By: Martin Hutchinson, Global Markets Analyst
Last week, the Brazilian cabinet briefly contained two Presidents, incumbent Dilma Rousseff and her predecessor Luiz Inacio “Lula” da Silva, before a court ruled that Lula was ineligible to enter Rousseff’s government.
Meanwhile, the economy continues to decline, and the budget deficit is spiraling to infinity.
The Brazilian electorate, having voted for the Lula/Rousseff Workers’ Party four times, now appears to be coming to the reluctant, overdue conclusion that the only way to clean up the economy is to throw these blighters out.
Lula came to office at the end of 2002, when Brazil’s debt was causing problems partly because investors thought a Lula government would overspend and drive the country into bankruptcy.
He did overspend, but he hid it well, preferring to fund boondoggles through the Brazilian Development Bank (BNDES) and other state companies rather than through the official budget.
He also focused international investors’ attention on the “primary” balance, before the country’s gigantic interest payments, which generally showed a slight surplus until 2014.
Finally, Lula was boosted by an astonishing stroke of luck in the form of an energy and commodities boom that boosted Brazil’s economic output, raising all boats and even paying for Brazil’s bloated government spending. (At 43% of gross domestic product (GDP) in 2014, it’s the highest in Latin America, 50% higher than countries with successful economies such as Colombia and Peru.)
For her first term, Rousseff continued to be lucky with commodities prices, even though the economy started slowing.
However, after 2012, commodities prices began a long decline, and with Rousseff’s re-election campaign in 2014, the cracks started showing. Brazil showed a budget deficit even on a “primary” basis before interest of 0.6% of GDP in 2014, having budgeted for a surplus of 1.7%.
That equated to a true budget deficit (before money escaped through BNDES and other holes) of 6.1% of GDP, which widened to 10.3% of GDP in 2015.
Today, the currency has halved in value against the dollar, while GDP shrank by 3.8% in 2015 and is projected to shrink again in 2016. The Rio Olympics this year won’t help, either; they’re bound to blow the budget deficit out further.
The current political crisis, centered on bribes paid by the oil company Petrobras, has been simmering for some months. On top of that, the CEO of Brazil’s largest construction company was sentenced to 19 years in jail on March 9, after which Lula was detained for questioning.
Rousseff promptly appointed Lula her Chief of Staff with cabinet membership, giving him immunity from prosecution – but a court has thrown this out.
Now Rousseff herself faces impeachment, a sanction not unknown in Brazilian politics. President Fernando Collor de Mello was impeached mid-term in 1992 after he failed to prevent inflation of 1,000% in that year.
Get Out the Brooms
Thus, it’s now clear that the only solution is a clean sweep.
The Brazilian people seem ready for truly radical reform, and as Argentina recently has shown in the short term, a complete reversal of policy is possible given sufficiently strong leadership.
Brazil needs new elections, new leadership, a new constitution, and new economic policies – in all areas except one.
The Brazilian central bank, with its own mandate to control inflation dating from the hyperinflation of the early 1990s, has an admirable commitment to keep interest rates safely above the inflation rate – its benchmark rate is currently 14.25%, compared with an inflation rate of 10.4% in the year to February.
Since the rich world is still experimenting with bizarre policies of negative short-term interest rates, this shows an admirable devotion to the traditional economic norms, which simply needs to be extended to the rest of Brazil’s economic management.
The presidencies of Lula and Rousseff have formed a dismal period of Brazilian economic policy, when a commodity boom that could’ve been used to make the country permanently richer has instead been frittered away by Brazil’s wasteful public sector.
The country now needs root and branch reform and a completely fresh start – and impeaching Rousseff, possibly imprisoning Lula, and holding fresh elections would seem the only way to achieve this.
For us as small investors, the Brazilian real is now cheap enough that we can consider taking advantage of the country’s high interest rates, even if equity positions should wait till stability is achieved.
The WisdomTree Brazilian Real Strategy ETF (BZF) invests in short-term Brazilian real money market instruments. It therefore typically makes a high return from income, but loses capital value as the real depreciates against the dollar.
However, with the real depressed, Brazilian money market interest rates should compensate for currency depreciation. The fund is small, only $13 million, but it has a competitive expense ratio of only 0.45%.
For 27 years, Martin Hutchinson was an international merchant banker in London, New York, and Zagreb. He ran derivatives platforms for two European banks before serving as director of a Spanish venture capital company, advisor to the Korean company Sunkyong, and chairman of a U.S. modular building company. In Zagreb, he established the Croatian debt capital markets, set up the corporate finance operations of Privredna Banka Zagreb, and arranged for the monetization of 800,000 frozen Macedonian foreign currency savings accounts. He has been a financial journalist for over 14 years, and is the author of Great Conservatives and co-author of Alchemists of Loss, which details the causes and consequences of the 2008 financial crash. He currently publishes a weekly column called The Bear’s Lair, in which he comments on the economy and market. He is also a correspondent for Reuters’ BreakingViews. Martin has a first class Honors Degree from Trinity College Cambridge and an MBA from Harvard Business School.