Brazil Recovery in Doubt as Tax Measures Found Unconstitutional - TheStreet

Brazil Recovery in Doubt as Tax Measures Found Unconstitutional

The government now will have to pass some other politically unpopular measures to recoup the lost budget revenue. Exactly what those measures will be is unclear.
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How short the honeymoon for Arminio Fraga.

Now that two critical taxes, which would have gone toward slimming Brazil's fiscal deficit, have been deemed unconstitutional, the bottom has fallen out of the recovery that Fraga's central bank was meant to protect. Now, the harder work of long-term reforms must begin, while traders and investors watch from the gallery.

The overturning last Thursday of a tax on retired civil servants and a tax increase for government workers erased $1.3 billion from projected revenue and sobered central bank president Fraga, who had made effervescent remarks just days earlier at the

World Bank

annual meeting. Indeed, Fraga had reason to trumpet -- albeit with a degree of modesty -- the surprisingly rapid progress made this year following what market analysts believed would be a devastating currency devaluation in January.

Brazil will likely meet its inflation target of 6% this year, foreign direct investment is over $25 billion, up from just about nil six years ago, volatile short-term capital flows are nearly nonexistent, and the only short-term debt projected is from a negative trade balance.

Riding on these successes, Fraga was quick to assert control despite his being in New York and not Brasilia for the tax shock. "We are not going to wait for some miracle to bail us out," Fraga said, promising Brasilia will devise a clear plan of action by the week's end.

Fraga had suggested amending the constitution, a notion the Brazilian government nixed on Tuesday.

Fraga and others in the Brazilian government will have to pass some politically unfavorable measures to recoup the lost budget revenue. Fraga says that either expenditures will be cut or other revenue will be found. But which expenditures and which revenue is still vague, although the government could opt to raise social security contributions of active civil servants and soldiers, as well as increase the financial transactions tax.

Such obliqueness makes investors skeptical about the depth and long-term nature of the previously positive economic news coming out of Brazil.

"The government is meeting and even exceeding


targets for the fiscal accounts," says Ian Campbell, head of Latin American research at


. "But there continues to be very little progress with the big structural fiscal reforms that the government was talking about last year."

Such realistic negativity is priced into Brazilian securities. Brazilian Bradys rose on Monday, evidence that it's hard to drop much further. Even the

Sao Paulo Stock Exchange's Bovespa Index

, which skidded 5% last week on the news, was up again Monday though not fully recovered.

"Most stocks and bonds in Latin America are undervalued. Spreads are huge and any news that comes out, nothing happens because there is a huge cushion factored in," said Arturo Porzecanski, chief economist for the Americas at

ING Barings

. "Whoever wanted to sell has sold."

Porzencanski predicts little will change for Brazil until January, after Y2K issues, additional reforms and regional elections have subsided. Before last year's Russian surprise, Brazilian stocks would move with rumors of Russian President

Boris Yeltsin's


Even the

U.S. Federal Reserve

's decision to change or maintain interest rates won't have much impact on the Brazilian market. Only domestic issues, such as fiscal responsibility, tax reform and generally faster fiscal reforms will cause ripples through Latin America's largest market and restore the confidences of domestic as well as international investors.