FACTBOX-Key political risks to watch in Brazil

BRASILIA, Sept 1 Thu Sep 1, 2011 12:42pm EDT

BRASILIA, Sept 1 (Reuters) - President Dilma Rousseff's main challenge in coming months will be to maintain a course of austerity and clean government amid growing dissatisfaction as Latin America's largest economy slows.

She will have to face rebellious allies, who could stall her legislative agenda and approve costly bills that may undermine fiscal discipline. Other risks include resistance to long-term structural reforms, persistent inflationary pressures, and renewed intervention in currency markets.

SCANDALS

A series of scandals that have forced four of Rousseff's ministers to resign in less than 3 months has exposed her government's vulnerability to opposition and media scrutiny. It has also renewed tensions within Rousseff's ruling coalition, partly because she fired many officials before concluding an official inquiry.

Agriculture Minister Wagner Rossi resigned in August after intense media coverage alleging he peddled influence and used an agricultural firm's corporate jet. The wave of resignations began in June when Rousseff's chief of staff, Antonio Palocci, stepped down over an ethics scandal [ID:nN08245414].

If Rousseff, 63, continues her "clean-up" in other ministries and state agencies, as her aides say she intends to, the career civil servant risks losing support from some allies who expect to get "perks" from government contracts and posts.

Already her coalition had been plagued by in-fighting over key government posts and cuts in pork barrel spending that legislators traditionally use for public works projects in their constituencies. Her refusal to make political appointments to key jobs angered her main ally, the PMDB.

Rousseff's popularity is still high and tackling corruption and nepotism could boost her standing with middle-class voters. But her disapproval rating has doubled since March, hit by rising borrowing costs and slow progress in improving public services such as health and security.

POLICY SHIFTS, WORKS DELAYS

The resignations, which also included the removal of the top ranks of the transport ministry, are likely to delay a series of government projects as incoming ministers and senior officials take time to settle in.

There are growing signs that the construction of roads, ports and railways, which form part of Rousseff's flagship public works program, are already delayed. [ID:nN1E7651GA] This could hurt the economy, affecting grain exports at over-stretched ports or the construction of hydroelectric dams that rely on paved roads to bring in construction materials.

The latest accusations of kickback schemes could also slow other infrastructure projects, including preparations for the World Cup in 2014 and the 2016 Olympics, as government watchdogs step up scrutiny of contracts.

The departure of Rossi could also pave the way for more nationalist farming policies. Rossi was investor-friendly and tried to stem efforts within government to limit foreign investment in the farm sector by banning only speculative but not productive capital [ID:nN16140439].

LEGISLATIVE AGENDA

Budget cuts, the slowing economy and Rousseff's drive to cut political favors have upset many legislators. In a symbolic warning to Rousseff, several allied parties blocked voting in Congress for several days and could derail her bid to control spending and pass economic reforms. [ID:nN1E77F1GQ]

Rousseff has tried to govern without Congress as much as possible but will now have to engage congressional leaders more pro-actively to push through reforms. They include an overhaul of an unwieldy tax code, framework legislation for the mining sector and a bill regulating oil royalties, all aimed at easing legal uncertainty and attracting investment. [ID:nN1E75L0H2]

Other projects on hold include bills aimed at ensuring that Brazil builds stadiums, airports and other infrastructure needed not only for the World Cup and the 2016 Olympics but also to overcome bottlenecks holding back the entire economy.

With the sporting events drawing nearer and a slowing economy exposing glaring problems from unwieldy labor laws to heavy taxes, Rousseff may need to engage Congress to approve structural reforms and emergency bills to speed up government procurement. In doing so, she may have to ease some of the austerity adopted so far.

What to watch for:

- Signs that Rousseff will loosen spending controls or make appointments to please allies.

- New media revelations of scandal among top officials.

CURRENCY POLICY

The risk of government intervention in Brazil's currency market remains high, as even weeks of global financial turmoil did little to undermine the strength of the real BRBYBRL=. By late August, the real was down only around 3 percent from its 12-year high in July of 1.54 per U.S. dollar. Then the government imposed a tax on currency derivatives, potentially the most aggressive measure so far designed to stem the currency rally [ID:nN1E76Q01I].

If the real tests new record highs, the government could hike the tax rate on currency derivatives from currently 1 percent to as much as 25 percent and adopt other measures as well, Finance Minister Guido Mantega has said.

Any fresh measures could hit fixed income and currency investors, while the stronger real can erode profit margins and the market share of exporters, particularly manufacturers.

FARMING AND MINING

A legislative proposal changing environmental regulations for farmers passed the lower house of Congress and could become law later this year. While the Forestry Code, which sets the percentage of native forest that farmers must preserve, reduces overall environmental liabilities for farmers, they would have to finance costs they have been putting off for years to reforest or invest in protected areas.

A mining bill Rousseff is expected to send to Congress this year would likely reduce the time companies have to develop mines to discourage speculation in mineral properties, and could hike royalties to promote mineral processing.

MONETARY POLICY

Consumer price pressure has remained surprisingly resilient and perhaps one of the biggest headaches for the Rousseff administration. Annual inflation in the 12 months through mid-August broke through the 7 percent level, well above the government's upper limit of 6.5 percent. [ID: nN1E77I06D].

Still, the central bank cut its benchmark interest rate by 50 basis points to 12 percent at the end of August, beginning an easing cycle after hiking rates five times this year by a combined 175 points.

The move prompted some concern among investors that the central bank may have moved prematurely and under pressure by the government to prevent an abrupt economic slowdown.

Two days before the interest rate cut, the government hiked its 2011 budget savings target, arguing tighter fiscal discipline would pave the way for monetary easing.

Inflation tends to hit hardest the poorer classes who form Rousseff's political base and sustained price rises could erode her approval rating. Inflation and rising interest rates have also weighed significantly on the stock market this year.

What to watch for:

- 12-month inflation rate failing to fall significantly.

- Signs of further rate cuts ahead.

ROUSSEFF'S HEALTH

Rousseff's hospitalization and her lengthy recovery from pneumonia in May renewed concerns over her health, which first surfaced in April 2009 when she announced she was being treated for lymphoma. [ID:nN01161483] [ID:nN12259498]

She has been given a clean bill of health by doctors but is reported to also suffer from diabetes, hypothyroidism, and high blood pressure. Rousseff's health is on investor radar screens. Were it to worsen, markets could slump due to uncertainty over economic policy under Vice President Michel Temer. (Editing by Kieran Murray)

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