Brazil’s State Capitalism Revisited: Mixed Signals to Businesses and Investors

Brazil’s State Capitalism Revisited: Mixed Signals to Businesses and Investors

May 16, 2024, Covington Alert

Executive Summary

• President Luiz Inácio Lula da Silva’s administration has been making announcements and adopting actions that signal conflicting economic policy directions, and that might indicate a potential shift towards State capitalism-type rather than free market and free enterprise policies.
• After its return to democracy in 1985, Brazil’s first attempt at State capitalism collapsed and resulted in a two-and-half-year, domestic policy-generated recession that reduced the country’s GDP by 8.1 percent between 2014 and 2016.
• Policies and actions adopted by the Lula administration have some similarities with this first attempt, in particular when it comes to government intervention in large business conglomerates. However, President Lula faces significant political and institutional constraints.
• Structural and microeconomic reforms also pursued by the administration offer an opportunity for businesses and investors, but State capitalism-type policies increase risks of capital misallocation, government and market inefficiencies, and corruption.

Analysis

As President Luiz Inácio Lula da Silva’s administration approaches its 18-month mark, federal government announcements and actions begin to signal a potential shift to move Brazil towards a State capitalism-type economy and reverse the free markets and free enterprise approach adopted by the past two administrations. When seen in conjunction with the recently-approaved new fiscal framework and historic tax reform, these signals provide a mixed message to businesses and investors. They point, at the same time, to more and less government intervention in markets.

State Capitalism

There is no clearcut definition of State capitalism, but it can be described as a wide policy spectrum that begins with State intervention in markets beyond day-to-day regulation, and ends with total State control of the economy. While industrial policy can arguably be characterized as part of this spectrum of intervention, it is typically limited to providing incentives (or disincentives) to market players through various policy instruments, including regulation, subsidies, government procurement, and tariffs.

Modern State capitalism normally goes beyond that, and is characterized by the government’s attempt to influence, participate or control businesses’ management, in particular large companies and conglomerates in key economic sectors, ranging from infrastructure to energy to natural resources. This attempt is continuous and not limited to one sector, but tends to spread throughout the economy.

The First Attempt

Since its return to democracy in 1985, Brazil’s first attempt at a State capitalism-type economy took place in the wake of the Great Recession of 2008-2009 and went full steam until 2014. That year, it collapsed and resulted in a two-and-half-year, domestic policy-generated recession that reduced Brazilian GDP by 8.1 percent between 2014 and 2016. The policy began to take shape in the final year of President Lula’s second term and was largely implemented by his successor, Dilma Rousseff.

The policy choices at that time had at least three main features. First, the abandonment of the country’s then long-standing economic policy – the so-called “macroeconomic tripod” of inflation targeting, fiscal surplus, and floating exchange rate. Initially adopted in 1999, the tripod was substituted by a monetary policy less concerned with controlling inflation, running fiscal deficits, and exchange rate intervention.

Second, at the microeconomic level, measures included increased trade protectionism; an industrial policy heavily reliant on subsidies, government procurement, and local content requirements; substantial funding to the private sector by state-owned financial institutions; and a federal government push to create, support and control the so-called “national champions”, large business conglomerates in key sectors, typically operating as a monopoly or oligopoly.

Third, the paralysis of structural reforms, in particular those seen at the time as necessary to keep the Brazilian economy afloat, and that were eventually approved in future administrations: labor and social security reforms.

Over time, this economic model collapsed under its fiscal weight, inefficiencies, and corruption-related investigations, prompting a recession and the eventual impeachment of then-President Dilma Rousseff in 2016. Her successors shifted course, reestablished the macroeconomic tripod, and embarked on a series of free market and free enterprise reforms.

Revisiting It

Since its inception, the Lula administration has been providing mixed signals when it comes to economic policy choices.

On one hand, in its first year, the administration prioritized a new fiscal framework and a historic tax reform. Brazil’s National Congress approved both in 2023. This provided a strong, positive message to businesses and investors, despite efforts to also approve a number of revenue-increasing measures.

On the other hand, the administration has been making announcements and taking actions that signal a desire to move Brazil again towards a State capitalism-type economy and reverse the free market and free enterprise approach adopted since 2016. These signals became stronger in the second half of 2023 and early 2024.

However, this potential second attempt looks different from the previous one due to at least three factors – institutional constraints, political constraints, and societal polarization. These factors combine to reduce the administration’s policy choices, making the current attempt a partial version of the first.

Differences and Similarities

One main difference is that the Lula administration decided to maintain the macroeconomic tripod. Part of it seems to be a choice, but part of it can be reasonably attributed to constraints. For instance, central bank independence, approved by Congress and signed into law in 2021, shields monetary policy from government intervention. In addition to that, polarization makes the administration concerned with sudden economic policy changes that might affect growth and employment levels.

Another main difference is the pursuit of structural reforms. Again, this seems to be a mix of choice and constraints. Independently of the administration’s plans, Congress is committed to structural reform. For example, Congress was ready to vote the tax reform, and the Speaker of the House and the President of the Senate both made it a priority. Congressional leadership would likely continue its push to approve reforms with or without the administration’s support.

Moreover, the administration has also proposed and adopted policies and measures that improve government regulation and market efficiency, correct market failures, and help Brazil reap the benefits of the green and digital economies.

Nonetheless, similarities remain, in particular at the microeconomic level. As was the case in the first attempt, the administration adopted a new industrial policy that reverted to some of the old policy instruments, in particular subsidies, government procurement, and local content requirements. It also withdrew Brazil from the World Trade Organization (WTO) Government Procurement Agreement (GPA) accession negotiations, slowed down its accession to the Organisation for Economic Co-operation and Development (OECD), and mandated state-owned financial institutions to provide additional levels of funding to the private sector.

However, what seems particularly concerning to investors is the administration’s attempts to intervene in large business conglomerates, either to control them or to nudge their management towards adopting federal government rather than company goals. The examples of this type of action are growing and include the following, all reported on by the Brazilian press:

• Changes in Petrobras’ (PBR) leadership, bylaws, investment plan, dividends distribution rules, and product pricing policy, as well as a reported attempt to repurchase assets;
• An attempt, through a Supreme Court case, to revert Eletrobras’ (EBR) privatization, approved by Congress in 2021 and implemented in 2022;
• A reported attempt to appoint Vale’s (VALE) new CEO;
• A reported attempt to appoint Braskem’s (BAK) new CEO; and
• Press reports of a potential attempt to use the ongoing Brazilian airlines’ financial crisis to create a new national champion in the sector.

Finally, there was an intent, voiced by key cabinet members, to partially or fully revoke the labor and social security reforms, approved in 2017 and 2019, respectively. This was blocked by congressional leadership. The Speaker of the House and the President of the Senate publicly stated, in several occasions, that Congress would not rollback approved structural reforms.

Constraints

A key element to understand the unfolding scenario is how institutional and political constraints, including societal polarization, restrict the administration’s policy choices.

A first major constraint is the increase in congressional power vis-à-vis the Executive branch in the past decade. This is demonstrated in the agenda-setting and blocking power of the Speaker of the House and the President of the Senate, which they have used on several occasions against the administration’s will.

The second major constraint is new legislation approved since the first attempt at State capitalism, which includes central bank independence, governance rules for state-owned companies, and limits on attempts to revert privatizations.

Lastly, the large conservative majority in Congress, fuelled by political polarization, offers another substantial constraint to the administration’s goals.

Nonetheless, it is important to have in mind that some political parties and congressional leadership members might be interested in further government influence, participation or control over key businesses. Supreme Court decisions might also limit the scope of existing legislation, although a recent decision upheld governance rules for state-owned companies.

Mixed Signals

These policy choices result in mixed signals to businesses. While the administration pursues a stable macroeconomic policy coupled with structural reforms, it also adopts some microeconomic policies similar to Brazil’s first and unsuccessful attempt at State capitalism.

Structural and microeconomic reforms offer an opportunity for businesses and investors, but State capitalism-type policies increase risks, including capital misallocation, government and market inefficiencies, and corruption.

Congressional leadership power, existing legislation, and political polarization are significant constraints to a shift to State capitalism. However, the election of a new Speaker of the House and President of the Senate in early 2025 weakens the existing leadership control of the congressional coalition, and reduces the effectiveness of this constraint, as the administration works to influence the outcome of this election.

If you have any questions concerning the material discussed in this client alert, please contact Diego Bonomo in our Latin America Public Policy group.