benefit from corruption but who were not personally accused.

Brazil is seething. The people are angry and disillusioned and the politicians do not have any legitimacy. Even the courts, which were once believed to represent a hope for justice, have become politicized as the leading Lava Jato judge, Sergio Moro, has allowed himself to be seen as an agent of opposition party PSDB, through injudicious public appearances with their leaders.

It is in this febrile environment that the government is set to push ahead with unpopular reform.  Brazil could be about to see huge, potentially violent, protests – perhaps sparked by predictable issues such as pension reform, or perhaps something less predictable, such as another police killing of a black youth in a favela, or a leak of evidence incriminating Temer. It could be anything.

Or the government could get lucky. That spark might not come. A society tired of scandals and long-accustomed to putting up with an abusive political system (half the population still doesn’t have access to a sewage system, while the development bank, BNDES, has been enriching privately held multinational companies through subsidized lending) may wearily shrug a collective shoulder and wait for next year’s presidential election.

Ultimately that could be the worst outcome for Brazil. For if the people’s anger is repressed to that point, it could be vented in a choice of the populist candidate – yes, I’m thinking of far-right politician Jair Bolsonaro – who would make Donald Trump look like an ineffectual clown.

For more analysis of Brazil and Latin America visit Euromoney’s website

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