What can we expect from the Brazilian economy under Michel Temer s government?

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1 What can we expect from the Brazilian economy under Michel Temer s government? Macroeconomic Report April, 2016 The economy remains highly dependent on political factors. Even if the most likely scenario is confirmed - a mild slowdown of the political crisis - the economic recovery is not expected to happen in the short term. Mr. Temer signals an increase in privatizations and concessions, end the automatic adjustment of the minimum wage and pensions, and the deepening of the pension reform. The goal is to equate the fiscal situation and restore confidence in the economy impeachment, Dilma will no longer be president. Hence, what could we expect from this period if the senate decides to proceed with the impeachment process? Below, the most probable scenarios are identified as well as the most relevant points of Mr. Temer s proposed economic policies. Political scenarios for Michel Temer s government On the April 17th, the Brazilian parliament had decided to proceed with Dilma Rousseff s (Workers Party, PT) impeachment process. Two-thirds of all votes were necessary for the process to be approved, which received 367 votes out of 513 (71% of the total). This is the second time the parliament has passed an impeachment process against a president in Brazil. In September of 1992, Fernando Collor de Mello (now a senator) had his impeachment passed by the parliament with 441 votes out of 503 (88% of the total). After the parliament s approval, it is expected that a special commission of senators will vote the impeachment in mid May. Once approved by at least half of the senators (41 votes out of 81 senators), Dilma Rousseff will be removed from the presidency for up to 180 days. The Supreme Court will judge and finally if two-thirds of the senators support the Scenario 1. The third runoff (Probability: 65%) Some specialists believe that immediately after the runoff of Brazilian presidential elections, in 2014, the opposition had started a new dispute for Dilma s post, which has been widely known as the second runoff deepening the political and economic crises. In a scenario entitled third runoff, they switch places, but the instability continues, with Rousseff s party trying to convince the senators and the STF (the Brazilian Supreme Court) to recover her mandate. It is also expected an intense political pressure of social movements for Michel Temer s impeachment as he is accused of committing the same irregularities made by Dilma. The impeachment approval by the parliament, therefore, is only one chapter of the political crisis. Mr. Temer 1

2 and his allies will not be able to implement the most important issues of their agenda, such as the constitutional reforms. To approve such a reform, it is necessary to have three-fifths of the parliament (or 308 votes out of 513). However, the opposition (formed by the left-wing parties) has at least 100 votes, and hence the proposal must have wide approval among the other parties to be accepted. Thus, the implementation of Mr. Temer s economic agenda will be only partial. The economy will continue to suffer from the same turbulences as before. There will be more doubts than certainties about the viability of a new government due to all political tensions. However, in this scenario, the economy will not continue to deteriorate. Further, it is expected a slight recover in 2017 and Why to bet in this scenario: Recent surveys shows that while 61% of Brazilian population approve Rousseff s impeachment, almost the same proportion (58%) would also support Michel Temer s impeachment. Therefore, Mr. Temer s government is expected to be a non-consensual transition government. With the 2018 presidential elections approaching, the government will not be able to approve significant changes and the economic situation will be only slightly better than Ms. Rousseff s second mandate. Why not to bet in this scenario: Although it is the most probable scenario, it cannot occur due to: the increase of social tensions, and the mobilization of social movements by the Workers Party (PT) and its allies; significant changes in the world economy; and the possibility that Mr. Temer and his party, the PMDB (the Portuguese acronym for Brazilian Democratic Movement Party), construct a sturdy base with other parties. Scenario 2. Temer in the wonderland (Probability: 25%) Michel Temer s government forms a solid coalition, and the opposition led by the Workers Party (PT) has no power to interrupt the implementation of PMDB s economic agenda. Michel Temer s impeachment do not receive support in the parliament, and his government restores confidence in the Brazilian economy. Why to bet in this scenario: Possible end of the "Lava Jato" operation in December, commodity prices recovery and hence better external conditions, Lula and the PT are unable to recover their mobilization power of social movements. Why not to bet in this scenario: It is required a coincidence of many circumstances, which results in a small probability. Scenario 3. The winter is coming (Probability: 10%) The political crisis deepens - and consequently, economic crisis. Mr. Temer is not able to form a coalition government and faces a stiff opposition from the PT and its allies. An increase in social tension with the mobilization of social movements linked to the PT, such as the 2

3 Landless Workers Movement (MST), the Workers' Union (CUT), the National Union of Students (UNE), among others. Government legitimacy is contested, and the political crisis reaches a higher level, with deepening social tensions, reflecting in an even more recessive economic scenario. Why to bet in this scenario: Current unemployment around two digits may intensify social tensions. The PT in the past proved to be a very combative opposition whilst the PMDB (Mr. Temer's party) may not have enough unity to support the government. Besides, the most pessimistic analysts believe that the recovery in commodity prices in the first quarter of 2016 will be reversed soon, which makes the external situation even more complicated. Why not to bet in this scenario: That would be an extreme situation for the first scenario. Not only the political dispute continues, but it becomes even worse. All the elements presented in the first scenario should coincide for this to occur, and the PT s power to mobilize social movements, trade unions and other entities have to be very high. Besides, the global economy also needs to deteriorate, preventing the exports and the investment to promote a small recovery of the economy. The economic scenario of Michel Temer s Brazil? Michel Temer proposes an increase in privatizations and concessions, end of automatic adjustment for minimum wage and pensions, flexibilization of the constitutional minimum expenditure limits in areas such as healthcare and education, tax simplification, and the creation of trade agreements. To equate the fiscal issue in the short term, it is expected that Mr. Temer s government will increase the collection of taxes with the return of the CPMF (Temporary Contribution on Financial Transactions) and reduce public expending. The results of the implemented economic policy will depend, to a large extent, on Brazil's political environment. In 2016, it is projected a GDP drop of 3.8%, inflation below 7%, unemployment near double digits and exchange rate at 3.70 reals per dollar. Following the example of Luis Inacio Lula da Silva who, through the PT (Worker s Party), launched in 2002 the so-called "Letter to the Brazilian people", the current Vice-President Michel Temer announced in October 2015 the document entitled "A bridge to the future" - developed by the PMDB and the Ulysses Guimaraes Foundation. This report proposes solutions aiming at setting the Brazilian economy back on a growth path in the short term and also creating the right conditions for a sustainable development trajectory over the long term. Thus, an analysis of its content provides an indication of what will be the priorities and guidelines of the economic policy to be adopted during his administration. What were the origins of the economic crisis according to the document? The document can be understood as a signal to the market and public opinion of 3

4 the economic policy priorities in Mr. Temer s government. The document only takes into account domestic factors in his diagnosis of the current Brazilian economic crisis. Therefore, the significant economic slowdown experienced by China (Brazil s largest trading partner), the collapse occurred in the international market price of raw materials, and the reduction of global liquidity to emerging markets during the period, are disregarded. According to the document, the fiscal imbalance is the chief cause of the economic crisis, accounting for a wide range of unwanted effects such as: i) rising inflation, ii) high interest rates, iii) uncertainty about the economy, iv) high taxes, v) exchange rate pressure and, finally, vi) decrease in private investment. Thus, for a full economic recovery, according to the document, the crucial point would be the achievement of a surplus in public accounts, not only in cyclical results but in a structural way. Such a result would be achieved by the reduction and improvement of public expenditure management. A tax increase is seen as undesirable, even though it can be considered a correct measure in situations of extreme emergency. Given the current situation of the Brazilian economy, we understand that the PMDB (Brazilian Democratic Movement Party) may request the creation of additional tax. For example, the return of the CPMF may be one of the solutions adopted by Mr. Temer to reduce the budget deficit. What then would be the recipe to achieve fiscal balance? The solutions proposed in the document are threefold. The first is the end of the constitutional bindings established by the Constitution of Spending on healthcare and education, for example, would no longer have its minimum fixed, thus depending on the budget adopted annually by the congress. The second is the end of the indexation of wages and pensions. In this way, they would be allowed to undergo constant actual losses. Minimum wage adjustments receive particular attention and are seen as unfair because they contribute to a forced income transfer, since such increases should be offset by a corresponding decrease in other public expenditures, such as healthcare and education, thus harming the poorest of society. Such a point of the document needs to be better explained, because it is not clear how an increase in the minimum wage would be a greater loss exactly to the most disadvantaged. The third point is represented by the spending in social security. In fact, Brazil has a much higher cost compared to demographically similar countries. The proposals range from increasing the retirement age to cutting real benefits (through the de-indexation proposal on the second point above). The document does not specify the distributional effects of such measures or who would inherit most of the adjustment burden. Mr. Temer s agenda: A bridge to the future The plan purposed by the PMDB (Mr. Temer s party) seeks to increase Brazilian income per capita by at least 2.5% per year. Despite not being an audacious target, such result has never been seen in Brazil since the 1970s. The decade with the best result was the 2000s when the Brazilian per capita income grew 2.1% per year in average. 4

5 The document argues that the Brazilian Debt to GDP ratio is high relative to other emerging countries, and its trajectory is not sustainable due to the high interest payments. It is purposed the adoption of primary surpluses to reduce the debt growth rate and, through the expectancy channel, promote the private sector investment. Such argument is not new. In 1999, Armínio Fraga (Central Bank president from 1999 to 2002) adopted the macroeconomic tripod, which consists of the inflation target, flexible exchange rates, and primary surplus. The document also argues that the growth cycle experienced in the period was based on the increase in domestic consumption (credit growth, reducing poverty and inequality) and it was sustained by the commodity price boom. This cycle, however, has saturated as there is no space for increasing credit and promoting consumption. Therefore, the country should now move onto a new strategy based on the expansion of private sector investment and the promotion of international competitiveness. Trade liberalization has a leading role in this strategy, and hence free trade agreements are seen as essential. The document clearly signalizes that domestic content policies, infant industry protection, and other recently adopted measures have to be abandoned. It is proposed that the Brazil should follow their neighbors in the "Pacific Corridor" (Chile, Peru and Colombia), by drastically reducing import tariffs and encouraging multilateral and bilateral trade agreements. The impacts on employment, industrial production, and income distribution are not discussed. The document also proposes a limit for government expenditures growth. Public expending, according to the document, should grow at a lower rate than the GDP in order to stabilize the Debt to GDP ratio and, consequently, control inflation. Such results would be responsible for the return of confidence in the economy, thus creating a business environment favorable to entrepreneurs. Consequently, it would promote the return of private investment (both domestic and foreign) leveraged by privatizations and concessions. However, it is not clear what would be done during recession periods. In the case of a fall in GDP, spending would be cut for the following year? Even if the recession is caused by aggregate demand shortage? We believe that discretionary analysis is preferable to following rules in these cases. Finally, the rationalization of bureaucracy, the increase of public transparency, tax simplification and incentives to research and technological development complete the agenda of necessary reforms for the economic recovery. Economic policy in Temer s government What could we expect from the economic policy of the Mr. Temer government? By analyzing the PMDB letter of intentions proposed in October 2015, we can identify some of the characteristics that should guide Michel Temer government. It is expected an increase of privatization of state enterprises as well as public concessions, flexibilities of labor rights and focus on fiscal adjustment through the reduction of public spending on pensions and wages (through the end of 5

6 indexation of the minimum wage). Moreover, the legislative and executive will have more freedom to re-allocate resources due to the end of the restrictions on minimum spending in education and healthcare imposed by the current constitution. Therefore, it is expected a further opening of the Brazilian economy, austerity in public expenditure - potentially opening space to increase private spending - and efforts to create a business-friendly environment. The document does not mention income inequality programs, and it does not establish targets for job creation. The pursued strategy is similar to those adopted in Mexico and Chile: reduction of state intervention in the economy, less social protection programs, and focus on competitive sectors in a free trade environment to promote exports. FORECAST Forecast table for 2016 GDP -3.8% Inflation 6.5% % Exchange rate 3.70 Unemployment 11% Interest rate 12.75% GDP In 2015, Brazil experienced a GDP drop of 3.80% and in 2016 the scenario is almost the same. As pointed out in the first quarterly trade report, set forth by MacroMatica, the balance of trade improvement following currency devaluation may not be enough to set the economy back onto a sustainable growth path in The rise in unemployment, coupled with the stoppage of investments due to the political crisis, create a scenario where we expect a fall of 3.80% of GDP this year, representing a loss of nearly 5% of GDP per capita. We expect a gradual recovery of the Brazilian economy in 2017 and 2018, with the recession cooling down in 2017 and a small economic growth in However, the main component for the resumption of growth remains the high uncertainty due the political crisis. Inflation In 2015, Brazil experienced an inflation of 10.67% as a result of a liberalization of State-managed prices, currency devaluation, and indexation. Such elements together contributed to the increase in the inflation rate. With the current scenario, the absence of other adjustments in State-managed prices, the deepening of the political crisis and no other rounds of currency devaluation, inflation should converge this year towards a figure close to the target s ceiling (6.50%). Besides, high unemployment and declining real wages are negatively impacting on the demand side, reinforcing the downward pressure on prices. The market expects, in average, an inflation of 7% for Our models go almost in the same direction, pointing to an inflation rate between 6.50% and 6.75%. It is expected that the Brazilian Central Bank achieve - or at least gets much closer - the center of the target (4.50%) only in Exchange rate As previously discussed, the exchange rate is directly linked to the political 6

7 scenario. In the very short term, the impeachment should generate a quick wave of euphoria in the market, leading to currency depreciation, with the Real fluctuating in a band between 3.30 and 3.60 (BRL/USD). However, in the short to medium term, there should be a readjustment of expectations if the most likely scenario of political uncertainty prevails. Thus, it is expected that the exchange rate remains within a range between 3.60 and 4.00 during the year. By the end of 2016, our models suggest an exchange rate of Unemployment Unemployment, which ended 2015 at 6.80%, tends to present a considerable increase in 2016, reaching double digits. If Mr. Temer decides to prioritize the fiscal adjustment, even if we have a favorable scenario with a small economic growth in the coming years, unemployment is unlikely to reduce. We expect an unemployment rate of 11% by the end of Interest rates With one of the highest base interest rates across the world (14.25%), the government will hardly find political space for further increases in such a policy tool with the aim to steer prices towards the center of the inflation target (4.50%) in In fact, the sharp slowdown in the core inflation shows that the economic recession and the fall in State-managed prices had a positive impact on inflation, which is now expected to settle close to the ceiling of the inflation target (6.50%) by the end of the year. If the downward trend of inflation continues over the first half of 2016, the monetary policy is likely to become less contractionary. To the end of 2016, we estimate a 12.75% base interest rate (Selic). Stock Market Since the beginning of March 2016, the Brazilian stock market has entered in a "rally" that benefited primarily public companies like Petrobras, public banks, and state-owned energy sector ones. If the impeachment process passes in the Senate, we expect a short uptrend tendency in the market. However, if the internal and external conditions of the economy do not suffer significant changes, the trend is likely to be replaced by a less optimistic market. Uncertainty about the strength of the government to implement its proposals should supplant the market optimism. Companies focused on domestic consumption should be viewed with caution. Petrobras, which is currently facing severe financial constraints, is likely to sell Controlling stake in BR Distribuidora. The Privatization of Petrobras is very unlikely because there is still a strong sentiment among the population of the company s importance and it would be necessary a huge political consensus. Finally, we can expect the IPO of Caixa Economica, a state-owned bank that can become a mixed-capital company, with the State keeping the majority of its shares. MacroMatica smart economics 7