Brazil: Caught Up in a Scandal

03/16/2016 - 10h43

When federal police knocked on the door of Luiz Inácio Lula da Silva at dawn with a warrant, the gruff former president was true to form. "The only way you'll get me out of here is in handcuffs," declared the charismatic leader, whose profile was so great that Barack Obama, US president, called him "the man".

The 70-year-old founder of Brazil's ruling Workers' party, or PT, who police suspect of involvement in a vast corruption scandal at state-owned oil company Petrobras, eventually went quietly after a word with his lawyer. But his brief detention on March 4, and his indictment last week for money laundering in a separate case, are unprecedented in Brazil, where impunity for the powerful has long been the norm.

The escalation of the corruption investigation has opened a dangerous chapter in the political and economic crisis afflicting Latin America's biggest country. Once a star among emerging market investors - the economy grew at 7.5 per cent in 2010, the final year of Mr Lula da Silva's eight years in power - Brazil is now struggling. It is mired in its worst recession in 25 years. And as the country prepares to host the Summer Olympics in August, there are questions about whether it will even have a sitting president when it holds the games. With Mr Lula da Silva facing a possible prison term, his anointed successor in the PT party, Dilma Rousseff, is looking vulnerable to an impeachment process under way in Congress.

The depth of frustration in Brazil over Ms Rousseff's leadership was apparent on Sunday March 13 as more than 1m protesters took to the streets to call for her impeachment and the imprisonment of Mr Lula da Silva. The sheer size of the protests could add pressure to Ms Rousseff's coalition partner to withdraw support for her party. Brazil's currency, the real, jumped on Monday March 14 as investors speculated that she will be forced from office.

"This weekend may very well have proved decisive for President Dilma Rousseff's mandate," says Christopher Garman, head of Brazil analysis at Eurasia Group. "A highly polarised environment following ex-President Lula's detention clearly played a key role in generating such a large turnout. The massive protests reinforce the odds President Rousseff will fall even more quickly than we had anticipated."

DRAMATIC CHANGE

The sense of grievance in the streets also reflected a broader change in fortunes. After seemingly being able to do no wrong in the first decade of the century, Brazil is struggling to do anything right in the second. It was lauded for hosting the 2014 World Cup but its own team got beaten 7-1 by Germany in the semi-finals. Its biggest billionaire, Eike Batista, saw his flagship companies go bankrupt. Now Mr Lula da Silva, the star politician who once represented the excitement and promise of the country, is at risk of being sent to jail. To top it off, the spread of Zika, the mosquito-borne virus, has plunged Brazil into a public health crisis.

A victim of its own excesses during the commodity supercycle, Brazil opened the fiscal taps under Mr Lula da Silva to counter the global financial crisis in 2009 - but forgot to close them again. It stoked consumption by pumping up state-bank credit and keeping prices low.

This helped Ms Rousseff win elections in 2010 and 2014 and allowed Mr Lula da Silva to leave office with popularity ratings of 83 per cent. But it has left Brazil with few resources to counter the end of the commodities boom and the fallout for industry and investors from the Petrobras investigation.

In 2015, gross domestic product contracted 3.8 per cent and economists expect it to fall again this year. Inflation is more than 10 per cent and benchmark interest rates are 14.25 per cent - a sharp contrast with the negative levels in some countries. There is little confidence Ms Rousseff's weakened government has the ability to carry out the reforms needed to rescue the economy.

"The core of the problem is politics because with the fiscal side the finance minister [Nelson Barbosa] can say whatever he wants but he needs to get it approved in congress," says Ilan Goldfajn, chief economist at Itaú Unibanco.

WIDENING THE NET

His conclusion rings true in Brasília, the capital, whose modernist monoliths stand as relics of the booms and busts of the 1950s and 60s. The centre of the storm is Lava Jato, the so-called Car Wash investigation, in which federal prosecutors accuse Petrobras executives of conspiring with ruling coalition politicians to extract bribes and kickbacks from the oil company.

Mr Lula da Silva is the most senior figure so far to be implicated in Lava Jato and a parallel investigation. He is accused of concealing suspected payments and favours from construction companies, charges he denies. These favours include allegations he has put a beach apartment and a rural getaway in the name of a construction company and friends to hide his wealth. Among the evidence are two pedal-driven floating swans, or pedalinhos, belonging to his grandchildren that were found on a lake at the rural property, prosecutors say.

The rural getaway is officially owned by business partners of Mr Lula da Silva's son. He derides the claims as an attempt to defame him.

Aside from the allegations against Mr Lula da Silva, Brasília is bracing for a mooted plea bargain that Delcídio do Amaral, the former PT senate leader, is reported to be planning with prosecutors. It contains allegations that Ms Rousseff tried to use her position to thwart the Petrobras investigation, charges that could hasten her downfall if proven. Ms Rousseff has expressed her "indignation" at the claims.

Aécio Neves, leader of the opposition Social Democrats (PSDB), smells blood. "Congress can do anything but it can't ignore public opinion," he says. "The quicker that society expresses itself, the faster we will find a way out of this."

The opposition is pursuing two complex routes to force Ms Rousseff from office: impeachment and the annulment of her mandate by the election watchdog, the TSE. Under the impeachment process, which could start as early as next month, a congressional committee will prepare a report on which the lower house will vote. If the house approves the motion by two-thirds, the senate will then launch formal impeachment proceedings which would last 180 days. Ms Rousseff will be suspended during the senate deliberations and Michel Temer, vice-president, will take over. She can only be impeached by a two-thirds majority of the senate.

The impeachment process centres on alleged manipulation of the 2014 budget by Ms Rousseff's first government. The TSE action, meanwhile, concerns accusations she funded her 2014 re-election campaign with the proceeds of corruption. While impeachment is a political process, the TSE is a judicial procedure that will probably end up in the Supreme Court. Both will take longer than markets, hopeful of a more investor-friendly government, might be expecting.

"While President Rousseff's grip on power has been weakened substantially, it is still far from certain that she will be removed from office," said Capital Economics in a report.

Neither Mr Lula da Silva or Ms Rousseff are expected to give up easily. After his detention, Mr Lula da Silva called for his supporters to take to the streets. Ms Rousseff, a former Marxist guerrilla who was tortured by Brazil's military dictatorship, is no pushover either. Asked whether she will survive until the end of her term in 2018, Edinho Silva, her communications minister, says: "To govern is to overcome challenges. She is a fighter."

FEDERAL BURDEN

No matter who leads Brazil, there is an urgent need to restructure its public finances. Brazil's 1988 constitution, which followed the end of dictatorship in 1985, created a budgetary time bomb in the form of unsustainable benefits, pensions and salaries.

Government spending has grown from 20 per cent of GDP in the 1980s to about 35 per cent today - the size of a European welfare state but with developing-country services and efficiency. Brasília last year awarded welfare benefits to 79m people in a population of about 200m, analysts say.

"Normally, first you have to bake the cake before you can split it but the constitution of 1988 was all about splitting the cake before you have baked it," says Daniel Leichsenring, chief economist at Verde Asset, an asset management firm.

The budget is riddled with constitutionally mandated expenditures that can only be changed through an amendment passed by three-fifths of both houses. What Raul Velloso, a specialist on Brazil's budget, calls the grande folha or "big payroll", consisting of salaries, pensions and welfare payments, takes up about 74 per cent of spending. A large part of this is indexed to inflation through formulas governing the minimum wage. This year the minimum wage rose 11.7 per cent even as the economy shrank. By law, public servants cannot be sacked or their salaries cut.

Worse, the federal pension bill is rising rapidly, from about 9.5 per cent of GDP in 2012 to a projected 19.5 per cent in 2040 as the population ages more rapidly than expected, says Mr Velloso. The only way Brazil can afford this system is through strong growth. Running deficits is not an option because Brazil's high interest rates mean the cost of servicing government debt is prohibitive.

"I think they forgot to explain to President Dilma that a country with a serious debt problem cannot afford the risk of letting GDP fall," says Mr Velloso.

Some argue Brazil's gross debt, at 67 per cent of GDP, is far below that of developed countries. But Mansueto Almeida, an independent budget specialist, says Brazil's gross debt is above the emerging market average of 40 per cent. "Depending on how you do the maths, the debt will rise. By my reckoning, it will be 84 per cent of GDP by 2018 but there are people in the market predicting it will reach 90 per cent," Mr Almeida said.

With fiscal problems growing in states such as Rio de Janeiro and fears that Petrobras and state banks will need to be recapitalised, the situation looks even more troubling. Seeking the help of the International Monetary Fund is not an option - at least not yet, argues Mr Velloso. "The solution this time must be a homegrown one," he says.

The immersion in scandal of Mr Lula da Silva, who fought for democracy against the former military regime and is a hero among the poor for his welfare policies, is sad for Brazil, says Paulo Sotero, director of the Brazil Institute at the Wilson Center.

"Lula was a transformative figure," Mr Sotero says. But he adds that if there is one silver lining to the crisis, it is that corruption at the highest levels is being punished for the first time since Brazil was colonised.

"There is a story for the future here," he says. "The era of Brazilian society in which there is impunity for corrupt people, I think it is coming to an end."

MARKETS: INVESTORS ARE BULLISH ON CHANGE IN BRASÍLIA

The Petrobras corruption scandal and possible impeachment of President Dilma Rousseff are fuelling a striking rally in Brazilian stocks, bonds, and its currency, giving the country an opportunity to tap international credit markets for the first time in 18 months.

By overlooking recession, a fiscal deficit and political unrest, investors are betting that Brazil is on the verge of installing a new government that will pull its economy out of the doldrums.

The real is up more than 10 per cent against the dollar this year, making it the best-performing major emerging market currency, while the Bovespa stock index has jumped 14 per cent. In credit markets, dollar-denominated Brazilian debt has provided high returns, with yields on a 2025 bond down by more than 130 basis points to 5.84 per cent.

Lower borrowing costs allowed policymakers to issue debt on international markets last week, the first sale since the country lost its investment-grade credit rating in 2015. Healthy demand enabled Brazil to borrow $1.5bn over 10 years at a yield of 6.125 per cent, lower than expected.

"Brazil has severe problems but it has dealt with worse and there is the possibility that the country is about to get a change of government," says Paul McNamara, investment director at GAM. "We have been topping up our position in Brazilian credit."

One of the strongest advocates for Brazilian assets has been Franklin Templeton's Michael Hasenstab, known for his bold bets in credit other investors will not touch, including Irish bonds in the eurozone crisis.

Last year, as prices for Brazilian debt were plunging, Mr Hasenstab added to his holdings. "Overall, we view the country as economically strong," the fund manager wrote to investors. "It's just the policy mix that needs to be corrected."

Additional reporting by Samantha Pearson

Copyright The Financial Times Limited 2016