"Brazil is back," Wellington Moreira Franco, one of
President Michel Temer’s most loyal lieutenants,
said at a business forum in May.
Indeed, Brazil has reasons to cheer. The country has pulled
free of recession. Action by the central bank has sent
inflation rates tumbling and interest rates falling. And the
president is advancing a multi-focus reforms agenda, including
pushing through new labor laws and a cap on fiscal
But few are quite as bullish as Moreira Franco, secretary
general of the presidency. Deeper reforms will be needed to get
Brazil’s economy on a footing to compete with
other emerging markets. Investors want to see Latin
America’s largest economy execute a turnaround,
but it is unclear whether Temer, hobbled by a weak political
standing and deeply unpopular with voters, will be able to make
Temer's already-abysmal public approval took a further
beating in May, when he was caught on tape apparently
discussing hush money payments with Joesley Batista, an
executive from JBS, the country’s largest
meatpacking company. Temer was up against a wall. He had to
assure a jittery market that he had no intention of resigning,
and his administration tried to play above politics.
"The president’s efforts aim to avoid the
political issues that could jeopardize the drive for reform and
the creation of an investment-friendly business environment,"
Moreira Franco said at the time.
Much of the political turbulence has since subsided and the
president has been able to advance his agenda. In July, as
corruption allegations dogged Temer, and Moreira Franco, for
that matter, the Senate passed a labor reform bill that aims to
cut business costs, despite opposition from trade unions. The
following month, Congress voted against putting Temer on trial
on charges of taking $12 million in bribes from JBS.
But the president’s weak standing, both in
Brasília and in the public eye, had suffered a harsh
blow. He had not been particularly popular when he took office.
Just 13% of Brazilians approved of his administration in July
2016, when he stepped in after the impeachment of former
President Dilma Rousseff, according to the polling firm Ibope.
But it got worse. Temer’s popularity rating sank
to just 5% this past July.
When Temer took office, the business community was
optimistic that he would deliver on promises to restore
economic growth. Temer stoked investor hopes by proposing a
series of reforms to get the country’s budget
deficit under control. He also appointed a pragmatic economic
team that included a former central bank governor, Henrique
Meirelles, as finance minister.
Temer has put his weight behind passing the reforms, deemed
as a necessary, if bitter, remedy for an ailing economy.
Unencumbered by the expectations of the next election, Temer
was supposed to push forward with unpopular measures, such as
raising taxes and cutting spending.
But a technocratic approach that mixes market-minded
economic policies and backroom politics can only go so
Meirelles has said the fiscal reforms could move through
Congress before the end of the year. But a growing number of
economists think Temer will leave the issue for his successor.
The delay has frustrated the market, especially with the next
presidential election still over a year away.
"What is disappointing is not the fiscal outcome, although
we would have preferred stronger numbers for sure. What is
disappointing is that up to now, the government has not passed
social security reform, and Congress does not seem to be
totally convinced of the urgency to do so," says Mario
Mesquita, chief economist at Itaú Unibanco.
"The market has lowered its hopes of what to expect," says
Alberto Ramos, co-head of the Latin America economic research
team at Goldman Sachs.
After a two-year recession – the economy shrank
3.9% in 2015 and dropped another 3.6% in 2016 – Brazil
has eked out muted growth rates in the first half of 2017. The
economy beat forecasts in the second quarter, but GDP only rose
0.3% year-on-year, helped by a bump in consumer spending. The
government predicts GDP will grow just 0.5% in 2017.
Although unemployment remains high, it came in at a
lower-than-expected 12.8% in July, as the economy added jobs
for the first time since August 2015. That growth, however,
came more from the informal economy and the public sector than
salaried employment in the private sector, Ramos says.
"Stability is not good enough. We need to find ways to grow,"
"It is a modest recovery, especially considering how deep
the recession was," says Arminio Fraga, the former central bank
president, who now leads the investment management firm
Gávea Investimentos in Rio de Janeiro.
Indeed, despite growth tilting up marginally, other economic
indicators remain listless. Productivity in Brazil, which was
already low by international standards, fell by 4.8% between
2014 and 2016, according to research by the
Fundação Getulio Vargas (FGV). Meanwhile,
investment levels tumbled 26% and could decline another 3% this
year, FGV says.
"The drivers of growth are not as strong as they used to
be," says David Beker, chief Brazil economist and fixed income
strategist at Bank of America Merrill Lynch in São
Paulo. The bank forecasts Brazil’s economy will
expand by 0.25% in 2017 and 1.5% in 2018.
But the worst may be over. The precipitous fall in
investments stemmed in part from the troubles faced by the
state-owned energy company Petrobras, wracked by the Lava Jato,
or Car Wash, bribery investigation. But now Petrobras has
started to turn around, which could help investments levels
recover, according to Mesquita. "This provides a bit of a
cushion in macroeconomic terms," he says.
The Instituto de Pesquisa Econômica Aplicada (IPEA),
the government’s own economic research
organization, sees a slight increase in investments in the
coming months, propped up by the private sector.
"Investment has remained weak, and there is the influence of
the ongoing scandals," Beker says. "Consumers are already
leveraged, but we expect the strong decline in interest rates
is going to help growth."
Other economists share the optimism. Although Brazilian
businesses want to see faster action from the president, the
Temer administration has passed reforms, including a cap that
limits the growth of federal government spending to the rate of
inflation for at least 10 years.
"Reforms are back on the agenda," Beker says. "It is
something [the government is] going to pursue in the coming
Reforms, especially a social security overhaul that includes
increasing the average retirement age from 54 years old, are
crucial for Brazil to grow in the coming years, according to
members of the president’s economic team.
Inflation has already dipped below the 4.25% target, and the
central bank has cut the Selic, its overnight lending rate,
below 10% for the first time in four years. It aims to get it
below 8% by the end of the year.
"Structural interest rates in Brazil were at 5% in real
terms in the past few years," Central Bank President Ilan
Goldfajn told journalists in August. "They were 10% in previous
decades. Now they are around 3% or 3.5%. The importance in the
long run is that we will be able to reduce neutral rates, and
for that we need the reforms. Real interest rates are now at a
low level, historically speaking. We believe the lower
borrowing rate can stimulate the economy."
The drop in inflation has lent more credibility to
Brazil’s monetary policy, says Fraga, who had
appointed Goldfajn as economic policy director at the central
bank in 2000.
"Given our sad inflation history, the achievement is quite
remarkable, and it has allowed significant interest rate cuts,"
Fraga says. "The massive recession has played a role, but the
central bank deserves a lot of credit for the solid anchoring
it has provided. Markets have responded well so far, but
further and sustainable gains will require significant
reductions in political uncertainty and long-term fiscal
Debt pile mounts
Despite the improvements in growth, employment and
inflation, official statistics show that Brazil’s
fiscal profile has gone from bad to worse. The
country’s net debt-to-GDP ratio stood at 73.8% by
July, up from 51.5% at the end of 2013. The average ratio among
emerging markets, according to the International Monetary Fund
(IMF), was 47.4% in 2016.
And the debt pile is only set to get higher. The IMF expects
Brazil’s net debt to rise to 87.8% of GDP in 2022,
even if pension reforms are enacted. Economists at Santander
are more glum, forecasting Brazil’s net debt to
equal 92% of GDP in three years. Even the Brazilian government
admits the ratio will keep rising until at least 2020, with the
first budget surplus not coming before 2021.
"If you look at the size of the Brazilian government,
it’s big," says Beker. "If you look at the
deficit, it’s big. If you look at the primary
deficit, it’s big. We need tighter fiscal policy
to have a more relaxed monetary policy."
The goal, according to Planning Minister Dyogo Oliveira, is
to turn the primary deficit before interest rate payments from
2.5% of GDP into a surplus of the same magnitude. "This is the
size of the task that Brazil needs to achieve over the next 10
years," he says.
Regardless, the government increased the budget deficit
target for this year and next to 159 billion reais ($50.9
billion), up from an initial estimate of 139 billion reais for
2017, due to lower-than-expected tax revenues.
Yet it is public spending that will make lowering the
deficit most difficult, Oliveira says. "Public spending has had
a vertiginous rise over the past years, from 14% of GDP to
almost 20%. Now, we will have to bring spending back to 17% of
GDP," he says. "We are currently spending 57% of the federal
budget on pensions, nearly 435 billion reais. We are using
resources to pay pensions and have very little to invest."
Fraga calls Brazil’s debt load a "relevant
vulnerability," but doubts the government can reduce spending
to 17% of GDP in 10 years. "Even if social security reform in
particular gets done, I have a hard time seeing it," he says.
"It is all quite impressive but in practice it means a
back-loaded fiscal adjustment, so the debt ratio is certain to
keep on rising."
Mesquita says turning the deficit into a surplus hinges on
the pension reforms. "The main pillar of [the
government’s] strategy, which is spending limits
in the medium term, is something that it will not be able to
deliver if it doesn’t pass pension reform."
Reforming a state pension system is controversial anywhere,
and in Brazil it is arguably even more complicated. With a
myriad of centrist parties, called the centrão, or the
big center, clamoring for compensation in return for
voting against pursuing Temer’s corruption
charges, Congress is sharply fragmented. If it does debate the
proposed pension reforms, it is likely to water down the bill
from its original form, says Marcelo Carvalho, chief economist
for Latin America at BNP Paribas.
That dilution has already started. The initial proposal
would have saved the government around 2% of GDP per year over
10 years. As the bill went through congressional committees,
that fiscal saving was dialed back to around 1.2%. More
negotiations will likely reduce the impact on the budget even
more, to around 0.5% to 1% of GDP, Carvalho says.
"Simply put, reform is inevitable. If the current government
does not get it done, then the administration taking office in
2019 will have to do it – but then probably in a
harsher version to make up for lost time," Carvalho says.
The rate at which the social security costs are rising
illustrates the urgency, increasing by almost 50 billion reais
in the past year alone, almost twice as much as the budget for
the government’s infrastructure investment
program, known as the Programa de Aceleração do
Crescimento, or PAC.
Yet social security is no longer the most pressing concern
in Congress. Electoral reform, which has to go to a vote before
the 2018 election, has drawn the attention of lawmakers.
Congress could also delay a vote on the Temer
administration’s plans to replace the loan
subsidies from the national development bank BNDES with costs
closer to market rates.
In the meantime, the government doubled the tax on gasoline
in July, looking to raise money to offset the deficit. "The gas
tax hike shows the political strength that the economic team
has to meet the fiscal targets for this year," Carvalho
Still opportunities to invest
Given the political uncertainty, investors are looking for
the government to unload tangible assets, particularly through
a privatization and infrastructure concessions program. The
government earned 3.72 billion reais in fees in March, when it
auctioned four airport concessions to European bidders. More
airport concessions, including Congonhas in São Paulo,
could go to auction, and the government’s
Investment Partnerships Program, or PPI, is slated to grant
contracts for hydroelectric dams and oil and gas exploration
blocks in late September.
The administration also plans to privatize 57 state-owned
businesses, including the federal utility company Eletrobras
and the national mint. Eletrobras, which has accumulated losses
of 228 billion reais over the past 15 years, according to the
asset management company 3GRadar, has attracted interest from
the local units of EDP – Energias de Portugal and
Engie of France. The government could earn an estimated 20
billion reais from the sale of part of its 51% stake in
"Fiscal pressures are the main reason behind the sale," says
a former government official, referring to the budget deficit.
"The fiscal issue is so strong that it may help overcome the
reluctance of some politicians towards privatizations."
Carla Junqueira, a partner at the law firm Mattos Engelberg
in São Paulo, says the "ambitious" privatization program
will have a positive impact on the economy, even if only some
of the 57 firms are sold. "In spite of the negative aspects
surrounding Temer himself, the economic stance of his
government is very responsible," she says.
While the fire sale could jumpstart investor interest, the
bigger impact on Brazil’s future could come from
the reforms. "It is not going to be the reform we may have
dreamed of but it is going to be what is possible for now,"
says José Guilherme Souza, a partner at the investment
firm Vinci Partners in Rio de Janeiro. "To me and to many
people I have been talking to, the main focus is politics,
rather than economics. That is the uncertainty that undermines
But Alexandre Schwartsman, an economist and the former
director of international affairs at the central bank, warns
against the complacency that he says has crept into the
Brazilian market. Investors are cutting Temer slack as a result
of their benign view on emerging markets, he says. The next
president will need to cut public spending – and there
is no guarantee that he or she will achieve greater success
than the current administration or even pick up
Temer’s politically unpalatable reform
"The market seems too quiet," Schwartsman says. "People feel
that liquidity will come this way whatever happens."