beyondbrics

By Tony Volpon of Nomura

The recent performance of Brazil’s outgoing government, led by President Luiz Inácio Lula da Silva, does not suggest that his chosen successor, Dilma Rousseff, will tighten fiscal policy.

Ignoring the highly distorted fiscal surplus figures, and looking at spending, we see that the central government’s expenditures in the last twelve months came to R$616bn, a huge 44 per cent increase from 2008. As Lula is leaving office with record-breaking popularity, would Rousseff dare change anything?

Many analysts say no, but we think yes. The belief that the incoming government is set to continue business as usual fails to recognize two realities.

First, Brazil clearly went through a particularly acute case of the “political business cycle”, the well documented tendency for governments to ramp up spending before elections.

The recent increases in big spending, first justified as an anti-cyclical, “Keynesian” response to the 2008 crisis, continued unabated even with economic growth topping 7 per cent a year. Now with the election won, there is no electoral reason to keep spending growth at the current level.

The second unrecognized reality is that this spending surge is already causing serious imbalances in the economy. This can already be seen in very tight labor markets, surging imports, and continued high inflation for non-tradable items (such as services, which mostly can’t be imported).

But more important than these short term effects, the “Lula model” for the Brazilian economy is finally showing its structural limitations.

Lula’s economic policy can be easily described as “one foot on the accelerator, one foot on the brake”; in other words, very easy fiscal, wage and credit policy balanced by very tight monetary policy to keep inflation low. This policy “mix” was politically successful, delivering strong growth and low inflation (in a mostly favorable international environment for Brazil). But a natural consequence of the policy mix is strong currency appreciation: since 2009, the Brazilian real has risen by over 40 per cent in real terms.

If current policies continue, Brazil will eventually face an explosive current account deficit and the destruction of its manufacturing export capacity – and the new government understands this.

Freed temporarily from the election cycle and able to look four years ahead, it has already signalled how it will change policy: cutting spending and credit to ease pressure on demand; and reducing Brazil’s ridiculously high real interest rates to ease pressure on the Brazilian real.

Fiscal restraint is the key element of a new economic “model” for Brazil, and although changing fiscal policy is always slow and difficult, the incentives to do so now are great. As Rousseff knows, an economic crisis is the one sure way to lose political power.

Tony Volpon is head of emerging market research for the Americas at Nomura

Related reading:
11 for 2011: the big questions on emerging markets, beyondbrics

Brazil’s new leader set to take hands-on role, FT.com