When Dilma Rouseff’s government announced the reduction of its primary surplus goal from 1.6 percent of GDP to .15 percent a few weeks ago, the reaction from international ratings agencies and currency markets was both swift and negative. While Brazil was able to retain its investment grade rating for the time being, the government was put on warning that it needs to quickly get its fiscal house in order.

However, in order to avoid a credit downgrade, President Rousseff’s administration will need to find a way to raise revenues amidst a deepening economic contraction. With a splintered political base in congress and a countrywide pro-impeachment protest scheduled for August 16, there is growing doubt that President Rousseff has the political support necessary for such an adjustment.

Reaching the new fiscal goal is far from guaranteed

In its latest fiscal report the government stated that it still expects 2015 public revenues to come in 1.4 percent higher than in 2014, a goal which the administration has calculated will require special revenues of R$51.6 billion during the second half of 2015. This figure is more than twice the amount brought in by “special revenues” in the second half of 2014. Additionally, in order to bring in these extra funds, President Rousseff will require greater cooperation from the legislature, where she currently has few allies. Not only will the administration rely on the legislature to pass new revenue generating legislation, but it will also need to protect against veto overrides for bills that would increase public spending on retirement benefits and public salaries.

Furthermore, overly optimistic government growth projections also stand to threaten the government’s primary surplus goal. With annual inflation at just below 10 percent and the central bank looking to regain credibility by maintaining its benchmark interest rate at 14 percent, private consumption will remain depressed in the near future. Likewise, uncertainty created by the ongoing investigations surrounding the Petrobras scandal and the oil giant’s decision to cut 37 percent of its capital expenditures between 2015 and 2019, are weighing heavily on investment.

Both falling demand and investment played into reduced output and employment in the first half of the year, leading to a .94 percent fall in government revenues during this period. While the administration has attempted to support job numbers through special programs and has announced a plan to launch R$198 billion in infrastructure concessions, these measures are unlikely to halt the continued fall in employment and further deterioration of the government’s tax base.

The President and Congress

Ultimately, the administration will need to restructure its political base in Congress if it is to have a shot at achieving its new primary surplus goal of .15 percent of GDP and avoiding a credit downgrade. To this end, President Rousseff is furiously meeting with the different congressional party caucuses and is considering a reorganization of her ministers (one of the main levers used to sustain a political coalition in Brazil).

President Rousseff has also turned her attention to the Senate, where her administration believes greater cooperation may be forthcoming. Indeed, in recent days President Rousseff has seen renewed engagement from the body’s president, Renan Calheiros, who has agreed to lend his support to a delayed bill that would raise new revenues by eliminating tax reductions for companies. However, key legislation that would incentivize companies to repatriate funds held abroad, generating further revenue and laying the groundwork for potential interstate tax reform, is still highly contested. Moreover, the lower chamber continues to pose a threat as it votes on legislation that would create significant new spending obligations and is unlikely to cooperate with additional measures proposed by the administration.

Impeachment

With her attention focused on the economic adjustment, President Rousseff must also remain attentive to several outstanding threats to her administration. These include the ongoing corruption investigation at Petrobras (where President Rousseff once served as the president of the company’s board of directors), the review of her government’s fiscal accounting in 2014, and the potentially illegal financing of her 2010 and 2014 presidential campaigns (also related to the Petrobras scandal). While these are serious challenges, at this time there are no legal grounds to justify an impeachment, and the party that takes over in this scenario would be stuck facing the political fallout of a still-sinking economy. In this regard, FSG continues to see the likelihood of impeachment as being restrained. Still, failure by the government to generate sufficient support in Congress to achieve its stated primary fiscal surplus goal could prove a blow from which a Rousseff administration may not recover.

Looking forward to growth in 2017

While FSG has revised its 2016 forecast from zero growth to a contraction of -.2 percent due to the need for further fiscal contraction, there are underlying bright spots and reasons to look forward to expansion in 2017. To begin, inflation should begin to fall with the conclusion of the pass through of the elimination of certain price subsidies, thus allowing for a less aggressive policy stance by the central bank. Both falling inflation and slightly lower interest rates will serve to support private demand and investment. In addition, the sharp adjustment in the value of the real (which has depreciated by nearly 30% so far this year) has just begun to support a shift in demand from externally produced goods to their domestic equivalents. The currency factor will provide increased international competitiveness for Brazilian manufacturers and is consequently expected to sharply benefit the country’s current account over the coming 12 months.

Actions to take

While the risk of a credit downgrade is undeniable, Brazil’s robust foreign currency reserves, which amount to 19 percent of GDP (10 to 15 percent is believed adequate to insure a country’s solvency), provide a significant cushion. However, multinationals should be prepared for continued economic volatility as the Petrobras investigation and political discord continue to drive market uncertainty.

Despite this short-term pessimism, multinationals must turn their attention to their long term positioning in Brazil. Several companies have already made the strategic decision to leverage depressed asset prices and the enhanced purchasing power of the dollar to make key acquisitions or to increase investment in ongoing projects. Such conditions also present an opportunity to localize operations and gain duty free access to the country’s enormous consumer base. Likewise, companies should consider targeting Brazilians located outside of the primary city clusters in the South and Southeast, while also reevaluating their customer segmentation and value proposition.

Indeed, as we documented in our report, Brazil Investment Case Studies, history shows that time and again, the companies who are bold enough to invest during periods of economic downturn are most likely to outperform their peers over the long run.

This post was written by FSG Latin America Research intern, Alec Lee.

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