Key political risks to watch in Brazil

Brazil’s presidential election in October looks less risky to investors than any other in the last quarter of a century and the economy has bounced back after a brief recession, but there are still investment risks to watch in Brazil this year.

President Luiz Inacio Lula da Silva’s leftist chief of staff, Dilma Rousseff, is the ruling Workers’ Party candidate to succeed him. She trails her main rival, Sao Paulo state Governor Jose Serra of the centrist opposition PSDB party. But most analysts make Rousseff the favorite because she can count on support from the hugely popular Lula and will be helped by the rebounding economy.

Unlike previous elections, there is no clear market favorite because neither of the main contenders is expected to break with the mostly market-friendly policies in place for the past decade: a free-floating currency, inflation control, and fiscal discipline. Some investors prefer Serra for his party’s centrist stance and his managerial experience.

But Rousseff and Serra both believe in a strong government role in the economy and could tighten regulation in financial markets. Though both candidates will try not to unsettle investors, such proposals could weigh on debt and equity markets in a country that has a history of election-year volatility.

They have also both called on the central bank to look at the broader economy and not just inflation in making its monetary policy decisions. Serra urged larger rate cuts instead of the incremental easing during the 2008 global financial crisis. Rousseff, who was endorsed by the Workers’ Party in February, has said the bank should consider economic and job growth when setting policy.

There is also some doubt about how firmly the candidates would push for a second generation of structural reforms to ensure Brazil’s international competitiveness if elected. These include proposed reforms to tax, pension and labor laws.

Neither is proposing nationalizations, but Rousseff has said she favors a strong role for state firms in the economy, a position that gained support after low-cost loans by state banks helped Brazil’s economy recover from the global crisis. Larger state companies could weaken private sector participation in sectors such as banking, oil, and utilities.

Government plans to revive state-owned telephone company Telebras to expand broadband Internet access have sent its shares sharply higher, but further moves to strengthen Telebras could depress shares of private telecoms. Lula also wants to strengthen state-owned power company Eletrobras, though the intent may be to expand mostly abroad.

Serra, who launched his candidacy in April, is widely believed to be the tougher of the two main candidates on fiscal discipline and has said he would cap current expenditures, potentially paving the way for swifter interest rate and tax cuts.

What to watch:

– Serra and Rousseff will name their economic advisors in coming weeks. A left-wing choice could unnerve investors and send jitters through financial markets.

– Rousseff and Serra are starting to outline some of their proposals but will only launch official platforms in July.

GOVERNMENT SPENDING

The government is expected to maintain a high level of spending before the election, putting pressure on the central bank to raise interest rates to keep a lid on inflation. Public spending rose sharply in 2009, eroding the primary budget surplus to an eight-year low of 2 percent of gross domestic product. Finance Minister Guido Mantega has pledged to pursue a surplus of 3.3 percent of GDP in 2010 but inflation expectations continue to rise.

What to watch:

– Weak monthly primary surplus figures would indicate worsening fiscal discipline and could push up interest rate futures.

– Lula and Mantega could put increasing pressure on central bank chief Henrique Meirelles to keep expected interest rate hikes to a minimum so as not to jeopardize the economic recovery in an election year.

OIL AND GAS

Congress is likely to approve by the end of the year government-proposed legislation that would increase state control over some of the world’s biggest recent oil finds. The overhaul seeks to ensure proceeds from vast new fields flow to the state to help bankroll investments in areas like infrastructure, education and poverty-reduction programs.

The measures will likely reduce competition in the sector while boosting the role of state energy giant Petrobras, offering fewer but still attractive opportunities for foreign investors.

Critics say the laws threaten the efficiency of Brazil’s successful oil sector by stifling investment and increasing the dangers of political interference and corruption.

Brazil’s Chamber of Deputies has approved the legislative proposal but it could be delayed in the Senate, where the government only has a narrow majority. Analysts give the bill about a 60 percent chance of approval this year.

What to watch:

– A bill allowing the capitalization of Petrobras; shortfalls to the proposed $60-$100 billion could throw into doubt its investment plan and push its share price lower.

– Disagreement in the Senate over how to distribute oil revenue between the federal government and states could hold up the legislative proposal, particularly after the beginning of the World Cup soccer tournament in June and election campaigning by legislators in August.

POLICY STAGNATION

Nearly a dozen cabinet members resigned in April to campaign for public office in the Oct. 3 election. Most have been replaced by career civil servants who typically lack the political capital to push the government’s agenda.

What to watch:

– If Lula’s successor fails to win a clear majority in Congress, reforms needed to improve Brazil’s long-term competitiveness may face difficulty getting approval. These include reforms to an unwieldy tax system, costly pension benefits, and rigid labor laws.

– Strong pledges from Serra or Rousseff to cut spending and boost efficiency could bolster sovereign bond prices.

CORRUPTION

Mud-slinging and corruption scandals tend to surface during Brazil’s election campaigns. They could paralyze Congress and harm the camp of either of the leading candidates. Lula himself came close to facing impeachment proceedings in 2005 when his party was involved in an illegal campaign-financing scandal.

FOREIGN POLICY

If elected, Serra may cool ties with some of Lula’s left-wing allies in Latin America. That could affect energy investments in Bolivia and Venezuela, where Lula had prodded Petrobras to invest to foster regional integration. Some analysts think Serra could also take a harder line in trade disputes with Argentina and the South American trade block Mercosur. Rousseff is expected to continue current foreign policy and could name the current deputy foreign minister, Antonio Patriota, as Brazil’s top diplomat.