Brazil’s president, Dilma Rousseff has been removed from office for up to 180 days while the Senate holds an impeachment trial regarding the use of ‘creative accounting’ (pedaladas fiscais) by her government. The Vice President, Michel Temer will now be elevated to the office of the presidency. Should President Rousseff be absolved of the charges against her, she will return to office. However, the current outlook is for Rousseff to be permanently removed with a vote in the Senate expected to occur between August and November.

While much is expected from a new Temer government, the timeline for showing progress will be short, while the margin for error is small. Here we discuss what the primary challenges are facing the new Temer government, while also providing an overview of targeted reform measures and signposts that multinationals can use to follow the progress of the new government and quickly react to changing economic conditions.

The challenge faced by the new Temer government

The primary goal of the new Temer government will be to drive higher business confidence and renewed investment. In order to do so, Temer will need to demonstrate significant progress toward fiscal consolidation and overarching structural reform in only the first months of his new government.

At the moment, Temer appears to have the necessary support in Congress to proceed with reform. The PSDB, the party that has been in opposition of the PT for the last 13 years, will join the PMDB in its attempt to enact fiscal and structural reform. However, the PSDB leadership has already stated that it expects the new Temer government to begin passing new legislation within one month. With new presidential elections set for October 2018, the PSDB will be unwilling to stand by the new Temer government if the situation begins to deteriorate. This short timeline will give Temer very little margin for significant political blunders.

Presenting further pressure in the short-term, the Brazilian Congress continues to be significantly fractured, and the one individual believed capable of keeping the Chamber in line, Eduardo Cunha, was removed from his position by the Supreme Court only days before the Senate voted on impeachment. With or without Cunha, Temer needed to continue the horse-trading that has long-marked politics in Brasilia in order to pass reform measures. However, without Cunha at the helm, this task has certainly become more difficult.

Finally, Temer’s party continues to be embroiled in the ongoing Lava Jato investigation (which is scheduled to conclude only in December). When looking at the composition of Congress, Temer would appear to have the necessary votes to push reform measures through Congress. That said, looking at the Rousseff coalition in January of 2015, the same conclusion could have been made, but instead Rousseff’s government was entangled by the corruption investigation and quickly lost its political capital. With investigations ongoing, and coalition loyalty at an all-time low, Temer can be said to face parallel challenges.

Key reform measures and opposing forces

With Brazil’s overwhelming fiscal challenges, Temer will need to begin by both cutting spending and raising new tax revenue.

• Delinking of spending from government revenue – With more than 90% of the federal budget made up of mandatory spending, the PMDB has suggested that it will attempt to delink key spending categories from government revenue growth. Such categories include education and healthcare, both of which have strong constituencies that will make passing new legislation extremely difficult.
• Pension reform – Brazil’s pension obligations are rising rapidly, with pension payments representing 54% of federal government current expenditures in 2015, after having risen by 10% in absolute terms in the same year. In order to reduce this cost, the PMDB has proposed raising the minimum retirement age for both men and women. Such a policy is vehemently opposed by most labor organizations.
• Increased tax revenue – The government has been desperately seeking new revenue over the past 12 months, selling assets and raising select tax rates. However, in order to achieve a primary fiscal surplus and stabilize the public sector debt to GDP ratio, it will be necessary for the Temer government to enact new tax measures. The most likely of which now are the CPMF (a financial transaction tax) and a tax on inheritance and capital gains. As Brazil’s tax burden now exceeds 34% of GDP, new tax measures will prove very unpopular. Additionally, upcoming elections in October at the municipal level will drive even greater hesitancy for coalition political parties to openly support new tax measures.

Signposts to watch and significance for business

As stated before, Temer is likely to have a very short honeymoon phase to make significant progress in terms of reform measures. In that regard, FSG is pushing clients to understand the key signposts to watch in order to quickly react to changing conditions and economic outlook.

• New president in the Chamber of Deputies – After the removal of Eduardo Cunha, a key ally of Michel Temer, the Chamber of Deputies faces a significant challenge in terms of its president, as the role is key to the proper functioning of the body. The interim president, Waldir Maranhão, lost legitimacy upon attempting to annul the impeachment process earlier this week, and as of today it is unclear if and how the chamber will be able to select a new leader. Look for a solution to be had in the next days, without which the new Temer government would be crippled before it even begins.
• July 17th – While the next 7-10 days will be critical for the new Temer government, FSG views July 17^th as the approximate deadline for the government to show considerable progress in terms of its reform program. On this date, the Brazilian Congress will break a two-week recess. By this point, look for the new government to have at least realized preliminary votes on bills to move forward with pieces of its reform package in Congress (e.g. pension reform, delinking of key spending categories from the budget, and the introduction of new tax measures).
• Business sentiment – Independent of the speed of reform, the Temer government will need to generate sufficient market confidence so that business sentiment begins improving in the short-run. Indeed, Temer and his allies have already been active in engaging the business community prior to the impeachment vote. While business sentiment fell in April, look for sentiment to begin strengthening already in May and into June.
• Lava Jato – Ongoing investigations into key members of the PMDB, PSDB, and other coalition partners could potentially deepen and threaten to derail continued cooperation. Furthermore, other ongoing cases such as Operation Zelotes (an investigation centered on Brazilian businesses that allegedly bribed the main tax investigation unit) could produce evidence of new wrongdoings by important political parties, thus creating new obstacles to reform.

Without progress on key budget reform measures, which remains FSG’s base-case, markets will quickly turn on the country’s currency, driving further depreciation in the second half of 2016. This would occur at the same time that the Fed is undergoing additional rate hikes in the US, thus driving heightened currency volatility in Brazil. Furthermore, a delay in reform, or the eventual return of President Rousseff (which cannot be completely ruled out) would ultimately result in a ‘muddle-through’ situation, with a robust recovery only beginning to surface in the quarters leading up to the next presidential election, slated for October 2018.

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