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With Dilma out, all eyes on structural reform

With the passage of Dilma Rousseff’s impeachment earlier this week and an appeal to Brazil’s top court unlikely to succeed, investors are now shifting their attention to whether the country’s lawmakers will be able to push through essential reforms – on which any long-term material improvement in the country’s circumstances depend.

Sep 2, 2016 // 2:11PM

The Brazilian Senate voted 61-20 in favour of dismissing Rousseff on Wednesday, which was quickly followed by promises of an appeal by the ousted former president. The decision has paved the way for Michel Temer to remain as the country’s president until fresh elections are held in 2018.

Despite a slight bump for equities trading on the Ibovespa, markets were mostly subdued in the wake of the vote as the result was widely anticipated by analysts.

“The markets had priced in [the impeachment] many months ago. The actual impeachment process started in December and it would have been a surprise if it had been delayed or the vote was close,” said John Peta, Head of Emerging Market Credit at Old Mutual.

Borrowing costs for many Brazilian entities have already dropped significantly since February this year, when a major sell-off in EM assets compounded the already precarious situation on the ground in the country. Brazilian corporates have already issued US$14.5bn in dollar denominated bonds this year, up from US$7.5bn the year before.

Vale was the most recent Brazilian corporate to price a dollar bond, when it printed US$1.25bn to yield 5.875% - over half of what comparable notes were yielding just five months earlier.

“I think the key issue going forward is the reform agenda that Temer can get through congress. Certainly the new Minister of Finance and Central Bank governor provide greater confidence in Brazil but many of Brazil’s problems are related to the fiscal rigidity,” Peta said.

Samar Maziad, a Vice President and Senior Analyst at Moody's said the Temer government has had some success in passing key reforms through Congress, but the details of key reform proposals such as social security reform remain unclear.

A new report published by Moody’s this week suggests that while the Temer administration has proposed a series of positive fiscal reforms, including a controversial bill that would freeze primary public expenditures in real terms for at least ten years beginning in 2017 and commits to inflation-linked spending increases, and a constitutional amendment designed to decouple social expenditure spending from rises in tax revenue, complying with the proposed spending cap would be extremely difficult without social security reform.

“Benefit payments currently account for about 40% of total federal spending. Absent an increase in retirement age and removal of indexation of benefits to the minimum wage, other government expenditures would have to be cut drastically to assure total public spending is consistent with the cap.”

Signs of an impending recovery in Brazil are mixed. The Brazilian government recently revised its GDP growth forecast up to 1.6% in 2017, up from a previous forecast of 1.2%. Inflation forecasts for next year remain unchanged at 4.8%. The IMF has adopted slightly more conservative estimates, and is forecasting growth of 0.5% next year following a 3.3% contraction by the end of 2016.

At the same time, the Central Bank, led by Ilan Goldfan, is struggling to control inflation, which is currently stuck at 9%. The Bank recently kept interest rates unchanged – for the sixth straight time – at 14.25%, citing higher food prices primarily.

Nevertheless, cautious optimism prevails as attention shifts to the political challenges ahead.

“Fiscally speaking, there is no room to increase taxes, and these social spending and constitutional reforms will have to pass,” said Zeina Latif, Chief Economist at XP Investimentos in São Paulo. “The real question is whether the reforms [Finance Minister Henrique Meirelles] tables will make it through the lower house without being watered down.”

Timing is essential. Whether Temer and Meirelles can get these reforms passed soon enough to see them bear fruit before general elections in 2018, but well-before that round of voting – in order to regain any political capital lost if things don’t go as planned – means their window of opportunity is more narrow than most concede, Latif explains.

“We are optimistic. But while we have seen hot money coming into Brazil for the past couple of months as investors chase bond and equity yield, long-term money investors and institutionals will need to see these political questions worked out.”

Americas Macro Policy & Government

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