Written by: David Souccar, Portfolio Manager, Vontobel Quality Growth Investment Team
Brazil’s equity market and currency have been weak this year as investors worry about the upcoming presidential election, the lack of social security reform, and emerging markets in general. We believe the current bout of hand wringing once again underestimates the stability of Brazil’s institutions. Brazil is a vibrant democracy backed by an independent judicial system that was created to correct the difficulties the country inherited from poor stewardship during the previous administration. In this paper, we outline the challenges the new government will face and why we believe it has little choice but to follow economic reform, which is what its people want and need.
This October, Brazil will arguably hold its most important presidential election in the last 30 years. At stake is the economic stability Brazil has battled to achieve since the introduction of the Plano Real in 1994. It is hard to believe that just four years ago the government ran a surplus, public debt was declining, and Brazil’s sovereign credit rating was investment grade. Today, under the mocking shadow of Operation Car Wash, the country’s biggest corruption investigation ever, Brazil’s public finances are a mess. Gross mismanagement by the past administration is partly to blame. But more damaging going forward is an overly generous social security system, whose mounting obligations are eroding the country’s balance sheet. If the system is not reformed, public debt as a percent of GDP will rise near the point of no return — printing money, which will lead to stagflation.
There is little room for Brazil to balance its budget without reform. The government cannot realistically raise taxes. Any increase will choke economic growth and potentially spark social unrest. Public taxes as a percent of GDP have increased from 24% in 1998 to 34% today, the highest of any Latin American country. Eduardo Gianetti, an economist and author of several books, summarizes well the situation: “40% of the GDP flows through the public sector today. And yet half of the households do not have access to basic sewage infrastructure. How is this possible? Bolsa Familia (income transfer program) accounts for just 0.5% of GDP. It is a crumb that falls from the table. But it has a giant impact in the life of millions of families. There is something deeply wrong with public finances in Brazil.”
On the expense side, there are no easy answers, either. Discretionary expenditures represent just 9% of the federal budget. And another 25% goes to hard-to-cut services, like health, education, and the very popular Bolsa Familia program.