For Brazil, It’s Finally Tomorrow

For the past century, Brazil has been a land of great potential—but few results. With runaway inflation and stratospheric national debt, the country was too much of a mess for anyone to take it seriously on the world stage.

How times have changed.

Consider this: In the face of the worst global economic crisis since the Great Depression, Brazil’s economic output dipped a tiny 0.2% last year, and is expected to grow as much as 6% this year. Everyday Brazilians have been too busy buying washing machines, cars and flat-screen televisions to even notice the downturn.

Brazil is already the biggest economy in Latin America and the 10th-biggest in the world. By 2050, it will likely move into fourth place, leapfrogging countries including Germany, Japan and the U.K., according to a study by Goldman Sachs.

Clearly, Brazil has turned a corner—and is now a nation with the heft, ambition and economic fundamentals to become a world power. But the country has enormous challenges it must overcome before it can fully live up to its potential.

Its public sector is bloated and riddled with corruption. Crime is rampant. Its infrastructure is badly in need of repair and expansion. The business environment is restrictive, with a labor code ripped from the pages of Benito Mussolini’s economic playbook. Brazil also risks patting itself on the back so much that it fails to see the colossal work that remains to be done.

“There’s too much good happening at the moment for the country not to take advantage of it,” says Ricardo Amorim, a well-known financial consultant in São Paulo. “Brazil has never had as much opportunity as it will have in the years ahead.”

Big Promise

Brazil has always had a lot to live up to, simply because of its size. The country is bigger than the continental U.S. and has almost as many people as Germany, France and the U.K. combined. Yet except when it came to soccer and music, many Brazilians themselves tended to believe the notion—apocryphally attributed to Charles de Gaulle—that “Brazil is not a serious country.”

Things started changing in the 1990s. The government adopted strict monetary policies and a laser-like focus on balancing the books. That fiscal prudence has given the country remarkable cash reserves—and breathing room during crises.

For instance, when the big downturn hit in 2008, private lending began to dry up. So the government, flush with cash reserves and the keys to an aggressive development bank, ordered state-run lenders to open the credit taps. The banks complied, lending out record amounts last year to Brazilians eager to join the country’s quickly growing consumer class. Internal demand soared, softening the blow of the slowdown.

“This is a different Brazil than 10 years ago,” President Luiz Inácio Lula da Silva boasted recently. Back then, he said, “the crisis in Greece would have already bankrupted Brazil.”

What’s more, there’s now a political consensus to avoid the mistakes of the past. Until recently, elections in Brazil were considered make-or-break contests between irresponsible, populist proposals and the voices of investment, stability and growth. Now neither leading candidate from the right or left in October’s election is expected to stray far from current economic policies, a functional blend of pro-business market rules and social-welfare programs.

Even a pledge for a bigger state role in the economy by Dilma Rousseff, Mr. da Silva’s outgoing chief of staff and his hand-chosen successor as the party’s candidate, isn’t scaring off the business community. “It’s refreshing to have an election and see there’s no fuss about either outcome,” says Andrew Béla Jánszky, a Brazilian investment lawyer in the São Paulo office of Shearman & Sterling LLP. “For once, stability is almost a given.”

The hard work has also enabled Brazil—already a leading exporter of iron ore, steel, coffee, soybeans, sugar and beef—to soar in sectors it once only dreamed about. After decades of research and investment, Brazil in 2007 discovered mammoth new oil beds beneath the Atlantic that are expected to double output in the coming years—generating billions of dollars in new revenue annually.
Cleaning House

The results of all these changes have been dramatic. The economic turnaround has pulled millions out of poverty and is creating a thriving middle class. For instance, Brazil’s northeast, long the source of internal migration to more-prosperous cities down south, now outpaces the rest of the country in growth. Companies there are scrambling to train workers, many experienced only as field hands, to build cars, appliances and computer parts.

The country’s promise is such that events that once rattled the faith of local and foreign investors are now taken largely in stride—be it the global financial meltdown or Mr. da Silva’s bear hugs and backslaps with leaders of regimes in Havana, Tehran and Caracas.

But before Brazil can achieve its first-world ambitions, it must tackle big economic, legal and social deficiencies that have hobbled its development.

For one thing, even after sweeping reforms, the government’s role in the economy remains relatively big. Government spending totals more than 20% of the country’s gross domestic product, compared with about 15% in the U.S., 13% in China and 7% in Indonesia, another fast-growing emerging market, according to data compiled by Mosaico Economia Política, a Brazilian consultancy. The government trimmed as many as 150,000 jobs in the 1990s, but since then has taken on twice that number, according to research at Banco Santander, the Spanish bank that is one of Brazil’s biggest foreign investors. Even with greater leeway to spend than ever before, government debt has begun to creep back up.

To help finance the growth in the size of government—and onerous pension and benefit plans—”the trend is likely to be in the direction of higher taxes, lower investments, and, thus, lower long-term growth,” Santander said in the report. The spending growth comes as consumer demand is also surging, spurred on by state lending. That has caused inflation to rear its head once more—forcing the central bank to consider raising interest rates again.

“The government can’t have it all,” warns Eduardo Giannetti da Fonseca, an economist and professor at Insper Instituto de Ensino e Pesquisa, a business school in São Paulo. “You can’t increase spending, private consumption and invest all at the same time, because something will eventually give.”

Another problem is the restrictive business environment, especially strict labor laws that date back to the 1940s and were originally modeled on the statist policies of Mussolini. Because it costs so much to start companies and hire workers, many entrepreneurs and businesses stay in the black market and pay workers informally. That creates a massive underground economy that, according to a 2005 study by McKinsey & Co., accounts for up to 40% of Brazil’s gross domestic product, takes about half of all urban jobs and drags overall economic growth by as much as 1.5% annually.

The problem is palpable across Brazil, where underground commerce is on open display from city sidewalks to public buses to the festive beaches of Rio de Janeiro. “I’d rather have a real job, but it’s a lot easier to get hired to do something like this,” says Milton, a 28-year-old vendor of pirate software and DVDs in central São Paulo, who declined to give his last name. “There’s plenty of this kind of work to go around.”
Bad Connections

Yet another obstacle to growth is a lack of infrastructure—from roads, railways and bridges to docks, airports and pipelines. Like most everything else in the country, infrastructure investment fluctuated with the booms and busts of the past. Projects were launched when times were flush, only to sit neglected for decades.

Not only is much of it old and in disrepair, but Brazil’s existing infrastructure is too small to handle the volume of people and goods currently using it—let alone accommodate new growth. The government this week is expected to announce the second phase of an ambitious “growth acceleration program” that it launched in 2007. The original plan foresaw infrastructure investments of some $342 billion, but many projects remain mired in bureaucracy. Contas Abertas, a not-for-profit research group that studies public spending, in a study this month said that only 11% of the projects outlined in the plan have been completed, while just over half have yet to be launched.

To casual observers, things will look better as Brazil gears up for hosting soccer’s World Cup in 2014 and the Summer Olympics in Rio de Janeiro in 2016. New roads and airport terminals will be christened along with modernized stadiums and scenic, well-policed promenades. But manufacturers, exporters and shippers—who regularly wait days or weeks for backlogs in ports and customs facilities to clear—know Brazil needs more than just cosmetic changes.

Progress in other areas falls short, too. Crime is still a big problem in most cities and in lawless rural areas where ruthless prospectors, loggers and landowners at times ride roughshod over their neighbors. Those charged with enforcing the law are so underpaid that police routinely look the other way in exchange for a little extra money or commit serious human-rights abuses in efforts to solve problems that overburdened courts rarely can. Using the government’s own statistics, a December report by Human Rights Watch disclosed that police in Rio and São Paulo together killed more than 1,000 people annually in recent years, many of them in execution-style “extrajudicial” killings.

Brazil’s politicians and legislators often run afoul of the law, as well. The country’s Federal Police, its most respected law-enforcement body and the agency charged with fighting corruption, currently has nearly 30,000 active investigations related to public corruption and fraud, according to a recent report. The deposed governor of Brasília, Brazil’s capital, at the moment sits in jail awaiting trial over alleged kickbacks from public construction projects.

Then there’s public education. Brazil has a popular welfare program that helps needy children by paying parents to keep them in school rather than send them out to help put food on the table. But schools themselves remain underfunded and the quality of education remains poor. Outdated university statutes mean that the best colleges, which are public and free, get filled by wealthy students from private high schools, while poorer students, the products of public schools, get stuck paying for second-rate degrees at costly classrooms in strip malls and fly-by-night academies.

Mr. da Silva and his ministers, including Ms. Rousseff, admit that much still needs to be done. The work so far, they insist, has been about laying the groundwork for stability and thereby facilitating investment and growth in the future. Now that popular social programs have helped ease suffering for the critically poor—and disastrous fallout from the financial crisis was averted—the government can begin focusing on ways to ensure it builds upon more solid economic foundations.

“If the past year was about measures to stimulate consumption,” Mr. da Silva said in a television address at the end of December, “now our emphasis is on reinforcing investments and thereby making the wheel of the economy roll in a healthy and