ISSUE BRIEF 02.17.17 The Lengthy Brazilian Crisis Is Not Yet Over

Sergio Fausto, Contributing Expert, Latin America Initiative

Since the first quarter of 2014, has funds, which were controlled by unionists been living in “crisis mode.” September affiliated with the PT; and a relatively 2016 marked seven consecutive quarters of restricted but powerful group of companies negative economic growth that resulted in a that were the primary beneficiaries of cumulative negative variation in the GDP of federal government-subsidized credit and more than 7 percent, the greatest recession contracts. With resources diverted from ever registered in the country. In the state-owned companies, these private same period, investigations conducted by companies provided electoral funding public attorneys and Brazil’s federal police for the dominant political coalition (the uncovered the largest corruption scheme opposition also received funding, but on in Brazilian history. The scandal was rooted a smaller scale). Intellectually speaking, in the largest state-owned company in the it is an interesting case of an attempt to country, Petrobras, but had widespread develop state capitalism in a competitive ramifications. By the end of December 2016, political environment. The lesson to be nearly 200 people had been indicted or learned is that this kind of experiment imprisoned. Most were businessmen and ends up undermining democracy by politicians, including the former president giving the incumbents an extraordinary of Brazil, Luiz Inácio Lula da Silva, who was electoral advantage and compromising a defendant in five judicial inquiries. At the the system of checks and balances, and/ confluence of the economic and political or generating fiscal disarray and financial crises, President , a member crisis. In the case of Brazil, the experiment of the Partido dos Trabalhadores (PT) and was interrupted before democracy mutated reelected in October 2014 to a four-year into a semi-democratic regime. That it fell term, was removed from office in April 2016 short of causing a mutation in the nature and permanently impeached the following of the political structure can be explained September. She was replaced by Vice to a great extent by the strength of some President , who is affiliated institutions: the independence of the judicial with the Partido do Movimento Democrático branch, the autonomy of public attorneys, do Brasil (PMDB). and the freedom of the press, all of which The economic crisis and the corruption are guaranteed by the Brazilian Constitution probe (called Operação Lava Jato, or and upheld by society. Operation Car Wash) destroyed the The destruction of the party’s system power system that had been expanding that was dominant between 2003 and throughout the PT administrations from 2015 turned into a crisis of the entire 2003 to 2016. This system was composed political system, as the opposition parties of an ideologically heterogeneous alliance also became involved in the criminal of parties under the PT’s hegemony; trade investigations carried out by the Lava Jato unions; state-owned companies’ pension operation. This picture is similar to the RICE UNIVERSITY’S BAKER INSTITUTE FOR PUBLIC POLICY // ISSUE BRIEF // 02.17.17

one that prevailed in Italy in the wake of commodities-producing countries led to the Mani Pulite investigation in the mid- Brazil’s long-term sovereign credit rating 1990s. Conducted by public attorneys, being raised to “investment grade” in this investigation revealed the existence 2008. In this context, Lula’s government of widespread and systematic corruption felt emboldened to distinguish itself from schemes involving businesses and political its predecessor. Second, in 2006 Petrobras parties. As a consequence, the Italian announced the discovery of reserves in the political party system that had developed pre-salt layer located in ultra-deep waters since the end of World War II collapsed. In within the country’s maritime territory. Brazil, however, the political crisis came in They were estimated to be large enough conjunction with a deep economic crisis. to double the proven petroleum and gas In the short span of this issue brief, I reserves of the country. Thus strengthened, analyze both the anatomy of these mutually Brazil responded effectively to the impacts This kind of experiment reinforcing crises and the challenges that of the global financial crisis of 2007-2008 ends up undermining Brazil faces in overcoming them. by adopting counter-cyclical fiscal and democracy by monetary policies made possible by the giving incumbents economic gains obtained during Lula’s first FROM THE PRE-SALT TRIUMPHALISM term. The resulting economic contraction an extraordinary TO THE PETROBRAS TRAGEDY was intense but short-lived. Much deeper electoral advantage and longer-lasting, however, was the Lula’s first term in office (2003-2007) ideological impact of the financial crisis. and compromising demonstrated continuity with the economic It seemed to confirm the long-held belief the system of checks policies adopted by his predecessor, of most of the Latin American left in the Fernando Henrique Cardoso. During his and balances, and/ unsustainability of liberal capitalism, as two terms in office from 1995 to 2003, or generating fiscal well as in the superiority of state capitalism Cardoso brought decades of chronically as an instrument of national development disarray and financial high inflation to an end and liberalized the for developing countries (now rebranded crisis. Brazilian economy, ending state monopolies “emerging countries”). These three factors on oil and gas and telecommunications, resulted in the introduction of fateful policy among other infrastructural sectors. He changes in Lula’s second term, which were also created independent agencies to to be deepened under Dilma Rousseff’s regulate competition in these sectors and administration. eliminated legal discriminatory treatment Petrobras played a major role in the against foreign direct investment. Long- “national development” venture that took term commitments with sustainable public shape almost in tandem with the global accounts and low inflation were translated financial crisis. To that effect, in 2010 into new institutions such as the Fiscal the government used its super-majority Responsibility Law, which was approved in in Congress to approve a package of 2000. These commitments, as well as the interrelated bills changing the regulatory general framework of Cardoso’s economic structure established to govern the oil and policy, were kept by Lula in his first term gas industry after the end of Petrobras in office. This started to change during his monopoly under Cardoso. The bills were second term (2007-2011). approved with much nationalistic fanfare Three factors produced this change: in the midst of a presidential campaign First, by maintaining his predecessor’s that would lead then-Chief of Staff Dilma economic policies and even tightening fiscal Rousseff to the presidency. This legislation policy in his first year, Lula’s administration created a new regulatory structure for the rapidly dissipated initial market distrust and pre-salt region. benefited hugely from the commodities Under the new structure, all exploration boom that started in 2004. The combination and production activities in the pre-salt of consistent macroeconomic policies region were to be conducted exclusively domestically and an extremely favorable by Petrobras. Foreign investment was economic atmosphere abroad for permitted only as long as Petrobras held at 2 THE LENGTHY BRAZILIAN CRISIS IS NOT YET OVER

least a 30 percent share in any consortium Between 2011 and 2015, the Petrobras formed to bid in the region. A new local investment program quadrupled in content policy—much stricter and more comparison with the previous five years. To detailed than the prior one—was applied finance this unrealistic program, Petrobras to the oil and gas productive chain. A started to rapidly acquire debt. At the production sharing agreement (PSA)—used same time, it lost revenue due to the almost exclusively in authoritarian regimes— government-dictated policy of deterring was substituted for the concessions inflation by controlling the price of fuel and program that had been adopted with great saw its expenditures rise as a result of the success after the end of Petrobras monopoly excesses of the national content policy. (the old structure remained in place for Between 2009 and 2015, Petrobras’ debt areas outside the pre-salt region). increased five-fold—becoming the largest Such a major policy change can only be corporate debtor on Earth—and its capacity After the pre-salt explained by the confluence of ideological for cash-flow generation was considerably and more practical factors. To increase the reduced, bringing the company to the brink discovery, the participation of the Brazilian state in the of financial ruin. expansion of future revenue stream that would come out investments in the of this new source of wealth, adopting a petroleum and gas higher level of taxation for the pre-salt region THE DOOMED INHERITANCE FROM would have sufficed. But Lula’s government DILMA ROUSSEFF sector became, all insisted that changing the regulatory at once, one of the The Petrobras disaster is the most prominent structure was the only way to ensure that case in a general process of deterioration main gears of the the oil coming out of the pre-salt region affecting Brazil’s economy and public Brazilian economy and would belong to Brazil. They invoked the accounts that had grown throughout slogan O petróleo é nosso (“The oil is ours”), the principal source President Rousseff’s first term. reminiscent of the nationalistic campaign of financing for the Between 2011 and 2014, all the that led to the creation of Petrobras as a parties belonging to the macroeconomic pillars established during monopolistic company in the 1950s. Cardoso’s presidency (1995-2002) were coalition led by the PT. After the pre-salt discovery, the shaken. Those pillars had proven to be expansion of investments in the petroleum instrumental for Brazil’s economic takeoff and gas sector became, all at once, one of under Lula’s administration, which took the main gears of the Brazilian economy place in an external environment that was and the principal source of financing for highly favorable to commodities-producing the parties belonging to the coalition led countries. Rousseff not only abandoned by the PT. The overbilling of approximately the policy of generating fiscal surpluses to US$2 billion in contracts irrigated a vast reduce the public debt but also compromised and heterogeneous political coalition that the principles of fiscal transparency and included 13 parties at its high point. The accountability established in the Fiscal electoral donations were the counterpart of Responsibility Law. She also undermined the the resources diverted from Petrobras to a policy of inflation targeting—putting both the cartel of approximately 20 contractors that monetary policy structure and the de facto was commanded by the five largest ones. autonomy of the Central Bank in jeopardy— Odebrecht, a leading Brazilian multinational and undercut the floating exchange rate company in heavy construction and the policy as well. In the field of microeconomics, petrochemicals industry (in association with she introduced numerous distortions via Petrobras), occupied a position of primus ad hoc tax exemptions and control of inter pares. Chosen by the PT government administered prices, among other means. to be a national champion, Odebrecht was At the root of this astounding series granted the lion’s share of government of mistakes in conducting the economic contracts domestically and was financially policy was a deep-seated matrix of Brazilian and politically leveraged abroad, particularly economic thinking, which includes the idea in countries where governments closely that national development depends on the aligned with the PT and Lula were in power. 3 RICE UNIVERSITY’S BAKER INSTITUTE FOR PUBLIC POLICY // ISSUE BRIEF // 02.17.17

state’s active role in leading investment with a view to generating a pre-interest either directly via state-owned companies surplus of 1 percent of the GDP in 2015—a or indirectly, by funneling subsidized credit fiscal shift equivalent to 3 percent of the GDP to the private sector. According to this and all the more difficult to be implemented belief, economic policy should also try to in an economy already in recession. This proactively determine relative prices in shift proved to be unfeasible, even more so order to favor growth, even at the expense because the government was forced by a of stability. This line of thought became ruling of the Federal Court of Accounts to influential in Lula’s administration and recognize liabilities that were not accounted At the root of this achieved dominance when Rousseff took for in previous years (between 2011 astounding series of office. The prospect of a second recessive and 2014, public banks paid for treasury mistakes in conducting dive of the global economy—a risk that expenses with their own funds in ever- increased by the end of 2011—was the growing numbers). the economic policy justification that had previously been One year after being appointed, with the was a deep-seated missing for an attack on all fronts on the inflation rate above 11 percent, an ongoing matrix of Brazilian so-called “neoliberal” inheritance from recession, and fiscal adjustment measures economic thinking, the Cardoso administration, which for the blocked due to lack of political support, Levy most part had been preserved during Lula’s was fired. Rousseff’s administration entered which includes the administration. its death throes. By the end of April 2016, a idea that national The only reason that the economic two-thirds vote by the Chamber of Deputies development depends disaster produced by Rousseff was not on a authorized the initiation of the president’s on the state’s active larger scale was because foreign exchange impeachment trial in the Senate. The reserves remained high. In the absence aforementioned unaccounted-for liabilities role in leading of a crisis in the balance of payments, the provided the judicial basis for the president’s investment either deterioration of the Brazilian economy— political judgment, since they represented directly or indirectly. which had become visible to analysts a violation of the Fiscal Responsibility Law. starting in 2011-2012—took awhile to be felt With the impeachment authorized by the by the majority of the population. Although Chamber of Deputies and accepted by the the economic growth rate decreased to less Senate, the president was removed. than half of the average of the previous four The replacement of Rousseff with years, barely surpassing 1.5 percent annually, her vice president, Michel Temer, in May the unemployment rate kept declining, 2016 awakened positive expectations in reaching less than 5 percent by the end of the domestic and international markets President Rousseff’s first term. and also in the political system. For the markets, the change in government represented the possibility of correcting the ROUSSEFF’S SHORT SECOND TERM disastrous economic policies of the previous administration. For the political system, it In October 2014, the president was reelected meant the possibility of somehow limiting by a difference of only three points over the prominence of the judicial branch and Aécio Neves, a Partido da Social Democracia the advancement in the investigations of the Brasileira (PSDB) candidate. In her campaign, Lava Jato operation. Up until that point, the Rousseff promised more of the same policies investigations had dealt mainly with the PT and accused her adversaries of intending to and the Partido Progressista (PP), a right- destroy the “social achievements” of the wing party that had been a member of the PT administrations with a draconian fiscal government-backing coalition since the adjustment. beginning of the PT administrations. In December 2014, she appointed an In the final moments of her government, orthodox economist named Joaquim Levy Rousseff appointed Lula as chief of as minister of finance, executing a program staff. The former president was her last shift without precedent in Brazilian history. remaining strategic asset in her attempt Levy promoted a correction of fuel and to rebuild her support base, especially in energy prices and instituted budgetary cuts 4 THE LENGTHY BRAZILIAN CRISIS IS NOT YET OVER

Congress. However, the Supreme Federal focused on attacking structural factors in Court prevented Lula from taking office, the expansion of public expenditure. claiming that such an appointment aimed In fact, from 1997 to 2015 the total public to obstruct justice (Lula was already under expenditure grew at an average of 6 percent investigation). In wiretapping authorized by above inflation, and mandatory expenditures the Judiciary and made public by the press, expanded until reaching approximately 90 the former president made it clear that it percent of the total expenditure. The main was time for politicians to fight back against cause of this trend was the expenditures the Lava Jato operation. Blocked from associated with pension benefits, which taking office, he was not able to lead the were on the rise due to the rapid aging of For the markets, the counterattack that most of the politicians the Brazilian population and the absence of a change in government had looked forward to. minimum age for retirement. When the revenue growth started to represented the slow down in 2011, the structural deficit possibility of correcting THE NEW ADMINISTRATION began to reveal itself much more clearly. the disastrous economic In order to tackle it, Temer’s government Although Temer took office provisionally policies of the previous bet on the approval of two constitutional with a very low popularity rate, the amendment proposals: one establishing a administration. majority of the population did not consider cap on federal government expenditures for him illegitimate (support for Rousseff’s the next 20 years, limiting their increase to impeachment stayed above 50 percent the previous year’s inflation rate, and the starting in March 2015, when it first other reforming the pension system in both became a rallying cry). The accusation that the public and private sectors. President Rousseff had been overthrown by With an economic team respected a “parliamentary coup” had much greater by the markets and a parliamentary resonance abroad than in Brazil. majority capable in principle of approving The new president appointed a team these constitutional reforms, the new with indisputable technical credentials to fill administration came in with a plan of positions at the core of the government’s putting in motion a virtuous cycle where economic sector—roles in the Ministry of For the political system, the shock of favorable expectations would Finance, the Central Bank, the National boost economic recovery sooner rather it meant the possibility Bank of Economic and Social Development, than later, leading to higher popularity of somehow limiting Petrobras, and Eletrobras (a federal rates, accumulation of political capital, the holding of the electric energy-generating the prominence of the approval of reforms in Congress, and so on. companies)—and formed a cabinet with judicial branch and the Up until the third quarter of 2016, the representatives from all parties, with the country watched this script playing out advancement in the exception of the left-wing parties. He did so accordingly. Asset prices were at a high. The investigations of the with the intention of securing the necessary constitutional amendment capping public majority not only for a confirmation vote of Lava Jato operation. expenditures was approved in Congress impeachment in the Senate, but also for the and in municipal elections in October. The approval of amendments to the Constitution PT suffered a historic defeat, and the PSDB considered essential for regaining control and the PMDB (mostly the former), the over public accounts. main parties in the coalition of support for With the economy in recession, the Temer’s administration, showed a good new administration opted not to increase electoral performance. the already high tax burden, despite the deficit in the public sector having reached 10 percent of the GDP after the payment of THE CRISES ARE NOT OVER interest on the public debt by the end of 2015. It also did not promote any significant In November and December 2016, a sequence expenditure cuts, considering that Levy had of events rapidly changed the scenario, already implemented the possible cuts in showing that Brazil still lives under the aegis non-mandatory expenses. The strategy was of political and economic uncertainty. 5 RICE UNIVERSITY’S BAKER INSTITUTE FOR PUBLIC POLICY // ISSUE BRIEF // 02.17.17

The release of data on the economic approving drastic fiscal measures. Street activity pertaining to the third quarter of protests organized by civil servant unions 2016 showed that the recession is ongoing and leftist parties have been happening and that a recovery will not happen anytime frequently and gaining momentum. Similar soon. The debt burden on deleveraging movements can erupt in other states that families and companies is diminishing, are also facing acute financial challenges. albeit slowly, with financial costs still In this environment, it remains to be high, consumption levels low, a high rate seen whether the social security reform of unemployment, and family income in will be approved under terms desired decline. Also heavily indebted, the public by the government. On one hand, the sector cannot accelerate a recovery. The calamitous financial situation of large hope for a faster investment recovery states dramatizes the need to reform social boosted by a new privatization and security, showcasing how unsustainable concession program is limited by regulatory fiscal accounts can turn into social calamity. and political uncertainties and by the virtual On the other hand, the electoral costs of paralysis of the large contractors involved reforming social security are higher in in the Lava Jato scandal. In the short term, the midst of a recession, and Congress is Some analysts have the only factor that favors the expansion of sensitive to this. started asking who the economy is the now-existing space for With the deterioration of expectations, would become the larger cuts in the benchmark interest rate rumors of an early termination of the Temer Brazilian Trump. The established by the Central Bank. With the government started to circulate in December market projections pointing to 4.5 percent 2016. Such rumors could become fact under national realities are inflation at the end of 2017, most analysts two scenarios: one, if the Superior Electoral not the same, but one believe the benchmark interest rate can Court (TSE) rules in favor of a lawsuit filed thing is certain: Brazil drop at least 300 basis points by the end by the PSDB against the Rousseff-Temer does not lack the same of 2017. Still, the market consensus is that ticket a few months after the 2014 election growth will not exceed 1 percent this year. accusing their campaign of being financed anti-establishment Along with the longer-than-expected by resources diverted from Petrobras; and anger that brought recession, the Lava Jato investigations two, if Congress approves a constitutional Donald Trump to the continue to unfold. The first testimonies, amendment calling for early direct elections. White House. made by 77 Odebrecht executives who If the TSE nullifies the Roussef-Temer ticket benefited from a plea-bargain agreement with half of the presidential term fulfilled, with the public attorneys, struck a blow to the Constitution calls for the indirect president Temer’s inner circle of ministers as election of a new president by Congress to well as leaders of the PSDB, the main partner fill the position for the rest of the term. of the PMDB in the government’s coalition. Despite the aggravation of the political The president himself was mentioned in crisis, the possibility of an early interruption the testimonies, which describe the illegal of the Temer administration seems remote. financing of electoral campaigns. The president has allies in the TSE and Three of the largest states (Rio de a large enough majority in Congress to Janeiro, Minas Gerais, and Rio Grande do prevent the approval of a constitutional Sul) have also declared a state of financial amendment to call for direct presidential calamity. The federal government is still elections this year. It is more likely that trying to negotiate measures that will the current president will serve his full combine immediate financial relief with term. The executive branch’s control over structural adjustment counterparts by Congress was reinforced in February 2017 by the states. An agreement has already the election of two of its staunchest allies been struck with , but its to preside over the Senate and the Lower implementation depends on Congress House. This not only reduces the chance of approving a general framework for debt Temer’s term been terminated by calling for renegotiation and financial recovery that direct presidential elections to almost zero, would be valid for all states, and on the but also increases the chances of Congress Legislative Assembly of Rio de Janeiro not watering down social security reform. 6 THE LENGTHY BRAZILIAN CRISIS IS NOT YET OVER

Going forward, the key question is what the state of the economy and the political atmosphere will be in the months leading up to the October 2018 election. The correction of the disaster produced by the PT cycle will take time and will not bear political fruit in the short term. One should also factor in the destruction that the Lava Jato is already causing within the existing political leadership. After the latest elections in the United States, some analysts, half-seriously, half-ironically, started asking who would become the Brazilian Trump. The national realities are not the same, but one thing is certain: Brazil does not lack the same anti- establishment anger that brought Donald Trump to the White House.

AUTHOR

Sergio Fausto is a contributing expert at the Baker Institute’s Latin America Initiative and executive superintendent of Fundação Instituto Fernando Henrique Cardoso, a think tank and presidential library founded by the former president of Brazil. Fausto co-directs See more issue briefs at: Plataforma Democrática, an initiative www.bakerinstitute.org/issue-briefs devoted to strengthening Latin American democratic institutions and culture, and is This publication was written by a co-editor of the book series “O Estado da researcher (or researchers) who Democracia na América Latina.” participated in a Baker Institute project. Wherever feasible, this research is reviewed by outside experts before it is released. However, the views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.

© 2017 Rice University’s Baker Institute for Public Policy

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy.

Cite as: Fausto, Sergio. 2017. The Lengthy Brazilian Crisis Is Not Yet Over. Issue brief no. 02.17.17. Rice University's Baker Institute for Public Policy, Houston, Texas.

7