Brazil sees itself as a maturing power, but in one respect it's still old-school Latin America: the government is ramping up spending to favor its preferred candidate in this October's presidential vote. The increased spending is taking place in areas such as pension spending, public works and state bank lending that are traditionally used to curry favor with special interests and win over voters by boosting the economy. The main risk for investors and policymakers could be greater pressure on inflation, which is already a concern as Brazil's economy expands at a sizzling nine percent annual rate. The spending has also exposed rifts within President Luiz Inacio Lula da Silva's Workers' Party and highlighted a broader debate about the role of the state in the economy. Lula, a leftist former labor leader, has earned respect abroad for tight fiscal management during eight years of government. But analysts say that discipline is now slipping as his chosen successor, former chief of staff Dilma Rousseff, faces a tight race in October. “The fiscal result this year is under threat because it is an election year,” said Raul Velloso, a Brasilia-based expert in public finance who is critical of the Lula administration. As an example, Velloso highlighted expenditures at key ministries including Transport, Cities, National Integration and Defense. In May, current spending on investments at those ministries rose in a range from around 77 to 166.5 percent, compared to about 80 percent growth across all government departments. “Since here there are public works of elevated value, it is where there is margin for deals and exchange of favors,” Velloso added. Gray Newman, head economist for Latin America at Morgan Stanley, said that heavy election-year spending is normal in the region but he described recent measures in Brazil as “extremely stimulative.” “My concern is it's easy to get addicted to those levels of spending ... it's not a model that can last,” Newman said. In an interview, Brazilian Treasury Secretary Arno Augustin denied that the spending increases have anything to do with the election. He said they instead reflect long-term investments in infrastructure and other strategic areas that are designed to propel Brazil to developed-world status in decades ahead. “These are the same (critics) that last year said the PAC (Lula's flagship infrastructure investment program) was not moving,” Augustin said. “Last year, we said investment is like that, it takes time. Now that the payment has started, (they say) it's because of the election.” Fears of overheating However, some of Lula's own top officials have expressed misgivings about the size and timing of the extra spending. As the president approved a 7.7 percent increase in pensioners' income in June, instead of the 6.14 percent originally proposed, Finance Minister Guido Mantega and Planning Minister Paulo Bernardo voiced concerns that the government did not have fiscal room for the increase despite fast economic growth. Meanwhile, tax collection has lagged - up 16 percent in May versus the year before, compared to a 19 percent rise in spending during the same period. Spending has soared even more dramatically in areas outside Brazil's official balance sheet. Loans at state development bank BNDES surged 64 percent in the 12 months through May, leading Central Bank President Henrique Meirelles to warn last week that the credit boom could have a distortionary effect on monetary policy, making it harder to control inflation. Other officials played down those concerns, with Augustin telling Reuters they were not based on a “rigorous” analysis. The government has acknowledged the risk of an overheating economy and slashed spending in some areas. Additional cuts to the 2010 budget announced in May amounted to 10 billion reais ($5.7 billion). In the same breath, though, the government unveiled new measures to stoke exports and extended tax breaks on trucks and capital goods, saying it amounted to a boost in investment. Signs of fiscal pressure abound. In the 12 months to May, Brazil's primary budget surplus stood at 2.13 percent of gross domestic product - below the government's target of 3.3 percent of GDP for full-year 2010. Brazil runs primary surpluses to set aside cash for its debt obligations. While inflation was flat in June, analysts still expect the central bank to raise interest rates by 175 basis points by the end of the year to prevent demand from driving up prices. “The rise in investment this year is very clear and is due to the election, there is no doubt about that,” said Arnaldo Madeira, a congressman for the opposition PSDB party. “We are behaving absolutely irresponsibly in relation to the future of our country, and our public expenditures.” Challenges for next government Ironically, spending designed to benefit Rousseff in the short-term could very well end up hurting her - or opposition presidential candidate Jose Serra - in years ahead. Projects approved by Congress this year aimed at lifting personnel and civil servant wages will cost the government 586.4 million reais, with more raises expected shortly. The increased spending could make it harder for the next administration to attract the money Brazil needs to finance its widening current account deficit, particularly as the euro zone crisis makes foreigners reluctant to invest in riskier assets. Morgan Stanley's Newman said Lula's successor would be best-served to rein in spending that yields quick short-term growth, and focus more on long-term investments such as education that will help Brazil build on its recent success. “The next administration really needs to rethink whether or not this is the right model to continue with,” he said.
