Less than a year after a series of corruption scandals threatened to bring down the Lula government – and opposition parties held their fire on the theory that a devastated Lula administration would only increase their chances in the presidential election on October 1 – Lula looks set to waltz back into power for a second term, quite possibly with an easy first-round victory. Part of the reason for his electoral success will be the fact that for all the political noise surrounding his administration, the Brazilian economy has done remarkably well under his tenure. Spreads on Brazil’s sovereign debt have come down from the quadruple figures to just 220 basis points over Treasuries, and with an upgrade from Moody’s in August, all three major credit rating agencies now put Brazil at the BB level, just two notches away from investment grade. The central bank has managed to keep inflation under control – albeit with very high interest rates – and foreign investment has been pouring into the country so fast that foreign reserves are likely to end the year at the $100 billion mark, even after $14.5 billion in prepayments to the IMF and billions more spent on buying back Brazil’s dollar-denominated bonds.
And on the fiscal front, Lula’s left-wing government has not only met but, in 2005, comfortably exceeded the targets it inherited from the center-right administration of Lula’s predecessor, Henrique Cardoso. Says Michael Hood, Brazil analyst at Barclays Capital: “The Lula government’s fiscal performance represents quite a feat, considering the sweeping promises for social transformation made during the 2002 campaign and the pressure for increased public spending that has characterized the last few years.”
Lula, of course, has been lucky as well as smart: high commodity prices and a glut of global liquidity have served his country well, despite its status as a net oil importer. Looking forward to a second term, it’s far from clear that his finance ministry will find things quite as easy.
Rosy economic conditions have allowed Lula to shelve vital economic reforms, none of which now have any chance of being pushed through a deeply divided Congress. Brazil’s labyrinthine tax system, especially, is in dire shape, with differences between individual states so high as to significantly depress trade within the country. It’s also so hard to navigate that many individuals and businesses simply don’t bother: the World Bank estimates that Brazil’s informal economy amounts to 40% of GNI.
More generally, says Walter Molano, head of research at BCP Securities, “the very large and very inefficient public sector pushes up the fiscal deficit,” which in turn keeps interest rates high. Molano also points to what he calls “structural impediments that spark inflationary pressures whenever the pace of economic activity accelerates beyond 5%,” – another reason keeping Brazil’s interest rates at levels two or three times higher than in most other major economies.
The beneficiaries of high interest rates in Brazil are domestic banks and foreign investors, who salivate at what is essentially free money in a country with an appreciating currency. The losers are Brazilian individuals sometimes paying over 100% interest on their credit cards, and Brazilian companies who can only justify borrowing money to grow if they get enormous rates of return on their investment. A recent report from McKinsey concluded that, “executives are left with little choice but to focus on short-term financial management at the expense of growth and operating efficiency.”
Brazil is also failing to prepare for the future. Molano talks of “the deindustrialization of the Brazilian economy, thanks to the appreciation of the real and the shift to commodity production,” which is increasing the unemployment rate and setting up Brazil for a hard landing if commodity prices fall.
Brazil’s labor productivity was 23% of the US level in 1995 and fell to 21% in 2004. If a quarter of the population continues to receive no secondary education, that figure will continue to fall – yet none of the political parties spent much time in this election talking about education reform.
