Brazil Elections: Who Ever Wins, Debt Reigns

For professional clients only October 2018 Research & Strategy Insights

Brazil elections: Who ever wins, debt reigns

Investors gear-up for potentially swift market reaction

Irina Topa-Serry Senior Economist (Emerging markets) Research & Investment Strategy

Governors and State Assembly members for 27 states. The Key points National Congress will reshuffle all of its 513 seats in the Chamber of Deputies and two-thirds of the Federal Senate • On 7 October and 28 October, Brazilians will elect the (54 out of 81 seats). The members will be inaugurated on 1 country’s next government i.e the President, the February 2019. Governors and most of the Congress members. These elections take place at a particularly difficult time, when This is an important election, not just because a lot of the economy has been weakened by the deepest political posts will be voted on, but because the future recession on record while corruption scandals have administration will have the responsibility to tackle Brazil’s significantly dented Brazilians’ trust in their politicians growing fiscal imbalances, and this will require politically • The next government will need to address Brazil’s challenging structural reforms. growing fiscal imbalances. Public debt has ballooned to 77% of GDP, and given persistent primary deficits, further contractions in the economy are expected. Structural Brazilian’s explosive public debt issue reforms, which require Congress support, are needed to Brazil’s external position is strong. The country is a net stabilise the debt trajectory in the medium term external creditor, thanks to a strong level of international • Visibility on the Presidential election outcome is low given reserves (US$367bn in August 2018). Public debt is a very fragmented race, with strong polarisation around predominantly BRL denominated (96% as of August 2018), political extremes non-resident ownership of local currency sovereign bonds is • Market reaction in the medium term will depend on both relatively low (12% at year-end 2017) and external roll-over the result and the new Government’s ability to pass much needs for both public and private debt are low, at around 8% needed reforms through Congress of GDP per year. Furthermore, over the last decade, Brazil’s large domestic economy was able to attract strong foreign direct investments, which provide a healthy financing of the Brazil elections: A needed wind of change… current account deficit.

On 7 October, all Brazilians between the ages of 18 and 70 Brazil’s big issue is its fiscal accounts. The next administration are being called to the polls to elect their next President needs to put the country back on a sustainable fiscal path. (voting is a legal obligation in Brazil). After the first round a Public debt dynamics have been shifting drastically since likely necessary run-off will be held on 28 October. Alongside 2014 given its large and persistent primary deficits (Exhibit 1) the President and Vice President of the nation (who will both and its recession has exacerbated the structural problems of take office on 1 January 2019), Brazilians will also elect the

government finances. Gross public debt has actually jumped All spending items need to be contained. The pension reform from 51.5% in 2013 to 77% at present. comes at the forefront of the consolidation efforts, given the current large weight on public expenditures. Stabilising Exhibit 1: Persisitent primary fiscal deficits pension spending requires an increase in the retirement age, Brazil central government balance (bn BRL) unified rules for public and private sectors through a 200 reduction of the generous public employee system, as well as breaking the link between minimum pensions and wages. All 0 of these measures are difficult to push through Congress, as unsuccessful efforts by Mr Temer’s show. The next -200 administration will have to address the same issues as the debt clock ticks louder, raising the stakes for the upcoming -400 elections. Nominal balance Primary balance -600 A difficult race in a difficult context Jul-99 Jul-04 Jul-09 Jul-14 Jan-97 Jan-02 Jan-07 Jan-12 Jan-17 Oct-00 Oct-05 Oct-10 Oct-15 Apr-98 Apr-03 Apr-08 Apr-13 Apr-18 The 2018 elections are taking place in a particularly Source: DataStream and AXA IM R&IS calculations challenging environment. The economy is just coming out of its deepest recession on record where GDP fell by a Public debt will inevitably rise further despite federal cumulative 9.4% from its peak in the third quarter in 2013 to expenditure remaining constant in real terms as requested by its trough in during the first quarter of 2017. This has left the constitutional rule. Simulations to stabilise the debt profound scars on the economy, such as a high 12.3% trajectory by 2023 show the need for a cumulative fiscal unemployment rate (as of July 2018). This situation has effort of 4.5% of GDP (i.e. achieving a 2.5% of GDP primary particularly impacted the younger population – 29% of those surplus by 2026). Such adjustment implies a strong aged 15 to 24 year-olds are unemployed and it has also willingness and ability to push through structural reforms. helped drive an increase in the informal economy. (Exhibit 3)

Exhibit 2: High share of mandatory spending Exhibit 3: A challenging economic backdrop Brazil budget expenditures, 2017 Brazil GDP growth and unemployment Other Disc.; 10% 16 Education; 10% 3% 14 Healthcare; 5% 12 Pensions; 8% 10 44% Other 0% 8 Compulsory; 6 14% -5% 4 GDP y/y % Unemployment rate (% RHS) 2 Payroll; 22% -10% 0 Source: Brazil Treasury Dept. and AXA IM R&IS calculations

Compressing government’s spending will be politically painful. 1997 Q1 1998 Q2 1999 Q3 2000 Q4 2002 Q1 2003 Q2 2004 Q3 2005 Q4 2007 Q1 2008 Q2 2009 Q3 2010 Q4 2012 Q1 2013 Q2 2014 Q3 2015 Q4 2017 Q1 2018 Q2 Source: DataStream and AXA IM R&IS calculations Excluding interest payments, 90% of current budget expenditures are “mandatory”, namely: spending on On the political front, the country faced a multitude of pensions, civil servants’ salaries, healthcare and education, tumultuous events recently. There was the knife attack on and subsidies (Exhibit 2). These types of spending are presidential candidate Jair Bolsonaro in the midst of a particularly difficult to reduce and require structural reforms, campaign rally, ex-President Lula da Silva’s imprisonment, the which need Congress support ahead of implementation. The impeachment of President Dilma Rousseff in 2016 while current administration under President Michel Temer has numerous politicians and parties were implicated in the Lava tried to push through a number of measures. However most Jato (Car Wash) corruption scandal. Unsurprisingly, Brazilians’ of the structural reforms have been rejected or postponed by public trust in their own politicians ranks among worst in the Congress, such as pension reforms or delaying civil servants’ world (137 out of 138 in 2017) according to the Global wage deal, leaving the reduction of federal investments, Competitiveness Report, sourced by the World Economic which have already been compressed to minimal levels, as Forum. All this caused the election race to be fragmented, the only option. Brazil’s primary fiscal deficit reached 1.7% of with low visibility and a significant rise of political extremes. GDP in 2017, missing the official government target.

Exhibit 4: Frontrunners for President leading the polls, have very limited Congress support at present - each can claim 16% of the seats in the Lower Candidate Party Coalition Public positions House, and almost no support in the Senate. Present Sao Paulo State To Unite Brazilian Social Governor, ex Congressmen Brazil (PSDB Exhibit 5: Extreme polarisation Democratic and Vice-Governor of Sao Geraldo Alckmin DEM PP PR Party (PSDB) Paulo, lost 2006 Brazilian presidential election polls PRB SD PTB centre-right presidential % valid vote intentions PSD PPS) electionsagainst Lula 40 Brazil Above Everything, 30 Social Christian Jair Bolsonaro God Above Congressman since 1991 Party (PSC) right 20 Everyone (PSL PRTB) 10 Previously Minister of Finance, Mayor of 0 Democratic Sovereign Fortaleza, Governor of 20-Aug 27-Aug 3-Sep 10-Sep 17-Sep 24-Sep 1-Oct Ciro Gomes Labor Party Brazil (PDT Ceara, Congressman, Jair Bolsonaro (PSL) Fernando Haddad (PT) (PDT) left AVANTE) scored third in 1998 and Ciro Gomes (PDT) Geraldo Alckmin (PSDB) fourth in 2002 presidential Marina Silva (REDE) races Source: Ibope (first round) and AXA IM R&IS calculations People Previously Minister of Workers Party Happy Again Fernando Haddad Education, Mayor of Sao The willingness to implement reforms was expressed by most (PT) left (PT PROS Paulo candidates but there are significant differences in the plans PcdoB) Previously Minister of they have put forward. It seems more likely that Alckmin, Rede United to Environment, Senator, Bolsonaro and Marina Silva will seek to push through reforms Sustentabilidade Transform Marina Silva Congresswoman, scored (Rede) center- Brazil (REDE but Congress would need to shift dramatically in order for the third in 2010 and 2014 left PV) latter two to obtain solid support among members. The other presidential races Source: various public sources and AXA IM R&IS calculations two candidates, Ciro Gomes and Haddad would also require meaningful changes in the Congress structure if they were to Elections in Brazil, for Congressmen and for the President obtain a strong mandate – this would likely favour social alike, are a beauty contest in which people vote for a person, spending over structural reforms. not for a party. Yet, there is no room for independent candidates, as in order to run for office, one must belong to a political party. There are 35 political parties currently active in Beware of potentially hard market adjustments Brazil, 25 of which have representatives in the Lower House Painful reforms need to be implemented but polls suggest a of the Congress. No single party has ever come close to a low probability of the election of a reformist President who commanding majority in the Congress. enjoys strong Congress support. It thus comes as no surprise that Brazilian asset prices have been under pressure. The BRL The fragmented party system means that there are no less has lost 15% of its value versus the USD year-to-date, MSCI than 13 candidates running for President (Exhibit 4), but only Brazil was down 10% in the first six months of the year before five of them managed to gather more than 5% of voting recouping its losses (-8% year-to-date in local currency) intentions in the various national polls (Exhibit 5) – with a while sovereign spreads have widened by 33bps to 268bps, strong polarisation around two candidates - populist right as of October 3. wing candidate Jair Bolsonaro and Fernando Haddad, Lula’s left wing replacement candidate, who happen to both have Yet, in case of a leftist candidate winning the election (e.g. the highest approval and among the highest rejection rates. Haddad or Gomes), markets may sell-off, on worries of a Second round polls simulations have therefore not been able widening deficit. Conversely, a more reform-oriented winner, to give a clear indication of who may win and markets may such as Alckmin, but also Bolsonaro or Silva, may bring some need to adjust quickly when the final results arrive. market relief in the short term. Still, the degree of Congress support for the future administration will determine whether The ability to reform Brazil will depend upon the political the country is able to credibly implement reforms. This in structure of the future Congress. So far, Geraldo Alckmin, turn would determine, whether some short-term relief could who was successful in consolidating a strong centre-right mark the beginning of a re-rating of Brazilian assets, or if it coalition, accounting for almost half of the Congress seats, merely a ‘dead cat bounce’ scenario. has not gained any traction in voting intentions, according to the polls. Meanwhile, Bolsonaro and Haddad, who are

3 For professional clients only October 2018 Research & Strategy Insights

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