Dilma or No Dilma? by Bill O’Grady, Confluence Investment Management

During the first round of Brazilian presidential elections on October 5, the incumbent Dilma Rousseff of the Workers’ Party received 42% of the votes while Aecio Neves of the Social Democracy Party received 34%. Since none of the candidates received more than 50% of the vote, the second round of runoff elections will be held on October 26. Currently, Dilma Rousseff leads the polls, signaling a likely continuation of state-centric policies. The results from these elections are significant for the Brazilian domestic economy as well as foreign investors.

Whether Dilma Rousseff or Neves wins, the next president will inherit a low growth and high inflation environment. Additionally, the incoming president will have to deal with high government spending while maintaining the high social spending that the ruling party has relied on for populist support. The growing domestic middle class is demanding an end to corruption and better social services.

Foreign investors are also closely watching these elections as a win for Neves could signal a more market-friendly political environment with better government fiscal responsibility and political transparency. This week, we will look at the Brazilian presidential elections along with the current political and economic environment in the country. We will briefly describe the recent political history of the country and look at the specifics of Brazil’s economic development. As usual, we will conclude with market ramifications.

Recent History

Brazil’s population of 199 million makes it the fifth largest country in the world in terms of population. Population growth has been rapid as the absolute number has doubled over the past 30 years. Brazil is the seventh largest country in terms of total economic size.

We need to remember that Brazil is still very new to the international markets as well as democracy. The country was ruled by the military from 1964 to 1985. During this time, civil rights were severely repressed while the military tried to implement economic reform. In 1985, the military peacefully ceded power to civilian rulers, and the country held its first democratic election in 1989 with great enthusiasm. The new government was able to get inflation under control through onerous reforms. The constitution was ratified in 1988 and its new currency was introduced in 1994.

Over the past decade, Brazil has benefited greatly from the surge in commodity prices. The wealth effect was multiplied by capital inflows and credit expansion. Recently, discontent has grown as economic growth has slowed and inflation has risen. Brazilian economic growth has mostly faltered due to weakening global commodity demand. The Brazilian central bank forecasts that Brazilian GDP growth will be 0.7% in 2014. The chart below shows the yearly GDP growth rates, which topped at 9.1% in 2010, when commodity demand from China boosted growth.

Dilma Brazil

Brazil’s recent growth has relied on commodity exports, especially soy beans, iron ore and oil. With grain prices falling on increasing supplies and industrial metals prices falling on soft demand, Brazil’s main exports have been hit on both price and quantity.

At the same time, Brazilian manufacturing has become less competitive and its importance has been overshadowed by its reliance on commodities. Additionally, the country’s strong currency and structural inefficiencies have made Brazilian companies uncompetitive in the export markets. Trade barriers, direct competition from China and inherent difficulties brought on by Brazil’s lack of infrastructure to accommodate for its size and difficult terrain have also hindered export growth. Infrastructure has remained a constant bottleneck for the country as railway systems are in their infancy, the river system is not accessible enough for reliable transportation and the roadway systems remain in poor condition. This is especially relevant since the country produces many low value-to-weight commodities. Mercosur, the South American trade bloc which includes Brazil, is likely to remain a drag on the economy due to its trade barriers. Additionally, Mercosur’s charter has limited Brazil’s ability to sign trade agreements with other countries as a new agreement for any member country requires unanimous approval from all the member countries.

Commodity Addiction

Given the importance of commodity exports to the country, the political process is also shaped by the needs of commodity producers. The crops that have historically done particularly well in the country are coffee and sugar, neither one of which is easily mechanized. Therefore, both industries need large pools of low-skilled labor. Due to this need there is a great disincentive to advance educational opportunities, resulting in a small pool of skilled workers and a large number of unskilled workers, in turn creating labor and infrastructure bottlenecks. During periods of strong growth, the lack of skilled labor tends to cause capacity constraints, making it difficult to boost productivity. Thus, Brazil faces persistent inflation pressures.

Historically, Brazil has been one of the highest inflation and lowest growth countries among emerging economies. For example, inflation reached 2,000% per year in the 1980s. The solution to this high inflation was an arduous path for the country, with capital controls, heavy bank regulation and deep cuts to the government’s budget. In the early 2000s, investors dove into emerging markets; this, coupled with Brazil’s falling inflation as a result of deep-seated reforms, resulted in large inflows of capital into the Brazilian markets. As a result, the Brazilian currency, the real, has appreciated and in turn made Brazilian manufacturing uncompetitive. It is important to remember that the Brazilian economy is mostly commodity related and low skilled, so exports need to compete on pricing rather than the value-added sphere.


Brazil has successfully lifted about a quarter of its population into the middle class category in the past 10 years. This is no small feat. By comparison, China moved the same proportion of people out of poverty over the course of 30 years. Brazil has been successful in alleviating poverty for the elderly as a result of comprehensive pension reform. However, this has left little money for educational reform, and commodity dependence has created a need for a large, low-skilled labor pool. However, in order to sustain the pace of improvements in living standards and support social mobility and equality, the availability and quality of education is crucial. Additionally, Brazil has been undergoing slowing population growth rates since the 1960s, which will soon lead to a significant demographic transition. The aging population and current low investment levels into human capital could hinder growth possibilities.

That being said, the country’s large middle class supports the growing domestic market demand and makes the economy more robust. This is not the case for many emerging markets. A study by the Brookings Institute indicates that about half of Brazil’s population is now considered middle class compared to 10% in China. Even through the recent economic slowdown, the expanding middle class has maintained its expectations for uninterrupted economic growth. Given the country’s commodity reliance and the slowdown in
end market demand, it is unlikely that either candidate will be able to meet these enhanced expectations.


Brazil’s government spending is large, approximately 40% of GDP. Government spending in comparable countries stands at about 25%. At these levels, public funds crowd out private investments. Since government investment is centrally controlled, it is generally less market efficient than its private counterpart. Although the country needs

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