Last week was an eventful one in Brazilian politics with potentially deep implications for the trajectory of economic recovery. Not only did the Rousseff administration fire and apparently miss with its most potent political weapon, the redistribution of ministerial seats, but it also saw the deepening of two threats to President Rousseff’s hold on office. The first occurred on Tuesday, Oct. 6, when the Federal Elections Tribunal decided to reopen a case regarding the suspected illegal financing of President Rousseff’s 2014 campaign with funds from the Petrobras corruption scandal. The second and potentially more important event took place on Wednesday, Oct. 7, when the Federal Accounting Tribunal rejected the government’s 2014 fiscal accounts.

Minister changes

After many frustrating months of battling Congress over various legislative initiatives aimed at securing a primary fiscal surplus for 2015 and 2016, the Rousseff administration finally triggered its key political weapon, the long planned reorganization of the president’s cabinet. The goal, in short, was to trade minister positions for greater political cooperation.

The Brazilian Democratic Movement Party (PMDB), the party with the most seats in Congress and the Workers’ Party’s (PT) main coalition partner, came out as the main winner. Not only did the PMDB increase its allotment of the federal discretionary budget by 300 percent, but it also took charge of the Health Ministry, one of the most important ministries in the executive branch.

Despite this transfer of power, the first test of the administration’s move, a vote on presidential vetoes of new spending measures, would suggest that the adjustment did little to generate renewed political cooperation.

Unable to co-opt the president of the lower house, Eduardo Cunha (PMDB), the administration chose to negotiate directly with the leader of the PMDB in the house, Leonardo Picciani, in order to secure agreement on the assignment of ministries the administration. The end result was for the PMDB to break into two factions, with one following the government and the other stonewalling the potential vote. By negotiating with Picciani, the government also failed to bring its smaller coalition partners into the fold, driving several of these parties to also rebel.

While the recent failure to generate enough support to hold votes on key presidential vetoes is believed to be momentary, as it is unlikely that the administration’s opponents are willing to commit to higher spending, the government is hardly in a better place than from where it started. Indeed, all indicators point to a continued struggle to secure the necessary backing for key initiatives needed to attain the announced 2016 fiscal surplus goal of 0.7 percent of GDP, a poor sign for the chance of a quick return of investor confidence and renewed growth.

Scenarios for the future of Rousseff’s presidency

While publicly the administration was attempting to trade minister positions for support on critical fiscal legislation, behind the scenes Rousseff’s advisers were also worried about garnering the necessary political support to guarantee the president could complete her current term in office. Indeed, the two main threats to Rousseff’s presidency, impeachment for faulty fiscal accounts and removal from office because of illegal campaign financing, have recently taken significant turns against the administration.

Rousseff finishes her term (Likelihood: 55 percent)

Despite recent events, FSG’s base case remains for President Rousseff to finish her presidency. This is primordially due to the difficulties surrounding political coordination between the PMDB and the main opposition party, the Brazilian Social Democracy Party (PSDB). There is also the question of how a transition would affect the vote intention of the electorate in 2018, especially considering the political repercussions that would be generated by the implementation of a tougher fiscal adjustment and the figure of Luiz Inácio Lula da Silva looming in the background.

• Economic implications: Should President Rousseff survive the mounting threats to her administration, she will still struggle to enact meaningful fiscal reform in the short term. Two factors weigh heavily on the administration’s ability to push through key measures. The first is the apparent failure of the ministerial changes to generate real political support. The second relates to the recent announcement by the ratings agency Moody’s that it will maintain a neutral outlook for its rating of Brazil’s sovereign debt, which currently stands at one notch above junk. A neutral outlook signifies that the agency does not expect a downgrade in the near future, and effectively lifts the pressure on Congress to participate more closely with the administration to achieve a significant rebalancing of the fiscal account.

Impeachment for faulty fiscal accounts (Likelihood: 35 percent)

The unanimous decision by the Federal Accounts Tribunal on Wednesday to reject the government’s 2014 fiscal accounts has set off a process by which impeachment is one of several possible conclusions.

Despite the ruling by the Tribunal, it is Congress that holds the ultimate power to rule on the government’s fiscal accounts, and a vote on the matter is expected by the first quarter of 2016. The rejection of the accounts would be a political event, hence the concern by the administration for garnering stronger backing from its coalition in Congress.

Should Congress elect to reject the accounts, a vote on whether to impeach the president would likely follow, which would occur in the lower house. In order to move forward with impeachment, the opposition would need to attain 342 votes, a majority of two-thirds. Prior to last week, the opposition asserted that it had 280 votes in support of impeachment.

• Economic implications: In the case that the opposition in the lower house is able to acquire the 342 votes necessary to move forward with impeachment, there will likely be an increase in market volatility as investors and consumers react to the doubt raised respecting the future political and fiscal trajectory of the country. However, an eventual conviction or resignation would allow for a deeper fiscal adjustment via a new political coalition. Such an adjustment would help to bring about a quicker recovery of business confidence and thus investment. Likewise, a stable political situation would help to attract foreign investors who, though currently recognizing the Brazilian market as being relatively cheap, are largely hesitant to move in the current political environment. On the other hand, due to the composition of the federal budget, in order to carry out real fiscal reform the new government would need to rely heavily on new tax measures in the short run, signifying a heavier tax burden for companies.

Removed from office for illegal campaign financing (Likelihood: 10 percent)

The now reopened case relating to the government’s 2014 campaign financing is set to be a more lengthy process, with a very best case scenario believed to be between six and eight months, and the potential for the process to last up to two years.

The opposition, however, believes removal from office via a decision from the electoral court to be the preferred route as it could potentially trigger new elections. If a negative ruling were to be handed down prior to 2017, effectively during the first half of the President’s current mandate, new popular elections would be called. However, should a negative ruling be made in 2017 or later, then Congress would ultimately select a new president and vice-president from amongst its own ranks.

As new elections would open the option for a potential PSDB presidency and provide greater legitimacy for the new administration, this is viewed as the preferred option. The hang-up, again, is that the process has the potential to last up to two years. As such, and because of the high bar for evidence necessary to convict the campaign of using illegally sourced funds, FSG puts the likelihood of this event at only 10 percent.

• Economic implications, removal during or after 2017: This scenario would likely be the most destabilizing and least productive of all. Should a change in governments occur in the second half of President Rousseff’s current term, a new president and vice-president would be indirectly elected by Congress. Elections would then be held again in 2018. To begin this would undermine the new government’s legitimacy, and the short timetable would constrain its ability to make significant adjustments, not to mention the sudden interruption to any progress that the current administration would have made towards fiscal consolidation.

• Economic implications, removal prior to 2017: In the low probability case that the Supreme Electoral Court removes President Rousseff from office prior to 2017, the result would be for new elections. In all likelihood, this would bring about a PSDB presidency and a significant fiscal adjustment.

Differently from the case of impeachment, new elections could provide sufficient support for a new administration to not only realize measures affecting the short term outlook for the budget deficit, but may simultaneously permit it to make meaningful changes to the social security system. The latter will eventually be necessary for the long-term sustainability of the country’s fiscal accounts, and would be closely followed by investors.

Actions to take

• Scenario planning: Considering the significant uncertainty surrounding the ongoing political struggle, companies should be implementing scenario planning based on the various potential outcomes outlined above. Key factors to keep in mind are the periods of extended political uncertainty and the potential for significant fiscal consolidation (with the consequent significance for a potential accelerated recovery) that each scenario presents. FSG’s base case projection is for the Brazilian economy to begin recovering by mid-2017, with average GDP growth increasing from 1 percent to 2.2 percent by 2020. The downside scenario calls for negative growth in 2017/2018 with growth only reaching 1-2 percent for 2019/2020, while the upside scenario calls for headline figures to move from 1.5 percent growth in 2017 to expansion at more than 2.6 percent in 2020.

• FX hedging: Companies should also continue to make sure that they are adequately hedged against foreign currency exposure. Although the Brazilian real has currently settled below 4 BRL:USD, movement towards a political transition would likely generate renewed currency volatility, especially if occurring simultaneously with the Fed’s eventual rate rise.

FSG expects the culmination of the current political turmoil to be lengthy, with significant new developments interspersed throughout the coming months. As such, FSG will continue tracking developments on the different fronts, providing analysis regarding the significance for multinationals operating in the country.

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