Brazil presidential election Zurich, 31.October 2010

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1 Brazil presidential election Zurich, 31.October 2010 Gus Drew Implications of Dilma Rousseff s victory Summary 2 Rousseff s personal history 2 Fiscal and business outlook 3 Outlook for political efficiency and reform 4 The threat of greater government control 4 Conclusion 5 Brazil presidential election 31.October 2010 & Implications of Dilma Rousseff s victory 1

2 Summary We said in the lead-up to the final round of the elections that we did not feel, from the investor s perspective, there would be an enormous difference between the two candidates at least over the next couple of years, if at all. Now that the results are concrete, it is worth just investigating some of the concerns and implications a little more closely. The most commonly aired concerns that we have heard can be listed as follows: 1) Rousseff s history as a militant leftist guerrilla suggests that she will be less business friendly 2) Related to the above concern are fears that she will be slower to lower taxes and to rein in current expenditure by the government 3) The PT party s reputation with respect to corruption will continue to hinder the business environment as well as the effectiveness of government, especially with regard to the implementation of necessary reforms 4) The PT party s acknowledged ambition for a greater role for government, including control of the press, is likely to lead to problems further down the line Briefly, our own view on the above is that the first three concerns are not only wide of the mark but likely to provide for pleasant surprises. As for the fourth concern, in our view, it is simply too early to tell: there is little doubting the PT s less than favourable ideology however, we derive already significant comfort from Rousseff s narrower-than-expected margin of victory, to the extent that it suggests that the significant growth in the middle class would appear to be having the natural consequence of strengthening the democratic process. Below, we give a little more colour to our views: Rousseff s personal history First, let us address the oft-cited concern over Rousseff s militant past: it should be remembered that this episode relates to a period when Brazil was under a military dictatorship (which lasted until 1985), following a coup d etat in Rousseff was imprisoned in Jan 1970, when she was not quite twentythree, for almost three years. Following her release, she resumed her opposition, this time within the law. She also trained and worked as an economist. Whilst we do not seek to trivialise any of Rousseff s misdemeanours (the exact nature of which are disputed), it is clear that anyone who chose to oppose the dictatorship physically during this period (and there are a number of others currently serving in government) would have been similarly branded and often feted as heroes at the time. Our concern is with the future and we do not feel that this episode in Rousseff s past, which has inevitably been sensationalised as a result of electioneering, constitutes grounds for prejudice about her future presidency. It is also worth noting that another highly lauded politician was subject to similar accusations about his youthful protest: Nelson Mandela. If anything, the torture that Rousseff endured without breaking has characterised her more recent political approach as a workaholic pragmatist, somewhat lacking in political tact, preferring to consult technicians rather than her superiors in her desire to achieve results. Whilst the government has been criticised for the slow pace of implementation of many of the programmes of the accelerated growth programme (PAC), Rousseff is generally acknowledged as having contributed a significant improvement in this respect, explaining Lula s admiration for her. As president, Rousseff will be relieved of some of these political pressures and be free to pursue the most expedient means of accelerating reform a trait which she displayed while minister for energy, when she both espoused and succeeded in accelerating universal access to electricity a programme originally initiated under the Cardoso regime but with significantly less ambitious targets and an even slower rate of implementation. Brazil presidential election 31.October 2010 & Implications of Dilma Rousseff s victory 2

3 Fiscal and business outlook As a trained economist, Rousseff is well aware of the requirements necessary for continuing reform of the tax and interest rate environment both of which she has gone on record as defining as her first priority. Brazil s economic success over the last eight years has produced a universal consensus over the need to continue with the sound fiscal and monetary policy that has underpinned its achievement. As outlined in our paper Brazil s Virtuous Circle (BVC), the lowering of interest rates that this has allowed has been absolutely key to this success. Rousseff herself has gone on record as stating the crucial need for this process to continue and also as acknowledging that in order to do so, it will be necessary to reduce the government s current expenditure as a percentage of revenues. Should we believe her, given that the Lula administration has been widely criticised for failing to rein in current expenditure to date? For sure, there have been some signs of improvement of late: budgeted expenditure was reduced on two occasions during the course of this year by a total of BRL 31.5bn (or 1% of GDP) an impressive sign of restraint in an election year. Moreover, government spending on investment has also increased. Whilst there has been further criticism that this has led to some compromise in the primary surplus, most notably by the expedient of including some investment spending in the calculation of the surplus, it should be noted that this is a widespread practice, including amongst many developed world governments. Whether or not this ought to be regarded as a material loosening of fiscal discipline, rather than an opportunistic acceleration of Brazil s long overdue increase in investment spending is a moot point. However, Rousseff s experience of the inadequacy of government administration in implementing the various PAC programmes for which she was responsible goes a long way to explaining at least one possible rationale for the increase in current expenditure, as administration has proved woefully inadequate. This is not to deny the obvious inefficiency and corruption within government that has precluded similar progress merely by better use of existing resources. However, the fragmented nature of Brazil s political landscape to date (see below) unquestionably indicates that the latter, as ever, would be a more long-term, if ultimately necessary, path to success. Increasing current expenditure has been, in short, a more immediate means of achieving results. We believe that fiscal discipline will prevail in particular because the best means of relieving the unwanted upward pressure upon the currency would be to reduce the lure of Brazil s high interest rates. And in this respect, it is likely that the two recent increases in the IFO tax on Brazil s fixed income markets are a pre-emptive measure to avoid market participants seeking to profit from the likely cuts in interest rates, hence negating the natural dampening effect on the currency that such cuts might otherwise be expected to have as a result of increased portfolio flows. However, if rate cuts are to be achieved without sparking renewed inflationary concerns, then they must be accompanied by cuts in the level of current expenditure. In fact, the cuts in expenditure announced earlier this year by finance minister Mantega were explained precisely as being the fastest means of controlling the rising rate of inflation. Moreover, Lula has suggested that he may seek to relieve Rousseff of the unpleasant task of implementing spending cuts during the takeover period, before she officially takes office. If this is all posturing, then it seems to us that it will backfire rather quickly, since it would leave the new administration open to charges of empty electioneering within a very short period time. Moreover, there can be no doubting the importance of continuing the downward path of rates, as explained in our BVC paper. This is not merely in respect of fuelling the economic boom but, at least as importantly from the government s point of view, because it will ensure an ongoing increase in the tax base, as ever more companies and individuals opt into the formal economy. Allied to this aim, then, is the promise to continue to simplify and lower taxes. There is plenty of literature supporting the view that lower tax rates, up to a point which is disputed but certainly far below those prevailing in Brazil, result in higher revenues, not only as a result of a diminishing informal economy but also as a result of increased economic activity, employment and profitability. As an economist who has been watching the manifestation of such theories in Brazil, Rousseff will be well aware of all this. It is therefore likely that much of the increase in current expenditure will have been brought forward under Lula s administration, in preparation for a switch to investment spending, which itself will be enhanced by reduced taxes, given the pivotal role foreseen by government for public private partnerships. Brazil presidential election 31.October 2010 & Implications of Dilma Rousseff s victory 3

4 Finally, it is worth noting that a proposal for the simplification and reduction of taxes was on the table in early 2008 but was shelved owing to the global financial crisis and subsequently owing to the current elections. Moreover, as we pointed out in our BVC paper, the current byzantine system of taxes results in huge costs and inefficiencies to businesses and, according to McKinsey, tax evasion even within the formal sector which amounts to around a third of all tax receipts. Hence the incentives for government to follow through upon these declared intentions are unequivocal. Which brings us to the issue of the new administration s political efficiency in comparison to the last eight years. Outlook for political efficiency and reform The results of the Congressional elections, which took place at the same time as the first round of the presidential election, yielded major gains for the PT alliance: overall, the number of seats in the Chamber of Deputies rose from 292 to 352 (arguably 359, including some non-alliance parties friendly to the PT) out of 513 a percentage increase from 57% previously to roughly 70% now. Within this, the PT party itself gained five seats and became, for the first time ever, the largest party within the lower house. Similar gains were achieved within the Senate: the alliance s share of the seats rose from 39 previously to 55 (out of 81), representing 68%, while the PT s share increased from 9 seats to 15, making it the second largest party in the upper house, behind its principal ally, the PMDB (with 20 seats). This means that the alliance has more than the necessary 60% share of seats required to make constitutional changes. Finally, in the gubernatorial elections, of the 26 states and the Federal district of Brasilia, twelve are already in the hands of the ruling alliance, with only six going to the opposition alliance. Of the remaining eight plus Brasilia, around six are expected to go the ruling alliance. Clearly, the net impact of the above is that Rousseff will enjoy a far stronger majority across all levels of government than did Lula whose popularity and charisma nevertheless faced unyielding political differences throughout his two terms. In such a fractured political environment, such a majority can only help improve the chances of forcing through reforms. Moreover, there are reasonable grounds for hoping that the mixture of Rousseff s pragmatism and Lula s avowed intention to devote himself to proselytising reform within the ranks of the alliance could prove a potent force for reform. We are not seeking to downplay the issues of corruption and vested interests, nor the daunting challenge of marshalling the ten party alliance (eleven, including the unofficial support of the PP party) to achieve the necessary votes for reform. However, given the broad consensus on the necessity for certain reforms and Rousseff s economic training, we are optimistic that the combination of personalities, together with such overwhelming majorities across all levels of government, offers better prospects of driving through the necessary votes than at any point since Cardoso s presidency. The threat of greater government control The handling of the recent Petrobras share offering is an early warning that this concern is indeed well founded. However, it should be noted that Brazil s eagerness to reserve the proceeds of its recent oil discoveries for the benefit of the state, in particular to the exclusion of the major oil companies, is entirely in keeping with the behaviour of most other sovereigns in recent years, explaining the dwindling share of reserves maintained by the oil majors. What has singled Brazil out for special attention is the sheer size of its projected investment, together with the increased percentage of direct government ownership effected through the recent share offering. The latter may be somewhat academic, given the already large percentage ownership enjoyed by the government and the inevitably close relationship implied by the sale of drilling rights. Whilst these concerns, together with the sheer size of the offering, no doubt exerted a somewhat negative effect on the Bovespa, foreign appetite for the shares was strong which in itself could be seen as some justification of the government s approach. However, what will determine whether such actions and ambitions truly represent a threat will be the degree to which government seeks to influence management decisions. Whilst it is true that there have been some expressions of concern from management over whether the company has the depth of resources, in terms of both management and technical capacity, to handle such an immense undertaking, it is worth remembering Brazil presidential election 31.October 2010 & Implications of Dilma Rousseff s victory 4

5 that the government has not necessarily embarked upon a path of no return: should a lack of resources become apparent, the option still remains to auction off a percentage of the rights to foreign interests. The greater threat is more likely to be the sheer size of the undertaking: should Brazil s rate of growth fall appreciably, (owing, most likely, to a renewed slow-down elsewhere in the world) or should the price of oil drop dramatically, then clearly there must be an economic risk. Again, the possibility of auctioning off rights to foreign oil companies still remains, should the situation require which certainly mitigates the risk. However, some risk is certainly apparent. On a wider scale, such government intervention could be seen as becoming symptomatic and therefore commensurately greater. Which certainly endorses our view that the best opportunities remain within the smaller, domestically oriented companies than in the larger, international companies constituting the bulk of the Bovespa. But from a more macro economic perspective, we feel that such risks cannot be pre-judged but must rather be monitored over time a stance which we are not uncomfortable with, as we see little chance of a major problem arising for at least another year to two years at the earliest and then most likely only in the event of the type of negative external developments mentioned above. Moreover, we remain optimistic that if the PT should make too bold a play towards an expansionist state, the inevitable negative consequences will encourage Brazil s strengthening democracy to assert itself by voting its disapproval. In this respect, we take great comfort from the far narrower-than-expected margin of victory achieved by Roussef and even then, only after a second round. Given the huge economic boom, the vast improvements made by the incumbent administration in terms of wealth distribution and the eye-popping popularity ratings of around 80% enjoyed by Lula, this is a heartening sign that Brazil s democracy is showing signs of confidence and beginning to flex its muscles. As regards concerns over the government s apparent desire to control the press, Globo, the main press agency, has shown itself to be strong enough to publish anti-government articles, including in the run-up to the current elections. And its increasingly frequent articles exposing high-level corruption are a further reassurance that Brazil s electorate is being nourished and empowered. Finally, what is equally encouraging is the seminal change that will be forced upon the opposition alliance, most notably the PSDB, whose original selection process of Jose Serra as presidential candidate betrays deep structural problems. It remains to be seen whether the much stronger candidate, Aécio Neves of Minas Gerais, will take up the challenge of reorgainsation necessary. However, such a capable politician, who has the additional advantage (nationally) of not coming from Sao Paolo, should be able to form a credible threat to the PT alliance most especially if the latter is tempted to exceed its mandate by pursuing its apparent ideological goals. And such a powerful opposition is the essence of a successful democracy. Conclusion In conclusion, therefore, whilst we expect little immediate reaction from the markets, we think that the continuity and strong political majority afforded by Rousseff s election should prove positive for the Brazilian markets over time, especially with the Petrobras issue now behind us and any lingering uncertainty over the elections now over. We think that there is plenty of room for upside as we believe that Rousseff will initially surprise by accelerating tax reform in particular and displaying greater spending discipline that current market consensus which in turn should hasten further reductions in interest rates. Longer-term, we will have to monitor to see whether the likely benefits of increased investment and improved tax efficiency will displace concerns over the government s ideology; however, we are comfortable that there will be plenty of time and plenty of interim upside to adjust portfolios should these longer-term concerns start to look a material concern. Brazil presidential election 31.October 2010 & Implications of Dilma Rousseff s victory 5

6 Switzerland arsago Latin Finance Limmatquai 1 / Bellevue 8001 Zurich Phone +41 (0) Fax +41 (0) Brazil arsago LatinFinance Rua Ramos Batista andar conj Vila Olimpia São Paulo Phone +55 (0) research@arsago.com Web: Important information This research document is solely for information purposes and is not to be construed as a solicitation, advice or recommendation to buy any security or make any investment. An investment in emerging markets carries substantial risks. The nature and extent of some of these risks differ from traditional investments in stocks and bonds of developed markets. In particular, the performance of an emerging markets investment may vary substantially over time. Investors bear the risk of losing all or part of their investment and thus should carefully consider the appropriateness of such investments for their portfolio. While reasonable care has been applied to produce the research contained in this document and the information has been obtained from sources deemed reliable, no re-presentation is made as to its accuracy, completeness or reliability, and it should not be relied on as such. Past performance is not necessarily indicative of future performance Brazil presidential election 31.October 2010 & Implications of Dilma Rousseff s victory 6