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Brazil's President Dilma Rousseff speaks during breakfast with reporters at the Planalto Palace in Brasilia Dec. 27, 2012. (UESLEI MARCELINO/REUTERS)
Brazil's President Dilma Rousseff speaks during breakfast with reporters at the Planalto Palace in Brasilia Dec. 27, 2012. (UESLEI MARCELINO/REUTERS)

Analysis

Rousseff makes controversial bet on Brazil’s economic future Add to ...

President Dilma Rousseff’s big bet in 2013 is that Brazil has matured enough to escape from a financial straitjacket that markets have imposed since the 1990s, when inflation soared beyond 2,000 per cent and the state was virtually bankrupt.

Since that chaotic era, Brazil has played by a more conservative set of rules than most modern economies – with laws that tightly regulate government spending, interest rates exceeding 40 per cent on consumer loans, and other rules and practices designed to reduce financial risks and ensure the bad times don’t return.

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Now Ms. Rousseff, a left-leaning economist who likes to make key financial policy decisions herself, is boldly wagering that Brazil is ready to turn the page.

This year she plans to loosen decade-old rules on public spending; ensure that benchmark rates stay at their current record low of 7.25 per cent, even if the economy accelerates; pressure banks into lending more; and force investors to accept lower returns on infrastructure projects and other investments.

The policies amount to a bet that Brazil’s government has earned enough credibility over the past two decades, and the economy has undergone sufficient structural change, to remove some of the safeguards that protected it from disaster, but may have also restrained growth in recent years.

If Ms. Rousseff is right, her moves could stir the world’s sixth-biggest economy from its recent doldrums and back on course for growth of 4-per-cent-plus in 2013 and in years to come.

If she’s wrong, some of Brazil’s old ghosts – high inflation, low growth and general financial disorder – could rear their heads again.

While a meltdown is unlikely, Brazil could slip further behind its peers in Latin America and the BRICS group of major emerging markets – which includes Russia, India, China and South Africa – and Msd. Rousseff’s re-election for a second term in 2014 could be in jeopardy.

Arminio Fraga, a former central bank president who helped design some of the financial framework that Ms. Rousseff now seeks to modify, is part of an increasingly vocal group warning that some of her government’s efforts may be misguided – or at least premature.

“Brazil has had a good run. Risk has been coming down here and we’ve enjoyed the benefits of that,” Mr. Fraga said in an interview. “But there’s no sense in abandoning the system that has served us so well.”

Mr. Fraga, a founding partner of Rio de Janeiro-based Gavea Investimentos securities firm andis still treated as an oracle in the business world here, said Brazil remains in good shape overall. But he said Ms. Rousseff’s willingness to intervene in the economy and expand the state’s role “resembles a bit of what we had in the 1970s” – when the country began to veer into real trouble.

Financial house of horrors

It seems like ancient history in today’s more stable Brazil, but that period of economic chaos still has a huge impact on day-to-day life.

Gross financial mismanagement by successive governments resulted in inflation that by one measure totalled an almost inconceivable 1.8 trillion per cent from 1968 to 1993.

Repeated attempts at stabilization failed, and Brazil had six different currencies in the eight years to 1994. Only then was former President Fernando Henrique Cardoso able to bring inflation down to single digits thanks to the so-called “Real Plan” – which introduced the real, the currency still in use today.

It was accompanied by reforms that plugged the perennial hole in public finances at the root of Brazil’s problems.

Since then, Brazil’s reputation has done an about-face, with the country widely regarded as a success story. The stability provided by the Real Plan gave many Brazilians access to credit for the first time, leading to two decades of solid economic growth that lifted some 30 million people out of poverty.

Despite its turnaround, Brazil’s government is still treated like a recovering addict, with a number of protections in place to ensure it doesn’t relapse.

Ms. Rousseff wants to change perhaps the most hallowed protection of all – the so-called Fiscal Responsibility Law, which was passed by Congress in 2000 and in part requires the government to compensate for any loss in revenue with an equal cut in spending.

The subject is so taboo that the government revealed its plans on the Friday between Christmas and New Year’s Day – suggesting it wanted as few people as possible to notice.

The change, which must be approved by Congress, would essentially loosen some of the law’s accounting rules. That would give Ms. Rousseff the freedom to sharply cut taxes, which are among Latin America’s highest, without making painful spending cuts, which could damage the economy.

Ms. Rousseff has let other long-sacred fiscal principles slip as well. Members of her economic team have said that in 2012 Brazil likely missed a key budget target, known as the primary surplus, which is a way to measure fiscal prudence. Making the 2013 target is in doubt, as well.

Despite some concerns, it seems likely Ms. Rousseff will get the greater budget flexibility she craves, with minimal protest from legislators or financial markets.

While not beloved by investors, Ms. Rousseff is seen as a sober economic steward who has limited government spending when necessary during her two years in office.

More importantly, she can argue that Brazil now has a clear track record of managing its accounts – public debt has fallen from nearly 60 per cent of gross domestic product a decade ago to just 35 per cent today, a low level that just about any rich country would love to have – although some rating agencies say it underestimates Brazil’s liabilities.

Ms. Rousseff is also sure to have support from Brazil’s business lobby, which believes an across-the-board tax cut is the best way to revive an economy that grew just 1 per cent in 2012.

Still, long-time Brazil observers worry about precedent, aware there are still profligate forces lurking in Brasilia.

“I don’t think (the proposed change) is a disaster,” said Alberto Ramos, Latin America economist at Goldman Sachs. “But by opening the door, you could eventually use those exceptions to do other things that are not warranted.”

‘Culture of high rates’

The far riskier bet is the one that Ms. Rousseff is making on inflation and interest rates. If it goes bad, it could potentially sink her presidency.

The benchmark Selic interest rate has for years been way above rich nations and other Latin American countries – another legacy of Brazil’s turbulent years. The Selic hit 25 per cent as recently as 2003, and was at 12.5 per cent in August 2011.

That was when Brazil’s central bank, led by its chief Alexandre Tombini but with clear input from Ms. Rousseff, set in motion an aggressive and unexpected rate-cutting cycle that pushed the Selic to its current record low of 7.25 per cent.

Economists generally agree the rate cuts now look prescient, as Brazil’s economic struggles and the euro zone crisis have kept a lid on inflation at home and abroad.

The potential problem: Ms. Rousseff wants rates to stay as low as possible throughout 2013, preferably at their current level.

Many investors warn that’s a recipe for trouble. Inflation has already crept up to 5.78 per cent in the past 12 months – near the top of the central bank’s target range, despite the moribund economy.

Meanwhile, economic activity is expected to kick into a higher gear at the beginning of this year, pressuring demand even more. A coming hike in gasoline prices will further complicate matters.

Some officials privately admit the approach carries risks, but say only bold government action can bring the financial system into line with other economies.

“We have to end this culture of high rates in Brazil,” a senior official said, speaking on condition of anonymity. “There’s no logical reason for them to still be so high … The market won’t (bring rates down) if we don’t oblige it to.”

The central bank has said it will raise rates if necessary. But Ms. Rousseff has made the record-low Selic one of her government’s calling cards, and touted the achievement in her end-of-year address on Dec. 23.

She has also publicly lobbied banks to translate the lower Selic into a bigger decline in interest rates for consumers, saying she “won’t rest” until they do.

And while investors have been spoiled with double-digit returns on investments in government projects, a coming wave of infrastructure programs such as railroads will only offer returns comparable to Brazil’s current lower rates, according to officials.

An enduring shift in interest rates would give Ms. Rousseff the defining achievement of her presidency and bring enormous benefits for Brazil’s economy – reducing business costs and making financing for construction, mortgages and other long-term investments more widely available.

But if Ms. Rousseff moves too fast and prices spike while growth stays flat, she will endure a third straight year of disappointing economic performance.

That would make her vulnerable to a challenge in the 2014 election from opposition leader Aecio Neves or another candidate. Voters are extremely sensitive to inflation when evaluating their leaders – another legacy of the 1990s.

Will it work out? Has Brazil left its past behind?

Gray Newman, Latin America economist for Morgan Stanley, said Ms. Rousseff’s saving grace ironically may be another down year for the global economy which helps keep prices subdued.

“Her strategy may well work in 2013,” Mr. Newman said. “But that won’t necessarily mean it’s a new era for Brazil.”

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