Up until mid-2016, the left-wing Workers’ Party (PT) governed Brazil for 13 consecutive years.
The PT came into power with Luiz Inácio Lula da Silva (Lula) in 2003. During his presidency, Brazil’s economy prospered, fueled by rising commodities demand from China. Lula took advantage of the fortuitous prosperity to please his voter base with subsidized housing and education, tax breaks to labor intensive industries, and other costly programs aimed at lifting Brazilians into the middle class. By the time Dilma Rousseff became president, demand for commodities had declined but Brazil was still spending at elevated rates.
On August 31, 2016, Ms. Rousseff was impeached and removed from office for manipulating the budget. Hours later, acting president and former vice president, Michel Temer of the Brazilian Democratic Movement Party, was sworn in as the new president of Brazil. He will serve out the remainder of the term, which ends in 2018.
President Temer has promised to revive Brazil’s economy by focusing on policies that will encourage stronger and more sustainable growth. He intends to reduce the country’s fiscal deficit, reform social security, and create a more business-friendly environment.
With an experienced economic team and a large government coalition, investors are optimistic that many of president Temer’s reforms will succeed.
One of president Temer’s first priorities is to stabilize the country’s growing debt burden. For 2016, the government’s gross debt is projected to rise to 78% of GDP, up from 63% in 2014.
President Temer intends to rein in the country’s debt by implementing austerity measures. In June 2016, he proposed a constitutional amendment to cap government spending. The proposal would freeze current government expenditures to the country’s inflation rate for 20 years.2 In early October, the proposal was approved by Brazil’s lower house of Congress and is in motion towards a final vote in the Senate. This is an important triumph for president Temer and is a signal of his willingness and ability to implement crucial changes.
Another important, and necessary, item on President Temer’s budget reform is the country’s social security system. Brazil’s existing social security system, which has no minimum retirement age, is one of the most generous in the world and represents more than a quarter of the country’s overall spending. Social security expenditures have been steadily growing while revenues remain fairly flat The Brazilian government is currently studying various options to manage the pension imbalance and this is an essential part of stabilizing the government deficit.
With a new government in place and steps towards fiscal reform, consumer and business confidence appear to have returned to Brazil. Over the past few months, the consumer and business confidence indices, a gauge of expectations, have trended upwards, an indication that both consumers and companies have a more positive outlook on the economy.
The enthusiasm over reforms and a rebound in global commodity prices have also been beneficial for the Brazilian real. Since the beginning of 2016, the real has continued to strengthen against the US dollar, from a record low of R$4.16 to the dollar in January to R$3.26 to the dollar by the end of September. According to Bloomberg, the real is the world’s best performing currency in 2016.
A stronger, stable real and an uptick in sentiment have led to an improvement in inflation expectations and potential interest rate cuts. Brazil’s annual inflation rate has declined from a high of 10.7% in the beginning of 2016 to 8.48% by September 2016. Although this is still much higher than the country’s official target of 4.5%, investors expect inflation to continue to decline. In October 2016, the Brazilian central bank cut the benchmark rate, known as the Selic, by 25 basis points (the first cut in four years).
As inflation slows, the Brazilian central bank has signaled that further interest rate cuts in the near future are possible which would reduce borrowing costs for businesses and consumers and drive investment and growth across the country.
The International Monetary Fund’s (IMF) GDP growth projections also suggest that Brazil’s economy may have bottomed and that a rebound is likely. GDP growth is expected to continue to contract, albeit more slowly, in 2016 but a recovery, returning to positive growth, is projected for 2017. At 3.8%, this is one of the biggest swings from current GDP expectations to projected GDP for any market.
The positive sentiment and potential economic growth in 2017 are signs that Brazil may be on its way to recovery. Although the economy is still very fluid and many challenges remain, there is evidence to support that Brazil is finally using fiscally responsible decisionmaking to reach its growth potential.
Malcolm Dorson is portfolio manager/senior investment analyst at Mirae Asset Global Investments.