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What Will It Take To Get Brazil Back On Track?

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What Will It Take To Get Brazil Back On Track? by Knowledge@Wharton

Felipe Monteiro discusses the current political and economic uncertainty in Brazil.

The proverbial phrase “when it rains it pours” captures Brazil’s woes today. As it prepares to host the 2016 Summer Olympics in Rio de Janeiro in August, the country is wracked by worsening political uncertainty, a severe recession that has caused its economy to shrink nearly 4% last year (with similar projections for this year), and the Zika virus outbreak that originated on its soil in April 2015 and has since spread to Central America, South America and the Caribbean.

The political uncertainty is rooted in a $2 billion corruption scandal involving the state-owned oil firm Petrobras. It now threatens Brazil’s president, Dilma Rousseff, with impeachment. The country’s economy has already been weathering export declines in the past two years, thanks to the slowdown in China, Brazil’s biggest trading partner. Alongside, its currency has been battered by a strong dollar, and capital inflows have been steadily negative. Not surprisingly, all the three big ratings agencies — Standard & Poor’s, Moody’s and Fitch — have in the past six months downgraded the country to non-investment or junk grade.

Much of the weakness in the Brazilian economy over the past year is because businesses are reluctant to make investments or major decisions in view of the political uncertainty, according to L. Felipe Monteiro, professor of strategy at INSEAD in France and a senior fellow at Wharton’s Mack Institute for Innovation Management. Monteiro is an expert on Brazil, having taught there and advised foreign companies investing in that country.

Monteiro pointed to one currency data point to highlight how much a role uncertainty is playing in the current scenario. “Just in the last 10 days, the [Brazilian] real appreciated 10% with the prospect that there will be some change in the government,” he said. The real has fallen more than 55% against the U.S. dollar in the past two years, but strengthened from levels of 4.1 to the dollar to 3.62 on Monday.

Monteiro discussed Brazil’s troubles and the road ahead for the country on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

“[One] positive aspect is how [Brazil’s] democratic institutions are showing their strength.”–L. Felipe Monteiro

The Threat of Impeachment

In discussing the cause of the Brazilian real’s latest uptick, Monteiro cited anti-government rallies on March 13 that drew some 3.5 million protestors across the country who demanded Rousseff’s impeachment. Rousseff increased that sentiment further last week by naming former President Luiz Inácio Lula da Silva — popularly called Lula — as her chief of staff, but a Brazilian court suspended that appointment and the country’s Supreme Court upheld that suspension.

Rousseff’s move would have ensured that Lula could be tried for alleged crimes only in the Supreme Court, and keep him beyond the reach of lower courts. Lula, who ran the country from 2003 to 2010, is suspected of involvement in the Petrobras scandal, and was detained and questioned after police raided his home in early March.

According to Monteiro, there is an “80%-85% chance of [Rousseff’s impeachment] occurring.” He noted that the political process for that impeachment is already underway. In fact, Brazil’s congress will henceforth hold extraordinary sessions twice every week to extract a vote on impeachment. “Now we are talking in terms of weeks or a couple of months,” he said. “Maybe by the Olympics we will have a new president.”

The impeachment could occur during or just before the Olympics, according to Mauro Guillen, Wharton professor of management and director of the school’s Lauder Institute. He foresaw a gathering sentiment that could force out Rousseff. “If there is impeachment, it might unlock the political situation, which is one of total paralysis?Twitter ,” he said. “Another possibility is that social protests may just become impossible to contain. There could be enough unrest to force the President out of office. All of that could happen during or before the Olympics, because people would perceive that the rest of the world is paying attention.”

Guillen described Brazil’s current situation as one of a stalemate. “If you go back three years, the problems were the slowing down of the Chinese economy that reduced Brazil’s export earnings and also the collapse in commodity prices,” he said. “Then you had the time bomb of corruption that finally exploded.”

The investigation into the corruption scandal at Petrobras is focused on politicians and executives at top engineering and construction companies colluding to inflate the value of contracts awarded by the oil company. In the past two years of the so-called Lava Jato (or “Operation Car Wash”) probe led by investigative judge Sergio Moro, several top businessmen have been sentenced to long jail terms, and scores of politicians are under scrutiny for money laundering and tax evasion. “Most of the corruption has been focused on Petrobras, but there are reasons to believe that you will see similar schemes of corruption in other companies as well,” said Monteiro.

“If there is impeachment, it might unlock the political situation, which is one of total paralysis.”–Mauro Guillen

Impact on Capital Inflows

The business impact of all that is paralysis. “Everybody is … waiting to see what happens,” said Monteiro. Guillen noted that tracking short-term capital flows into the country gives a sense of business sentiment. Brazil had net capital outflows of $4.4 billion as of January 2016, worsening from $2.4 billion of outflows in the previous month, research services firm Trading Economics.com reported, citing data from Brazil’s central bank, Banco Central do Brazil. Net capital flows into Brazil peaked in May 2007 at $15.8 billion, but have been in negative territory continuously since early 2010.

Guillen saw some respite for the Brazilian currency in the U.S. Federal Reserve’s recent decision to postpone further monetary tightening measures (and higher interest rates). “If interest rates go up in the U.S., that might push Brazil over the edge at this point,” he said. He noted that the Federal Reserve in September decided not to raise interest rates. “The main motivation for that decision was to avoid putting too much pressure on emerging markets,” he added.

It also helps that Brazil has strong foreign currency reserves on hand, said Guillen. “[However], if there is a sentiment in the market that things might be about to collapse [and] there won’t be enough to compensate for massive outflows of short term capital, [then things could get worse],” he said.

“[One] positive aspect is how [Brazil’s] democratic institutions are showing their strength,” said Monteiro, adding that it should give Brazil’s global partners some confidence. “It’s very easy for other countries in such a situation to turn to non-democratic solutions.”

Brazil – Difficult Transition Ahead

Meanwhile, the political setting in Brazil doesn’t point to an easy transition to a new regime. Since Rousseff’s re-election to a second term last year, Brazil has had an electorate divided between the supporters of Rousseff and those opposed to her, Guillen noted. “This has turned into an unsustainable situation, in which the President is clinging to power but has very little legitimacy left,” he said. In such a scenario, economic reforms are a far cry, he noted, adding, “The country is in gridlock.”

Monteiro agreed on the polarization within the country. “Brazilians are soccer fans, and two sections of people are trying to support their own teams,” he said. “But I don’t think the solution will come from this polarization; it will come from finding a way of working with the two sides.”

It doesn’t help that the country is governed by a fragile alliance of Rousseff’s Workers’ Party and the Brazilian Democratic Movement Party (PMDB). Eduardo Cunha, a PMDB member and president of Brazil’s lower house of Congress, is at the forefront of the move to impeach Rousseff and is also being investigated in the Petrobras scandal.

“If interest rates go up in the U.S., that might push Brazil over the edge at this point.”–Mauro Guillen

According to Monteiro, the political impasse could resolve in one of three ways. One is where after Rousseff is impeached, a transition government headed by the vice president will be in charge until the next election in 2018. The second possibility is to nullify the previous elections and hold fresh elections. “The third option is getting a new person — an outsider — someone like the former chief justice of the Supreme Court [Joaquim] Barbosa,” he said. “There must be some new blood, new solutions on the table. Overall, there is dissatisfaction with the old political class. The middle ground is somewhere there. Brazil can no longer … live with this level of corruption.”

Amid all that, the Zika virus outbreak may not be a big issue by the time the Olympics begin, according to both Monteiro and Guillen. Monteiro noted that with the onset of winter by August, it will no longer be mosquito-breeding season. Guillen said that while the virus has been mostly concentrated in the northeastern parts of the country, a big problem is people transmitting it to one another while traveling around the country.

Zika is suspected to be linked to microcephaly, a condition that affects mothers-to-be and causes their newborns to have undersized skulls and brains. Since October last year, when reporting microcephaly became obligatory in Brazil, a total of 745 microcephaly cases have been confirmed, the Wall Street Journal reported, citing Brazilian health ministry data.

As for the Olympics, the big worry is the underwhelming enthusiasm it has generated. As of early March, less than half the 7.5 million tickets on offer had been sold, according to a report in the Buenos Aires Herald. That compares with the 8.2 million tickets sold for the 2012 London Olympics out of 8.5 million on offer, according to a report by the International Olympic Committee.

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