Over the last 8 months or so, Brazil has been captivated by the impeachment process of president Dilma Rousseff. As expected, the senate voted to remove Ms. Rousseff from office on Wednesday, August 31st, by 61 votes to 20. Her vice-president and former ally, Michel Temer, already in charge since May of this year after the Senate decided to start the impeachment trial, now has formally replaced her as president and will govern until the end of 2018 (assuming he will not be impeached himself) when new presidential elections are due. Ms. Rousseff was charged and found guilty of concealing the true size of the budget deficit by moving funds between budgets (which is illegal under Brazilian law). Specifically, she used state banks to finance social programmes, like the Bolsa Familia, where the banks were running large overdrafts with the Treasury, who failed to fund the programmes on time (a clear case of “bicicletar” (pedaling) as this widespread practice is known in Latin America). Pedaling has been used by previous governments as well but Dilma pedaled like Eddy Merckx, running up deficits of USD 10 billion in 2013 an USD 15 billion in 2015. Even for Brazilian standards this was a significant tour so that the Federal Court of Accounts rejected the government’s 2014 accounts because of this. Dilma used the money to win votes in 2014’s presidential election that she narrowly won.

Dilma pedaling in front…

Financial markets have rallied since it became clear that Ms. Rousseff could be impeached and removed from office. CDS spreads tightened from 500 basis points in the first months of this year to 260 basis points now. The real was worth 25 dollar cents at the beginning of the year against 31 cents today and Brazil’s equity market rose by nearly 35% this year. However, Brazil’s economy is in dire straits, shrinking 3.8% year-on-year in the 2nd quarter. Unemployment is up from 7% in 2014 to nearly 11% today and is set to rise further as domestic demand is contracting. Inflation remains stubbornly high at 10%, requiring the central bank to keep the interest rate at 14.25%, although we would expect that inflation will subside in the course of next year. Little wonder then that the government’s finances keep deteriorating with the fiscal deficit expected to be -9.9% by year-end and gross government debt reaching 75%. Exports are the only bright spot right now, helped by the depreciation of the real, although weak commodity prices (metals and oil specifically) are dampening the positive impact of a more competitive currency. The issues that need addressing are well known (read, for example, our previous blogs on Brazil): slash government expenditure in non-productive areas, reform the ridiculously lavish pension system for civil servants, get rid of automatic inflation linkage to government outlays and wages, improve infrastructure to boost productivity, introduce a VAT to replace a myriad of indirect taxes, reduce trade barriers and subsidies and, last but certainly not least, improve (primary and secondary) education.

So, Mr. Temer and his team have their work cut out for them with an urgent need to slash government expenditure to avoid a debt crisis. Mr. Temer’s short-term plan is a freeze on total public spending (in real terms as opposed to nominal terms, we understand) for up to 20 years. This is a rather crude instrument as current budget misallocations may not be addressed but it also means there is no room for pork barrel politics, an omnipresent feature in Brazil’s Congress. The spending freeze requires a constitutional amendment so needs a three-fifth majority vote in both houses of Congress. It is by no means certain whether Mr. Temer will succeed to get the measure approved (even members within his own party, the PMDB, are demurring) and, in any case, the spending freeze does not prevent primary budget deficits for a few years to come.

Therefore, political uncertainty will persist, in our view. This is made worse by the seemingly never-ending Petrobras corruption case. Temer’s political party, the PMDB, is deeply involved in the Petrobras corruption case. Some of his ministers had to resign, ironically including the anti-corruption minister, Fabiano Silveira. In July, the speaker of the Lower House, Eduardo Cunha, resigned in tears (but not before greenlighting the impeachment request). Cunha, a conservative evangelist who would not be out of character in House of Cards, has warned Temer that if he has to go to prison, he will not go alone. Cunha probably will not be the last politician to be implicated in Lava Jato. Given Brazilians’ loathing of their politicians, it is difficult to see how the political landscape will develop in 2018 when new elections are to be held. A whole class of new “clean” politicians would need to be elected to break with the past, but chances are that many corrupt(ible) politicians will survive thanks to the byzantine political system. Today, there doesn’t seem to be an untainted leader who could run the country.

Time to party?

Although we believe that Brazil’s economy is bottoming out, financial markets do not seem to price in this political uncertainty and have been on fire as if it is time to party (Brazilian corporate bonds trade at a spread of 540 basis points, half the level reached in February this year). Our base case scenario is that Brazil will muddle through, making enough spending cuts to avert an immediate debt crisis but failing to make long-lasting structural reforms that make Brazil great again (apologies for this Trumpism). So, no party time yet, in our view. We still believe it would be better for Mr. Temer to resign and to hand over the keys of the Planalto to an untainted technocrat with economic reform credentials as it would be easier for such person to rise above the parties and to cut a sensible deal. Armínio Fraga may fit the bill but we think this is unlikely to happen. Let’s at least hope that Michel Temer will not use accounting tricks to make ends meet. As Brazilian football star Pelé once said: the bicycle kick is not easy to do…