It has been an Indian summer for the real, which was stable for much of Q2, before weakening in the third. But, with an ostensibly market-friendly challenger making gains in opinion polls, hopes for a change of government have pushed the real higher against the dollar, by around 2.5% in the past month, and around 5.6% year to date.
The outcome of the election remains too close to call, but a recent poll puts Rousseff of the Workers’ Party in the lead with 34% of the vote, down from around 38% in the months prior.
Unless Rousseff prevails outright in the first round, she is expected to lose to the Socialists’ Silva in the second, securing a projected 36% of the vote to Silva's 45%, as momentum is expected to shift to the latter candidate, famed as an environmental campaigner, who secured 20% of the vote in the last election.
In recent years, Brazil’s fiscal slippage, and inconsistent policies, more generally – challenging the central bank’s bid to kick a lid on inflation – riled foreign bond investors during the taper tantrum, leading to the country’s inclusion in the fragile-five grouping.
However, the market has continued to move higher in recent months, driven by recent survey data, registering momentum for the opposition candidate, and the 2Q GDP release confirming Brazil entered a technical recession in the first half of the year, which increases the likelihood of a shift in economic policies.
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Even if Rousseff emerges victorious, she is likely to replace finance minister Guido Mantega – whose tenure since March 2006 has been characterized by inflation-inducing, pro-cyclical fiscal expansion, without corresponding productivity gains – as a statement of reformist intent.
In a nod to the shift in political climate, Silva has pledged fiscal responsibility, inflation-targeting, a floating exchange rate and central-bank independence.
Kathryn Rooney Vera, strategist at Bulltick Capital Markets, a brokerage firm focused on Latin America, says: “We note [Silva] has widely been considered as having performed well in her two debate performances and sounding more market friendly, even touching on BNDES financing and inflation indexation, two of the critical reasons Brazil has sticky high inflation and a Selic perennially high to compensate.
“Silva called for transparency in federal monies funnelled in BNDES [the state development that de facto chooses national winners and losers financing the likes of JBS and PBR at extremely favorable rates]. She pledged to reduce the level of indexation of wages in Brazil’s economy. Also of high relevance from our perspective, coming from a serious environmental hawk [former Green Party], Silva backed pre-salt exploration.”
She adds: “At this point, given the intense optimism for electoral change ramped up with Silva, a disappointment therein would in our view cause a near-term retrenchment in risk appetite for Brazilian assets immediately ex-post the election. If Rousseff is in fact re-elected, however, we do expect some economic pragmatism to curb inflation and avoid further rating downgrades, including some real fiscal consolidation.”
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Kamil Amin, currency analyst at Caxton FX, says: “The market will be forced into buying [Silva's] promises due to the fact that she is a already an historic political figure with a strong pedigree.
“If she does win the election, she will have huge political capital in her hands, including internationally, so it will be in her interest to deliver as expected.”
A new administration will need to tackle near-term challenges – high inflation at 6.5% compared with the 4.5% target, a gaping current-account deficit, weak growth and fiscal consolidation to avert ratings downgrade – as well as stubborn structural hurdles to growth, including rigid labour and tax policies, and the infrastructure deficit.
Silva, a more aggressive reformer than the incumbent, has indicated she would set the inflation target at 3%. And both she and Aécio Neves, another challenger of the Social Democracy party, have indicated they will grant the central-bank independence as part of their strategies to bring Brazilian inflation under control.
The move would be well received in the business community. “The next step for Brazil is making inflation targets credible and to do that we need a more robust institutional arrangement such as central-bank independence,” says Gustavo Arteta, Latam FX strategist at UBS.
Yet it will not be an easy promise to keep, with some elements within government likely to resist ceding control of the monetary authority, mindful of growth targets. If one of the challengers prevails and is able to deliver on that promise it will be a positive step for the market.
Ultimately Brazilians face a choice between higher growth or lower inflation in the short-term, says Arteta. UBS expects rates to be hiked after the election to bring inflation under control, with around 100 basis points of rises in 2015 coming in the first half of the year, though the market is pricing in a smaller rise.
Given the extensive list of problems facing Brazil, the response in the currency markets has been relatively muted, with the Banco Central do Brasil intervening where necessary to minimize currency volatility. “Not much is happening in the FX markets because the central bank keeps intervening which has left the real overvalued,” says Arteta.
So unless something happens to radically alter risk appetite, such as a dramatic escalation of hostilities in Europe, the market looks poised to wait to see who will be charged with tackling Brazil's economic problems.
“I expect the FX situation to become more of an issue after the election and for the real to end the year at around 2.45 against USD, so there is plenty of room to weaken from here,” says Arteta.
More significant real weakening will begin next year, as US rate hikes get closer, regardless of who wins the election.
Only structural reforms on steroids, including better governance, will deliver pre-2011 growth rates – around 7.5% in 2010 and an average of 4.3% between 2008 and 2010 – analysts conclude.