Brazil’s economy is in dire straits, experiencing a balance of payments crisis amid political dysfunction. How did we get there?

Since 1993 when Fernando Henrique Cardoso introduced the real, Brazil experienced macroeconomic improvements (with a brief interception in 1998-2000 when the country came under investor pressure after the debt crisis in Asia and Russia and the slow-motion collapse of neighbor Argentina), resulting in growth pick-up and inflation decline (which ran at 1,500% in 1993). The country adopted a conservative fiscal policy resulting in lower public sector net debt and lower real interest rates (which were 25- 30% in the mid 90s). Helped by the boom in commodities, Brazil became an attractive destination for FDI. Unemployment fell from 12% in the 80s-90s to 6%.

When the Federal Reserve ignited its quantitative easing policies in response to the financial crisis in 2008, investors refound their love for riskier, higher-yielding Emerging Markets assets. Easy money flowed into the country, so much that the government actually imposed a penalty (the IOF tax) to discourage foreigners to send money Brazil’s way. Brazil’s currency, the real, became very expensive, reaching a low of 1.54 reais per dollar in mid-2011. Thanks to a credit boom (Brazilian banks’ access to international capital markets was wide open), consumption, unfortunately mainly comprising imported luxuries, increased rapidly. Wage costs grew ahead of productivity gains, which made Brazil uncompetitive. To make matters worse, manufacturing suffered from a high tax burden, poor infrastructure and low educational skills. The current account went into persistent deficit (-4.3% in 2014). Worse, instead of importing capital goods and funding to improve infrastructure, many Brazilians went on a buying spree acquiring condos in Miami Beach. Meanwhile, the government refrained from pushing through much-needed structural reforms (not Brazil’s strongpoint in any case) and instead led the bloated civil service get even bigger. Civil servants can retire at 55 and receive a well-endowed pension. So much, that many retired men have no problem finding a playful young woman to spend the rest of their (now romantic) life. When he dies, the young widow will get almost his full pension for the rest of her life (in Brazil called the “Viagra effect”). Government expenditures as percentage of GDP exceeded 40% (compared to Mexico’s 26%).

When commodity prices declined due to weaker demand from China and investors reconsidered their love affair with Emerging Markets assets after the Federal Reserve discontinued its asset purchases, Brazil’s economy came to an abrupt halt.

The government’s response was to weaken the real by intervening in financial markets (always a wasteful exercise, in our view), to cut interest rates (even though inflation was rising to 6.3% in 2014), to support industry through subsidized public credit (BNDES loans grew from 6% to 11% of GDP), to cut electricity tariffs (discouraging new investments in the sector), to increase tariff protection for certain industries and to privatize infrastructure (ports, airports, roads). Despite these (mostly ill-advised) measures, Brazil’s economic growth slowed from 2.5% in 2013 to about 0.1% in 2014. Fiscal discipline was also thrown out of the window, especially in 2014, which was an election year. The primary balance for the first time went into negative territory (-0.6%; +3.4% in 2008), whereas the fiscal balance reached a terrifying -6% in 2014 (against -2.0% in 2008).

The decline in the oil price since the middle of 2014 (Brent dropped from USD 110 p/b to below USD 30 p/b as of January 2016) has hit Brazil hard and exposed the structural problems that the country is facing. With the presidential elections out of the way, Dilma Rousseff decided to change track and effectively adopted the more orthodox macro-economic policies of her opponent in the elections instead of continuing with her disastrous populist agenda. Mrs. Rousseff appointed Joaquim Levy, an University of Chicago-trained former Treasury secretary, as finance minister. Mr. Tombini, the flawed head of the central bank, announced that the central bank would reduce its reserve-wasting currency intervention program to prop up the overvalued real (better late than never) and Mr. Levy wasted no time to hike interest rates to fight inflation.

However, Dilma’s political position, already suffering from a bruising election campaign, further weakened after a large scale corruption case was discovered at Petrobras in March of 2014 (known as the “Lava Jato” which loosely translates as operation car wash; the name comes from the use of a chain of dry cleaners and gas stations to move money around) of which the magnitude only became more clear in September of that year. Before succeeding Lula as Brazil’s president in 2010, Mrs. Rousseff was responsible for overseeing Petrobras in her role as minister of energy. Suppliers of Petrobras were told to overcharge the company for projects and equipment and pay the surcharge into shell companies used to funnel money to politicians, including members of Dilma’s Workers’ Party (PT) and the PMDB, the most important coalition party. Public discontent grew, forcing the hands of the courts actually to prosecute politicians that are involved in this case, including heavy weights like Lula and his former chief of staff Jose Dirceu as well as Eduardo Cunha, speaker of the lower house and PMDB political leader. The political situation deteriorated late last year after the Federal Accounts Court ruled that the government illegally used money from state banks to pay for social welfare programs in the run-up to the presidential elections in 2014. This cleared the path for initiating impeachment proceedings against Dilma Rousseff, which was vetted by Eduardo Cunha. His move was probably driven by the detention of Delcídio do Amaral, a leading senator from Dilma’s party, dispelling a long-held belief that sitting lawmakers are all but untouchable because of a quirk in Brazilian law that affords politicians special treatment in criminal investigations.

It is highly uncertain whether Ms. Rousseff in the end will be impeached but what is certain is that Brazil risks to become ungovernable in the meantime. About 90% of the federal reserve is constitutionally ring-fenced, so without political willingness to act not much can be done, even if Dilma had the strong conviction to cut spending (which we doubt). Much-needed government spending cuts were rejected for inclusion in the 2016 budget, which induced Joaquim Levy to resign. He was replaced by Nelson Barbosa, a less formidable left-leaning figure. Meanwhile, the economic metrics make grim reading. Mr. Barbosa’s first act was to announce that the 12-month primary fiscal deficit worsened by 0.2% to 0.9%. The overall fiscal deficit for 2015 may turn out to be more than 10%. The economy is in outright recession with GDP growth in 3Q15 shrinking by 1.7% quarter over quarter, the third consecutive quarter of decline. The IMF expects that GDP has shrunk by 3.8% in 2015 and will decline by a further 3.5% this year. Inflation reached 10.7%, preventing the lowering of interest rates (Selic now stands at 14.25%). Although Mr. Barbosa promised that he would implement Levy’s policies, he is (or, at least, has been) a lap dog of Dilma (and very much involved in the disastrous policies that led to this mess), who herself is under pressure from her party to ease the fiscal and monetary reins. Meanwhile, public debt as a percentage of GDP is rising fast and is now at 70%. Obviously, the high interest rates required to fight inflation have a detrimental impact on economic growth and debt, so much that many analysts are talking about fiscal dominance (doubting Brazil’s solvency, confirmed by the credit downgrade to junk by Fitch in last December).

With the wrong politicians in charge and a complete political deadlock between the governing coalition parties, it seems unlikely that a credible fiscal policy will be adopted anytime soon. The likelihood of the current adverse economic headwinds developing into a severe and uncontrollable debt crisis has risen substantially over the past couple of months. Dilma has to go for the good of Brazil…