Brazil - Economic Briefing March 2004

Political Scandal Taints Government’s Corruption-Free Reputation

The president’s key legislative liaison and an important advisor to the government has been dismissed amid allegations of soliciting illegal campaign contributions in the 2002 presidential elections, threatening to taint the government’s corruption-free reputation.  Meanwhile, the economy promises to rebound from recession this year amid lower interest rates and the pick-up in international demand.

Corruption taints government and undermines the President’s political leverage
In February, a senior presidential advisor, Waldomiro Diniz, was dismissed amid allegations that he illegally raised campaign funds for the governing Worker’s Party (PT, Partido dos Trabalhadores) for the 2002 presidential elections.  Diniz was not only a close associate of the current presidential chief-of-staff, Jose Dirceu, but also served as a key congressional liaison for the Lula administration.  The opposition parties are likely to use the corruption scandal to erode the government’s standing in order to gain leverage for the upcoming October mid-term local elections.  Furthermore, legislators may institute a congressional investigative committee, which could stall the government’s progress on more pressing structural reform legislation.  In the longer term, the scandal is likely to tarnish the PT’s reputation of being corruption free – a key factor behind the strong public endorsement in the past. 

Political scandal triggers sell-off of in capital markets
Immediately following the revealing of the corruption affair, Brazilian assets experienced a sell-off.  In February, the stock market dropped 5.3% - the first monthly decline since June last year.  However, the benchmark JP Morgan EMBI+ Brazilian sovereign bond spread to comparable US Treasury bonds widened just 38 basis points and the currency actually appreciated 0.1% in nominal terms versus the US$ compared to a 1.8% depreciation in January.  As evidenced only recently in the 2002 nationwide elections, political concerns can rapidly deteriorate investor confidence and the resulting currency depreciation if accompanied by tighter monetary policy inevitably raises concerns about the country’s heavy public debt burden (58.2% of GDP in January).  Even though the impact of the corruption affair has so far remained relatively benign, a more pronounced change in investor confidence resulting from political stalemate could lead to a renewed sell-off in Brazilian assets.

Inflation dropping but remaining above target
The strong appreciation of the real over the past year is beginning to pass through to domestic prices.  The mid-February consumer price index (IBGE-IPCA 15) that covers monthly price increases up to the 15th of every month increased 0.90% over January.  The February figure was the highest spike observed in a year and was up from the 0.68% increase registered in the preceding month.  Seasonal effects linked to education in particular have contributed to the stronger price increase.  These effects have been offset by declining food prices associated with the beginning of the harvest period.  However, the strong monthly price hike remained well below the 2.19% increase registered in February last year and, as a result, the annual inflation rate dropped from 8.5% in January to 7.1% in February. 

At its current level, annual inflation is well above the 5.5% Central Bank’ inflation target for this year but is within the +/- 2.5% tolerance margin.  Participants anticipate that the Central Bank will overshoot the inflation target for the fourth consecutive year, anticipating consumer prices to rise a more pronounced 6.1%, which is unchanged from last month’s forecast.  Furthermore, participants expect the Central Bank to exceed next year’s central inflation target as well with consumer prices seen increasing 5.1%, on the upper end of the +/- 2.5% range around the central target of 4.5%.

Uncertain inflation trajectory postpones further interest rate cuts
In its 18 February meeting, the Central Bank’s monetary policy committee opted to maintain the benchmark SELIC rate unchanged at 16.5% for the third consecutive month.  Monetary officials cited that lingering uncertainty over the current inflation trend warrants a more cautious policy stance and highlighted the fact that higher economic activity may exert upward pressure on prices in the coming months.  Panellists have left their interest rate forecasts for this year unchanged over last month and anticipate the Central Bank to lower rates gradually throughout 2004 and to bring down the benchmark interest rate to 14.3% by year-end.  The moderation in inflation next year should give monetary authorities additional leeway to bring down interest rates, which are seen by the Consensus Forecast to drop to 12.9% by the end of 2005.