As the old financial cliché goes, when the global economy catches flu, Brazil gets pneumonia. Now it is the corruption crisis at Petrobras, Brazil’s largest company, that has proved highly infectious and toxic.
The new finance minister Joaquim Levy, appointed in November to put the economy back on its feet and stem the contagion from the Petrobras scandal to the whole economy, must be wondering what on earth he signed up for.
The largest Latin American economy was already teetering on the brink of recession when the Petrobras scandal broke a year ago. It involves kickbacks on a massive scale at the state-controlled company, with former politically appointed directors taking bribes from large contractors and siphoning funds off to their political masters.
Confessions were obtained as part of plea bargaining arrangements. Pedro Barusco, a former Petrobras executive manager, candidly told a parliamentary investigation committee earlier this month that he used to be a small time crook in the late 1990s (he took bribes on his own initiative, he said) but that he later became involved in a greater corruption scheme, which, he said, was more “institutionalised” after 2003.
That was when the Workers’ Party took power and decided to carve out the Petrobras directorate to appease its various coalition partners and ensure Congressional support.
Barusco offered to pay back the $97m he said he had received illegally in Swiss bank accounts. But this may only be the tip of the iceberg. The total corruption figure may be as high as $2bn, according to the federal police.
So far, Petrobras has been unable to put a precise figure on asset depreciation and to gauge the financial impact of the scandal. It has repeatedly delayed the release of its financial statements. Now it has until the end of May to release last year’s audited third quarter figures. Failing that, Petrobras could be asked to start early repayment of at least part of its mountain of dollar debt.
A new Petrobras executive board was appointed in February. Meanwhile, several CEOs and senior executives of engineering and construction companies have been detained. Fifty lawmakers, mostly from the governing coalition, are now being investigated by the Supreme Court, owing to their alleged involvement in the complex but well-oiled corruption scheme. They include the chairmen of both houses of Congress and even various members of the Petrobras parliamentary investigation committee, as well as former ministers.
Brazil has seen worse
Investors have been taken aback by the recent turbulent economic and political events. The government has a mountain to climb to regain investor confidence and generate positive expectations.
“We have run through a series of difficulties,” Nelson Barbosa, Brazil’s budget and planning minister, tells Emerging Markets, “but our potential is much greater than the size of our problems.”
Barbosa used to be deputy finance minister but left the previous government over policy disagreements in mid-2013. The academic from the Getulio Vargas Foundation, a São Paulo business school, was cited as a potential successor to Guido Mantega, who was finance minister between 2006 and 2014, but he eventually agreed to take on the budget and planning portfolio, which also includes responsibility for the key area of concessions and public-private partnerships. He argues that the current conflicts are manageable.
“We can deal with these divergences of opinion and work towards a consensus in order to put the economy back on the growth path,” he says. “We have had a democratic regime since the mid-1980s, and democracy in Brazil has been able to put an end to hyperinflation, to stabilise the currency and to improve the quality of fiscal policy.
“However great they may seem, the current challenges are less important than those that the Brazilian democracy has dealt with in the past... Brazil is actually a country that moves slowly, but it does go ahead. I think people have to trust our tradition of strength. We are going to overcome this stage much faster than what most people think.”
Belt-tightening
Despite Barbosa’s confidence, this is far from the perfect environment in which to conduct a deep policy adjustment such as the one Levy and his team are trying to implement.
Yet the new finance minister’s tough message was clear from the start. His priority is to curb deficits and avoid a downgrade from credit rating agencies to speculative grade. (Moody’s has already cut Petrobras from Baa1 all the way to Ba2, junk status, since the scandal broke but Brazil remains Baa2/BBB-.)
Last year, the fiscal deficit doubled to 6.7% of GDP. “This deficit is not tenable,” said Levy, who has set new targets of a 1.2% of GDP fiscal primary surplus this year and 2% in 2016 and 2017.
In 2014, Brazil suffered a shocking 0.6% primary fiscal deficit. Levy is now aiming for a nominal fiscal deficit of 2.5% by 2017 in order to reduce the gross debt to GDP ratio. “We need to send strong signals on the budget front,” he said.
One of those strong signals was putting an end to the incestuous relationship between the Treasury and the National Development Bank — BNDES — which has seen massive transfers of public funds to BNDES in the past five years. Such transfers pushed gross debt to 63.4% of GDP last year.
Brazil’s economic situation has deteriorated fast, with the current account deficit also worsening in 2014. The sum of the fiscal and current account gaps came close to 11% of GDP, against just 5% four years ago, says Rodrigo Azevedo, a partner at Ibiuna, a fixed income management fund in São Paulo. “They have figured out that this is not sustainable,” he says.
Letting the currency fall
Levy has signalled that the exchange rate will have to adjust, and the central bank’s attempts to soften the currency depreciation through currency swaps have gradually been phased out.
At the beginning of the year, Levy told investors he had “no intention of letting the exchange rate appreciate artificially”. In a single day, January 30, the real fell 3% against the dollar.
Political instability and protests linked to the Petrobras scandal have also fuelled the currency’s decline. The dollar gained a further 2% on March 8, the day after angry Brazilians banged their pots and pans and jeered President Dilma Rousseff during her nationwide address on Women’s Day. By mid-March the real had depreciated a full 11% since the end of February.
A weaker currency may support the balance of payments in the face of weaker international commodity prices but this is a delicate balance. The central bank swap programme may have had a fiscal cost, but an overshooting of the currency (which hit R$3.25 to the dollar in mid-March after being R$1.60 just four years ago) is bound to complicate the battle against inflation further.
“The passthrough from a weaker currency to inflation is far from trivial (around 6%) and there are a number of amplifying and propagating factors, such as the fact that this has been a very large depreciation that is perceived to be permanent rather than transitory,” says Alberto Ramos of Goldman Sachs global investment research.
Many emerging market currencies have come under pressure as the US Federal Reserve prepares to begin raising interest rates but it is the Brazilian real — along with the Turkish lira — that have suffered most.
Inflation is also being swelled by domestic factors and policy decisions — such as Levy’s removal of subsidies on electricity rates. Headline inflation hit 7.7% in February, well above the central target of 4.5% and its tolerance margin (up to 6.5%).
This points to a likely extension of the monetary tightening cycle (already 550bp in three years, including a lull during last year’s electoral campaign), which in turn will weigh on economic activity.
At the beginning of the month, the monetary policy committee of the central bank raised the benchmark Selic interest rate to 12.75%. At least one further increase is expected next month.
Blood, sweat and Levy
The Chicago University-trained Levy has been speaking the language of truth. “If it does not hurt, it does not work,” could be his motto as he pushes through a blend of spending cuts and tax increases to achieve his ambitious targets.
But he has also learned to negotiate with Congress after the president of the Senate, Renan Calheiros, rejected a presidential decree including key austerity measures.
There was also some speculation about how much support Rousseff would give her new finance minister, who took office at the beginning of the year.
She had consistently blamed the international environment for Brazil’s current economic woes. But she eventually admitted that the previous economic policy, conducted under her first term of office, led Brazil up a blind alley.
“We have exhausted all the resources to fight the crisis that started in 2009,” she said in mid-March. “We have tried to avoid putting the burden of the problems on the people and the workers and put it on public finances and the federal budget. [But] this crisis has lasted for all this time. Now we have to use other instruments to fight it.”
Time for a new direction
Raul Velloso, a former government official and now a consultant in fiscal affairs in Brasilia, says Rousseff actually had little choice but to follow her natural instinct of survival.
“She understood that if there was not a radical policy change [from the policy implemented by the previous finance minister Guido Mantega], the situation would deteriorate very quickly and Brazil would lose its investment grade status,” he says. “There would be a capital flight, or just no entry of capital, which is much needed in a country that runs an elevated current account deficit. Governments always react and adapt to change in order to survive.”
Levy looks confident and absolutely determined to carry out the fiscal adjustment regardless of the hurdles Congress may put in his way. “A lot of things actually do not depend on Congress. He may even postpone expenditures, even though they have been included in the budget,” says Velloso.
Levy’s policies are also viewed as going in the direction of rebuilding trust among investors. “Joaquim Levy has been doing a good job so far rebuilding a policy reputation,” says Ramón Aracena, chief economist for Latin America at the Institute of International Finance in Washington. “If Brazil achieves a 1.2% of GDP public sector surplus and market expectations converge to the target over the next 24 months, confidence will slowly start building up and people will start feeling they are doing better — they should be able to keep the investment grade rating. But I am telling you, there is not too much room for mistake.”
Adds Arthur Carvalho, Morgan Stanley economist in New York: “The finance minister can deliver 80% of the necessary fiscal tightening without any Congressional help. Indeed, the administration could achieve even more if it were willing to hike some taxes even further.” This may include the return of the unpopular (but fiscally powerful) financial transaction tax known as CPMF.
Bouncing back
But what will actually shake the Brazilian economy out of its torpor — and when? Several observers have already been talking of another lost decade in a reference to Latin America’s weak economic growth in the 1980s. But Nelson Barbosa reckons the Brazilian economy can bounce back rapidly before the end of this year.
“This year is going to be negative but it is not a lost year: it is a year of adjustment,” says Carlos Kawall, former treasury secretary and chief economist at Banco Safra, referring to hikes in government-regulated prices, the exchange rate and fiscal measures. “This is the year of truth. A lot of issues are going wrong at the same time, but if most of them are getting fixed, things will look better and we may have a recovery next year.”
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Brazil’s infrastructure hope
The resumption of investment in infrastructure, mainly through concessions, will be central to changing the course of events. But the Petrobras scandal has also meant that all the largest construction and engineering companies are out of the loop or even facing financial difficulties.
The oil and gas sector has been hit hardest. But construction companies that have been under investigation are also active in other infrastructure projects. Galvão, for instance, won a road concession in central Brazil but has been unable to receive a R$2.7bn bridge loan from the national development bank, BNDES.
OAS is a key partner in Invepar, the private consortium that manages the country’s largest airport in São Paulo, but it has put its stake up for sale due to cashflow issues.
Nevertheless, the government is expected to try and inject new blood into its concession programme by April, with new openings in airports, waterways and dredging and better rates of return on investment. “Brazil is able to keep on carrying out its large infrastructure works in spite of the difficulties faced by some companies,” says Nelson Barbosa, budget and planning minister.—T.O.