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Brazil's economy faces trouble after World Cup, election

Brazil's President Dilma Rousseff reacts during a press statement after a meeting at the 6th European Union (EU)-Brazil summit at the Planal
Brazil's President Dilma Rousseff reacts during a press statement after a meeting at the 6th European Union (EU)-Brazil summit at the Planal

By Brian Winter and Silvio Cascione

BRASILIA (Reuters) - With the World Cup in June and July and a presidential election in October, many Brazilians aren't thinking beyond 2014. But next year is likely to be memorable for all the wrong reasons in Latin America's biggest economy.

President Dilma Rousseff, or whoever wins the election, will have to make deep budget cuts, raise taxes and take other painful steps to address Brazil's growing financial imbalances.

The fallout will likely be more damaging than many investors anticipate, resulting in a fourth straight year of disappointing growth - a big fall back to earth for a country that last decade was one of the world's most dynamic emerging markets.

Economists currently expect Brazil's gross domestic product to grow 1.68 percent this year, and 2 percent in 2015, according to a weekly survey by the central bank. Yet the latter forecast is somewhat misleading, because many economists admit their estimates are based on computer models that don't fully account for what politicians will do after the election.

"No matter who wins (the election), it's going to be a difficult year, worse than many believe," said Fernando Henrique Cardoso, who was president from 1995 to 2003 and still retains considerable influence in financial circles as a leader of the main opposition party.

An official close to Rousseff, speaking on condition of anonymity, broadly concurred: "Few people are talking about 2015 right now. But it will be hard, no doubt."

The biggest and most disruptive task will be trimming Brazil's fiscal deficit, which investors and ratings agencies say has been too high in recent years.

No one expects Rousseff, a pragmatic leftist, to make painful budget cuts while campaigning for re-election. As a result, the cuts will need to be even deeper when the next presidential term begins on January 1, 2015 - especially if Brazil's sovereign credit is downgraded in the interim by Standard & Poor's to its lowest investment-grade rating, as many in Brasilia now anticipate.

Tax hikes are also likely. So are adjustments to bus fares, gasoline costs and other prices administered by the government, which Rousseff has held in check to prevent inflation, running around 6 percent, from rising even higher.

If done properly, belt-tightening policies could restore balance to the economy and rebuild Brazil's tattered credibility with the private sector. That, in turn, could set the stage for an eventual return to the good old days last decade when GDP often grew better than 4 percent a year.

Yet, even in a best-case scenario, the measures will smother domestic demand in the short term - perhaps not quite enough to cause a recession, officials and economists say, but enough to result in another lost year in terms of GDP growth.

"2015 is going to be the big year of adjustment," said Marcelo Salomon, chief Brazil economist for Barclays in New York. "What needs to happen is a credibility shock so that the government shows it isn't just thinking in the short term."

COUNTRY STUCK IN TRAFFIC

The seeds of Brazil's current predicament were sown during the good years.

Thanks to strong demand for its soy and iron ore from China, plus smart fiscal management and social welfare policies under Rousseff's predecessors, Brazil has managed to pull some 35 million people out of poverty since the mid-1990s. It also became a top market for foreign automakers, retailers and telecom companies.

But economists say that, generally speaking, Brazil sold too many cars during the boom while not building enough roads.

That is, it channeled too much of the windfall toward consumption and not enough on investment. The result is an economy now plagued by infrastructure bottlenecks and low productivity - and, thus, high inflation and slow growth.

Rousseff, who took office in 2011 just as the economy was slowing, reacted by making a series of targeted tax cuts worth approximately 1.5 percent of GDP, while also keeping fiscal spending robust to stimulate the economy.

Her actions may have prevented a sharper slump. The economy grew 2.3 percent in 2013, and defied predictions of a minor recession during the second half of the year.

But priming the fiscal pump has carried a cost: The budget deficit is expected to hit nearly 4 percent of GDP in 2014, a percentage point above the past decade's average.

That's not a huge budget gap by global standards. But investors hold Brazil to a tighter standard than most countries because of its history of runaway spending that resulted in hyperinflation in the 1980s and early 1990s.

At the slightest sign of fiscal slippage or an uptick in inflation, it's not just ratings agencies that get worried. Anyone over age 40 or so remembers watching their salary get decimated.

"There's been a very large worsening in expectations" among businesses and consumers alike, said Aloisio Campelo, who runs economic surveys for the Getulio Vargas Foundation, a Brazilian business school.

"The incoming government will have to hold the line on fiscal austerity to bring credibility back," Campelo said.

WAITING FOR THE ELECTION

Budget cuts in the first year of a presidential term have become part of the economic cycle here. Rousseff made relatively minor adjustments in 2011, while her predecessor Luiz Inacio Lula da Silva made a big austerity push in 2003.

The size of next year's cuts will depend in part on who wins the election.

Rousseff, who must cope with an unwieldy coalition of resource-hungry political parties, is seen wielding the budget ax with the lightest touch. But her two opponents - Senator Aecio Neves and Eduardo Campos, a state governor - are running to her right, and have suggested in courting business leaders they would slash spending deeply.

Felipe Salto, an economist for Tendencias consultancy, said that to recover credibility while accounting for what's politically possible, the government will likely need to target a primary budget surplus of about 2.5 percent of GDP in 2015.

By comparison, that goal, which excludes debt payments from the fiscal balance, is set for 1.9 percent in 2014. However, most analysts said in a Reuters poll last month that they expect the government to miss that target as it ramps up election-year spending, making the 2015 adjustment that much more traumatic.

Meanwhile, there are other distortions waiting to be fixed.

Rousseff's policy of keeping fuel prices artificially low has helped subdue inflation, but it can't last forever. The gap between local gasoline prices and those abroad has hovered at about 11 percent, with a 19 percent gap for diesel. That has caused huge losses for Petroleo Brasileiro SA , the state-run energy company known as Petrobras.

For Petrobras to be able to afford its ambitious investment plan to develop offshore oil reserves over the next decade, which the company recently scaled back because of its struggles, the next president must raise fuel prices. That would take money out of consumers' pockets.

Other pent-up pressures are coming from a severe drought pressuring electricity prices; a freeze on bus fares in place since nationwide street protests last June; and the growing tax burden posed by Brazil's generous pension system.

None of those issues are expected to be fully dealt with until after the election is over.

(Editing by Todd Benson and Tom Brown)

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