An alternative perspective

01 November 2010

Brazil Post-Lula

IAN BREMMER, PRESIDENT, EURASIA GROUP

In Brazil, we have seen this story before. Market watchers wait nervously as a new president with a ‘leftist’ reputation takes office. When outgoing president Luiz Inácio Lula da Silva was first elected eight years ago, many analysts, pundits, and observers worried that he would steer his country sharply to the left, competing with Venezuela’s Hugo Chávez to become Latin America’s leading populist firebrand. In some ways, that was Lula’s fault. In three previous runs for president, his policy ideas and populist rhetoric cost him the confidence of Brazil’s business elite. But Lula’s winning campaign in 2002 proved he had learned his lesson and pledges to pursue disciplined and market-friendly macroeconomic policies earned him broad support.  Then again, dismissing him as a fist-shaking Chávezstyle ideologue never made much sense; Lula earned his man-of-the-people reputation as a tough-minded labour negotiator, a man who made his living as a maker of deals.

In January, Lula will pass the presidency to his former chief of staff, Dilma Rousseff. As in 2003, some observers fear the new president will stunt the country’s growth with heavy-handed government interference in the country’s economic development and contempt for the private sector. But in today’s Brazil, we must move beyond the stereotypes of left and right for a clearer view of a complex country governed by a sophisticated political class. Critics who dismiss Rousseff as a leftist – as a ‘Lula without the substance’ – underestimate her pragmatism, the realism of those she has chosen to advise her, and the potential for a genuinely market-friendly approach to policymaking, within certain limits.

On the other hand, pundits who predict that Rousseff will move sharply in the other direction, by rolling back the pace of government spending, underestimate Brazil’s growing ‘challenge of abundance,’ a developing prosperity which leaves policymakers with fewer incentives to follow through on reforms that are likely to make them less popular. Austerity is a harder sell when the times seem so promising.

Optimists and Pessimists

For those hoping that Dilma Rousseff will pursue a market-friendly policy approach, expectations fall roughly  into two categories. Optimists expect her government to enact the much-needed economic reforms that Lula failed to achieve – like a slowdown in the growth of government spending. By placing a limit on future spending – actual cuts are not on the table – the Central Bank would have more room to lower interest rates without triggering inflation, reducing capital inflows that strengthen the currency and undermine exports. Optimists are encouraged that popular former finance minister, Antonio Palocci, served as one of Rousseff’s closest campaign advisers, and that he is likely to help define her reform agenda and to formulate legislative strategy.  They argue that Lula might have cut spending in 2010 were it not an election year, and that  Rousseff will move quickly to begin tightening the government’s belt – as Lula did (on a different scale) after taking office in 2003.

Pessimists worry that Rousseff is more ideologically activist than Lula, and that she favours a much more direct role for the state in the next stage of Brazil’s development. They fear she will speed up the increase in state spending, further strengthen state-owned enterprises, and pressure privately owned national champions, like mining giant Vale, to align investment decisions with the government’s development plans. If they are right, the Central Bank will not have room to keep interest rates low, and recent government steps to dominate the exploitation of Brazil’s vast offshore oil deposits will prove a sign of things to come in other sectors. There is probably some truth in this view.

But Rousseff will ultimately prove both camps wrong. The reasons stem from the two countervailing trends that will shape her administration and yield a mix of positive and negative surprises for investors in Brazil’s success.

The Challenge of Abundance

The first is Brazil’s ‘challenge of abundance.’ Over the past 15 years, fears of economic shocks have dominated the country’s politics. Advisers to both former president Fernando Henrique Cardoso and to Lula could justify the need for government austerity by warning that a sudden surge in spending might trigger a wave of inflation. Lawmakers could push for approval of fiscal reform measures with warnings that failure might trigger a crisis of confidence – and an economic meltdown. Policymakers had little room to experiment with industrial policy through federal financial development banks or to bolster state-owned enterprises in heavily regulated sectors of the economy.

But Brazil’s success has dealt risk aversion a heavy blow, as investors now have little fear for the country’s solvency and the country’s debt-to-GDP ratio is set to decline. Rousseff’s economic advisers agree that a robust economic outlook demands a curb on the growth of government spending and her government will begin by signaling a tighter fiscal policy. Investors will cheer. Yet, without the credible threat of anxiety over the country’s solvency, Rousseff’s team will struggle to persuade her to take any steps that will quickly undermine her political popularity. Her administration will win some political battles. She may be strong enough to cap payroll spending. Yet pension levels in Brazil are tied to the national minimum wage – a huge source of growth in government spending, and we are not likely to see much congressional support for any move to reduce them.

As a result, fiscal policy will not be of much help to those who make monetary policy, and pressure for a stronger currency will remain. Some of Rousseff’s most influential economic advisers, such as current president of the National Development Bank and a leading candidate to become her finance minister, Luciano Coutinho, have argued that a strong currency creates problems that need to be addressed, and Rousseff’s government will probably move forward with new restrictions on inflows of capital. In addition, her administration may be tempted to nominate a more dovish Central Bank board than the current one – though she will not threaten the bank’s operational autonomy. This is another area where Brazil’s maturity should reassure skittish investors worried over Rousseff’s plans.

On the other hand, her administration is unlikely to backtrack on initiatives begun under Lula that increase the role of the state in key sectors of Brazil’s economy. The most obvious area of state interventionism will come in the oil sector, as the government looks to maximise its control of development of the country’s vast offshore oil fields.  Rousseff intends to replace the existing concessions framework for offshore exploration and production with production-sharing agreement contracts in which Petrobras, Brazil’s state-owned oil company, will remain sole operator with a minimum 30 per cent stake in all projects. Rousseff’s government will also likely move forward with plans to try to increase state control in the mining sector with the introduction of stricter rules on mining rights, the creation of a regulatory agency to issue licences and oversee the sector, and the introduction of tax changes designed to extract more rents. An active industrial policy spearheaded by the National Development Bank will move forward, and Rousseff will probably increase the state’s influence (either directly or via state-owned companies) in the utilities and telecommunications sector as well. New restrictions on foreign land ownership will also make headlines.

Rousseff and many within her inner circle credit Lula and his approach to economic policy with helping Brazil weather the financial crisis and global recession with far less lasting damage than the champions of free market capitalism in the US sustained. There is little reason to believe that Brazil’s new president will change her mind on that subject.

The Learning Curve on the Left

That said, the second prevailing trend in Brazilian politics will ensure that Rousseff pleasantly surprises investors in several ways. The experience of the past eight years has given leaders of the Workers’ Party – including Rousseff – a deeper appreciation for the rewards that come with disciplined, market-friendly macroeconomic policymaking. The new president and her primary advisers appear to accept the argument that low inflation is crucial for political and economic success in today’s Brazil, but they have also learned important lessons on microeconomic policy. The credit boom to consumers appears to have persuaded her economic team that capital markets cannot deepen unless creditors can collect on collateral, that only  effective and independent regulatory agencies can protect the interests of private investors, and that private investment remains essential for badly needed upgrades of infrastructure. With the World Cup (2014) and Olympic Games  (2016) coming to Rio de Janeiro, the government is well aware that infrastructure investment has never  been more important. This is why the Rousseff administration will care a great deal about investor perception of economic policymaking. The largest positive surprise will be on tax reform. (For the time being, that may be the only major economic reform she is able to push through Congress). But her government has also signaled plans to take on a range of more modest reforms – from creation of a positive credit bureau and antitrust reform to creation of incentives (and removal of bureaucratic obstacles) for greater private-sector investment in large infrastructure projects.

The moral of this story is that Brazil has become an increasingly complex emerging market country. Its politics have evolved far beyond easy characterisations of left and right, and the country now enjoys the beginnings of a broadening and deepening prosperity and self-confidence. The challenges ahead are formidable, but the growing sophistication of Brazil’s political class suggests that the country’s next generation of leaders may well prove up to the task.

Ian Bremmer, President, Eurasia Group

Ian Bremmer is president of Eurasia Group, the world’s largest political risk consultancy. He is also a columnist for Slate, a contributing editor at The National Interest, and a political commentator on CNN, Fox News and CNBC.

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