beyondbrics

Brazilian interest rate futures have hit new highs this week as investors continue to demonstrate how little they trust the Dilma administration to defeat inflation and deliver a significant fiscal adjustment.

How so? After barely a month in office, the government could hardly have sent stronger signals that it means business on both the monetary and fiscal sides. For investors, though, talk is not enough. And the longer the government takes to deliver on its promises, the more investors will demand.

But Dilma has already delivered more than talk. She kept the annual rise in the national minimum wage to the smallest allowed by law. And she did it in the teeth of opposition from her biggest coalition partner, the pork-loving PMDB.

Investors worry that the true cost of the deal will appear later. But the PMDB appears to have been bought with assurances that it is not “in” the government but “is” the government, plus the “rehabilitation” of Renan Calheiros, a disgraced former leader of the Senate. If that’s it, Antonio Palocci, Dilma’s chief of staff and behind-the-scenes string puller (pictured with her) really is, as many suspect, a genius.

Elsewhere, too, tough talk has been matched by deeds. Until the 2011 budget is ratified, ministries should be getting one-twelfth of last year’s budget per month. But Dilma is giving them just one-eighteenth. And Dilma has held back from filling what are usually jobs for the boys, saying only technocrats may hold administrative positions.

But investors want more. Dilma has promised big spending cuts and the word is these will amount to R$40bn to R$60bn – at the top of the range, almost 2 per cent of GDP. That is a massive adjustment that would slash Brazil’s budget deficit by two thirds. The trouble is, many investors now regard it as the acceptable minimum.

“The difference is between delivering the minimum and delivering a credibility shock,” says Flavia Cattan-Naslausky of RBS Securities. “If she could do that [the latter] – wow! But she is having trouble delivering the minimum.”

Cattan-Naslausky, who describes herself as a sceptic, says investors are right to be worried. In addition to global food inflation, Brazil has an output gap and inflation is spreading across the economy. Meanwhile the central bank has lengthened its inflation outlook from a year to a year and a half – nothing wrong with that, she says, but it’s not exactly hawkish.

On top of that, she says, Dilma has inherited:

Self-defeating foreign exchange policy in the form of prolonged intervention on the spot market: the central bank is always there, buying dollars, reducing volatility and giving investors a guaranteed carry between the Brazilian Selic at 11.25 per cent and Libor at 1.55 per cent a year – plus appreciation in the BRL.

Expansionist and opaque fiscal policy: the Lula government spent Brazil out of recession in 2009 and kept right on spending last year, when growth was about 7.5 per cent. It also massaged public accounts to deliver a less than credible primary fiscal surplus (before debt payments).

Monetary policy too, has become less transparent, as the central bank has gone beyond its one-weapon arsenal of interest rates to use “macroprudential” measures such as reserve requirements, and intervention in futures and forwards markets. All these are harder to foresee, and therefore harder to account for in risk analysis.

Poor Dilma. With none of Lula’s populist charisma, she offers instead the promise of hard-headed discipline and tight government. In several of Brazil’s states, this has turned out to be surprisingly popular. But investors will believe it when they see it.