EM Contagion Risks Rising Ahead Of Brazil Election - Emerging Market Views

EM Contagion Risks Rising Ahead Of Brazil Election

The leading presidential candidate in Latin America’s largest economy finds himself in a awkward place for a political revival: the inside of a jail cell.

Brazil’s Supreme Court this week officially disqualified disgraced and imprisoned ex-president Luiz Inacio Lula da Silva, who was an integral part of a vast corruption scandal that has engulfed his Workers’ Party and much of Brazil’s body politic.

The breakdown has left a political vacuum that has opened the political window to dangerously extreme candidates, like Jair Bolsonaro, a crass, Trump-ish militarist and former army general known distaste for the poor and disregard for the rule of law.

Another top candidate is Marina Silva, an environmentalist with a compelling personal story of rising out of poverty to become a prominent activist. This is her third run at the presidency but she has failed to build a sufficiently large coalition to propel her to national office.

What does this mean for financial markets: Absolute uncertainty of the kind that may please day-traders in the Brazilian real but which is otherwise deeply destabilizing for longer-run business decisions and for visibility into what sorts of economic policies might be in place next year.

One priority for markets, echoed in the International Monetary Fund’s latest assessment of the Brazilian outlook, is an overhaul of the country’s lopsided pension system, which is not only untenably costly but also overwhelmingly benefits the wealthy.

“In the run-up to this October’s Brazilian elections, the country’s presidential hopefuls would do well to heed the International Monetary Fund’s (IMF) latest and unusually explicit warning as to the urgent need for Brazil to address its very shaky public finances,” writes Desmond Lachman, a scholar at the American Enterprise Institute, in a Seeking Alpha blog.

He adds: “Brazil is the world’s eighth-largest economy. With a public debt of more than $1.5 trillion, a Brazilian debt crisis has the potential to cause real waves in the global financial system.”

The country is still struggling to recovery from its deepest recession in modern history, which reduced gross domestic product by a cumulative 8.2% over two years.

The Brazilian real declined past 4 per dollar for the first time since February 2016 after the latest polls showed  presidential candidates seen as more market-friendly are falling behind, and in the wake of Turkey’s own currency debacle.

Carmen Reinhart, the Harvard economist and financial crisis scholar, told Bloomberg recently she sees what happens in Brazil as central to what happens next for emerging markets.

“Do I think Turkey will turn into a major contagion episode? I think a key answer is what happens in Brazil,” she said.

“If Turkey were to come in and have a sovereign default, I think that would be a surprise. If the outcome is one in which you get more corporate defaults and capital controls, that wouldn’t be a game-changer. A sovereign default would be a game-changer for Brazil.”

Then there’s the exposure to neighbor and major trading partner Argentina, which has just hiked interest rates to a shocking 60% in a hapless and belated effort to contain runaway inflation and plunging peso.

There’s at least a modicum of stability in the chaos. It looks as if Brazil’s nickname as the “perennial country of the future” will remain relevant for some time.

Photo Credit: Henry Romero/Reuters