FACTBOX-Key political risks to watch in Brazil

BRASILIA Mon Oct 3, 2011 9:03am EDT

BRASILIA Oct 3 (Reuters) - President Dilma Rousseff's biggest challenge in coming months will be to deal with growing discontent over persistent inflation and austerity measures as the fallout from global financial turmoil hits Latin America's largest economy.

Rousseff will have to face rebellious allies wanting more government spending and a greater say in policies as well as unions demanding higher wages. Other challenges include rising inflation, currency volatility, and resistance to long-term structural reforms.

A FADING ECONOMY

Compared to many developed countries, Brazil's expected 3.5 percent economic growth this year looks attractive. But after the boom under former President Luiz Inacio Lula da Silva, that culminated in last year's dizzying expansion of 7.5 percent, it feels disappointing.

Bank and postal workers striking for higher wages to offset inflation are the latest groups to become unhappy with the course of the economy. While cheap credit and rising real wages fueled the consumption boom under Lula, real wages have fallen marginally and lending rates are sharply higher since Rousseff took office on Jan. 1. That has fueled discontent in the rising middle class that forms the cornerstone of her support base.

Rousseff's disapproval rating doubled to 25 percent in July but eased to 21 percent in September, an Ibope opinion survey showed. Rousseff performed worst on health care and easing the country's high tax burden.

To prevent pessimism from spreading, Rousseff stepped up ribbon-cutting events designed to showcase improvements in public services and social welfare. Her aides privately say they expect worse economic data in the third quarter.

What to watch for:

- A fall in Rousseff's approval ratings.

- More industrial action for wage hikes that could pressure inflation.

COALITION CRACKS

Budget cuts designed to ease inflationary pressure have turned some of Rousseff's allies against her, eroding what was at least nominally a massive majority in Congress. A series of corruption and ethics scandals that led to the resignation of five cabinet members exacerbated discontent and caused deep divisions in her coalition. Her refusal to make political appointments to key jobs angered her main ally, the PMDB.

The clearest sign of internal divisions was the defeat of a government proposal to implement a financial transaction tax to finance health spending [ID:nS1E78K0PN]. Her ruling Workers' Party was alone in her 16-party alliance to vote in favor of the bill.

Rousseff, 63, has tried to govern without Congress as much as possible but relies on legislators for a series of bills. 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 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 measures adopted so far.

One pivotal case is whether she can continue to withstand demands for a massive wage increase for civil servants in the judiciary. At stake is a 7.7 billion reais hole in the budget and a possible domino effect on wage negotiations throughout the public sector and beyond, as judges' salaries are often used as a reference.

What to watch for:

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

- New media revelations of scandal among top officials.

INFLATION

Consumer price pressure has remained surprisingly strong and is perhaps one of the biggest headaches for Rousseff. Annual inflation in the 12 months through mid-September rose to 7.3 percent, well above the 6.5 percent upper limit of the government's target range. [ID:nS1E78P04M].

The central bank formally forecast year-end inflation at 6.4 percent but one director said it could miss the target.

The bank's job has become more difficult since it cut rates in August in an apparent attempt to help economic growth.

Industrial action for wage hikes, a depreciating currency that makes imported goods more expensive, and an economy that is still highly inflation-indexed all add to the burden. This has potentially serious political implications for the government. Inflation tends to hit hardest the poorer classes who form Rousseff's political base and sustained price rises could erode her approval rating.

What to watch for:

- 12-month inflation rate failing to fall significantly.

- Signs of further rate cuts ahead.

CURRENCY POLICY

Rousseff's government has been particularly active in intervening in the currency market, first to prevent the real BRBYBRL= from gaining further and more recently to prevent its depreciation amid fallout from global financial turmoil.

Through its interventions, the government has indirectly signaled what it considers a "suitable range" for the currency - a ceiling of 1.6 and a floor of 1.9 against the U.S. dollar.

Among the measures the government adopted to prevent a further rise of the real was a tax on currency derivatives, potentially the most aggressive measure so far to stem a currency rally [ID:nN1E76Q01I]. To stem losses in the real in September, the central bank sold currency swaps in the futures markets.

Any fresh measures could hit fixed income and currency investors, including manufacturers or farmers seeking to hedge against currency fluctuations.

FARMING AND MINING

A 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.

The government also intends to send a new bill to Congress, regulating the purchase of farm land by foreigners. It has tightened restrictions over the past year but is now likely to fine-tune rules to allow for more foreign investment in some farming sectors.

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. It would also hike royalties and slash taxes in an effort to promote mineral processing.

ROUSSEFF'S HEALTH

Concerns over Rousseff's health have faded but remain on investors' radar screens since her hospitalization and lengthy recovery from pneumonia in May. Such concerns 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. Were Rousseff's health to worsen, markets could slump due to uncertainty over economic policy under Vice President Michel Temer. (Editing by Kieran Murray)

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