Rarely in the history of economic reform has the fate of so many hinged on the actions of so few: Brazil’s elected representatives hold in their hands the very future of their country.
It all depends on whether they approve the critical pension reform, which is currently making its way through the lower house.
If the parliament passes the pension bill, the Brazilian economy will, very likely, be able to bounce back and enter a long and sustainable expansion.
On the other hand, if parliament fails to approve the reform they will almost certainly plunge Brazil into a fiscal crisis the likes of which makes the recent downturn seem like a minor dip in the business cycle.
Never in recent history has the outlook in Brazil looked so binary.
Businesses in Brazil are holding their breath. International investors are holding their breath.
The economy is slowing as investment and consumption decisions are placed on hold pending the outcome in parliament.
So, which direction will Brazil take?
Before considering this question, it is helpful to examine how Brazil ended up in this predicament in the first place.
The sorry tale began on January 1 2003, when Luiz Inacio Lula da Silva was sworn in as Brazil’s 35th president.
Initially fearful of Lula da Silva, markets soon fell in love with him – and with Brazil.
Lula da Silva surprised investors by appointing orthodox policy makers.
Contrary to all expectations, he preserved the market-friendly macroeconomic framework, which had been put in place by his predecessor.
Inflation declined, rates came down. Growth rates soared. External conditions were also highly supportive with sky-high commodity prices and strong demand for emerging markets assets among global investors.
Soon, however, the cracks began to appear.
Already during Lula da Silva’s first term in office, key officials began to get arrested for corruption, including the respected finance minister, Antonio Palocci.
Brazil, having failed to set aside savings in the good times, was then ill-prepared for the downturn in global conditions as the US sub-prime crisis unfolded. Investors absconded and the economy tanked.
Dilma Rousseff succeeded Lula da Silva, but she never commanded the same authority as her predecessor.
Operation Car Wash
At the precise moment when Brazil most needed to reform, Sergio Moro, a crusading judge, paralysed parliament by unravelling the largest election campaign funding scandal in modern Brazilian history.
‘Operation Car Wash’ – or ‘Lava Jato’ – saw Lula da Silva, a handful of parliamentarians, a large number of executives of Petrobras and other state-owned enterprises and private sector companies sent to jail.
Ms Rousseff was impeached, but only after her finance minister, Guido Mantega, had damaged the fiscal accounts almost beyond repair, turning the public finances into a ticking macroeconomic time bomb.
The political fallout from the many years of policy failures culminated in the 2018 general election, which saw voters wipe out Brazil’s traditional political parties and shove Jair Bolsonaro – a right-wing populist with little experience and no majority in parliament – from political obscurity into the country’s top job.
As president, it did not take Mr Bolsonaro very long to realise that pension reform had to be his top policy priority.
Not that he has much choice in the matter. The economic reality facing Brazil is sobering.
The public debt stock is rising every year, almost entirely due to the large current deficit in the public pension system.
The debt stock is already close to 80 per cent of GDP, which is nearly twice as high as the average in emerging markets.
The laws of economics are universal: you can only abuse the public finances for so long; eventually a combination of rising interest rates, slower growth and the sheer weight of liabilities push the debt trajectory beyond the point of no return.
Brazil stands at this important threshold today. If parliament fails to fix the pension problem, Brazil will likely face a currency crisis, another decade lost to recession, massive political upheaval and, eventually, sovereign debt default either outright or via rampant inflation.
The good news is that Mr Bolsonaro has a clear political mandate to effect change.
His lack of ties to the discredited political establishment may be his most valuable asset, at least in the eye of voters.
However, this holds little sway in the shell-shocked parliament, and Mr Bolsonaro’s political capital is being depleted by costly coalitions in parliament and a money laundering investigation involving his son.
Economic issues
The other problem is the economy.
Consumers and investors in Brazil are already putting spending decisions on hold pending approval of the pension reform.
Recent economic data has been extraordinarily weak, raising the prospect of a double-dip recession in Brazil this year. If so, the timing could not be worse.
The hesitation of the private sector, although strongly in favour of the pension reform, could ironically undermine the odds of its passage.
Economic weakness discourages parliamentarians from supporting reforms, which inflict pain on significant and vocal segments of the labour force, such as public sector workers.
Brazilians have already started taking to the streets in protest against spending cuts elsewhere in the public sector.
The government is bound by a fiscal rule, which means that cuts in education and other public spending become inevitable unless the pension deficits are reduced.
It follows that the longer it takes to pass the pension reform the worse the economy will get.
Stabilising finances
Still, despite all these challenges, it is likely that parliament will pass the pension reform sometime within the next few months.
A majority of parliamentarians recognise that there is no even remotely palatable alternative.
Mr Bolsonaro’s trade-offs will certainly water down his reform, but even fiscal savings of R700bn, down from the original target of R1.2tn, would still go a long way towards stabilising Brazil’s public finances.
Once the uncertainty of the pension reform is out of the way, pent up spending will be released and Brazil can embark on multi-year cyclical expansion.
After all, the currency is competitive, the external balances are healthy, central bank credibility has been restored and there is enough spare capacity to allow the economy to grow for many years before inflation becomes a challenge.
Indeed, Mr Bolsonaro may even be able to get on with his other policy objectives, including privatisations and deregulation. Foreign investors will approve and return to Brazil.
Key points
- Brazil is trying to reform its pension system
- Problems set in under Lula da Silva
- If reform happens then Brazil's economy could be rescued
The hesitation of the private sector, although strongly in favour of the pension reform, could ironically undermine the odds of its passage.
Economic weakness discourages parliamentarians from supporting reforms, which inflict pain on significant and vocal segments of the labour force, such as public sector workers.
Brazilians have already started taking to the streets in protest against spending cuts elsewhere in the public sector.
The government is bound by a fiscal rule, which means that cuts in education and other public spending become inevitable unless the pension deficits are reduced.
It follows that the longer it takes to pass the pension reform the worse the economy will get.
Stabilising finances
Still, despite all these challenges, it is likely that parliament will pass the pension reform sometime within the next few months.
A majority of parliamentarians recognise that there is no even remotely palatable alternative.
Mr Bolsonaro’s trade-offs will certainly water down his reform, but even fiscal savings of R700bn, down from the original target of R1.2tn, would still go a long way towards stabilising Brazil’s public finances.
Once the uncertainty of the pension reform is out of the way, pent up spending will be released and Brazil can embark on multi-year cyclical expansion.
After all, the currency is competitive, the external balances are healthy, central bank credibility has been restored and there is enough spare capacity to allow the economy to grow for many years before inflation becomes a challenge.
Indeed, Mr Bolsonaro may even be able to get on with his other policy objectives, including privatisations and deregulation. Foreign investors will approve and return to Brazil.
Jan Dehn global head of research at Ashmore Group
