Activist supporting the  anti-corruption operation demonstrate against former president Luiz Inacio Lula da Silva Heuler Andrey/Getty Images

Brazil’s Economic Deliverance

Brazil's proliferating corruption scandals have imposed substantial costs on some of the country's largest companies. But, in the long term, today's efforts to strengthen the rule of law and ensure fair market competition will prove to have been well worth it.

WASHINGTON, DC – Ongoing corruption investigations in Brazil have exposed a tangled network of illicit relationships between private firms, government bureaucrats, and elected politicians. The corruption scandals have already reached the highest levels of Brazilian society. Several high-level politicians and corporate owners and executives have been convicted and imprisoned. Even former President Luiz Inácio Lula da Silva is now under indictment.

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Meanwhile, the drama has taken its toll on the Brazilian economy. In addition to individual businesses, entire value chains that contribute heavily to the country’s GDP have suffered a sudden operational and financial freeze.

But while many observers have focused on the scandals’ short-term political and economic fallout, it is worth remembering what Brazil stands to gain by exposing corruption and punishing offenders. Reforming the relationship between Brazil’s public and private sectors can improve the country’s long-term economic performance.

The ongoing prosecutions have already changed the calculus for any economic agent who is thinking about violating the public’s trust for private gain. There is now a widespread perception that those who engage in illicit dealings have a higher probability of being caught and punished, regardless of their social status. And this is just as true for those demanding bribes as it is for those paying them.

One need not be an economist to know that the perception of increased risk can be a powerful disincentive. Even though most of the biggest corruption investigations and trials are still ongoing, Brazilian firms have already revamped their compliance efforts for fear of being caught. According to Bruno Brandão, Brazil country manager for Transparency International, the country is now in the midst of a “corporate governance revolution.”

Corruption has far-reaching deleterious effects on an economy. When corruption is rampant, public expenditures and human resources throughout the economy tend to be allocated in ways that maximize opportunities for rent-seeking rather than wealth creation. Instead of innovating or improving productivity, private actors try to beat their market competitors by pursuing special privileges.

After the dust from the corruption investigations settles, Brazil will be able to strengthen its economy in at least three different dimensions. First, public spending can be made substantially more cost-effective. Decisions about investment projects, state tenders, and other administrative and regulatory matters will no longer be made in such a way as to maximize rent extraction.

Second, and in response to the first change, a wide range of sectors that interact with the public sector will undergo significant restructuring. A “business model” based on the organized creation and distribution of public-sector demand and the suppression of competition will no longer work. Without the opportunity for kickbacks, businesses will emphasize efficiency, and markets will once again perform their proper function of selecting winners and losers.

Third, Brazil could vastly improve its reputation among investors. The risk premium on doing business in Brazil will improve if investors believe its economy is governed by the rule of law, rather than by market-rigging on the part of a privileged few. Strengthening the rule of law and ensuring compliance with formal rules will require more transparency and the elimination of opaque extra-market factors in private-sector competition.

Of course, Brazil will have to undergo a long, painful economic transition before it can benefit from such opportunities. Currently, large domestic companies implicated in judicial proceedings are finding it increasingly difficult to secure financing and assuage doubts about their reported asset values and net worth. This, in turn, has led to shrinking client demand and various other operational challenges.

With investigations and prosecutions ongoing, many outsiders have adopted a wait-and-see attitude, while they weigh acquiring existing assets from corporate liquidations as an alternative to green-field investment. Ultimately, it will take time to rebuild confidence. Investors need to see Brazil stay the course in its reform efforts, as well as more fine-tuning by regulatory agencies and state companies. If the “governance revolution” is to succeed, the process must not end with the ongoing prosecutions.

For starters, judicial action needs to be complemented by a microeconomic reform agenda – such as what Minister of Finance Henrique Meirelles has proposed – to change features of Brazil’s business environment that generate no value and only breed corruption. The government needs to improve public-sector accountability at all levels, and then gradually look for more ways to prevent malfeasance in the first place. And it needs to ensure that governance reforms are resilient against future attempts to unwind them.

The network of cronyism that is being dissolved is neither new nor unique to Brazil. But it clearly began to expand in the recent past, perhaps as a symptom of a “natural-resource curse,” stemming from the discovery of deep-sea pre-salt oil reserves during the 2000-2014 commodity super-cycle.

In any case, dissolving Brazil’s corrupt public-private relationships will be painful in the short term. But in the long term, the reforms now underway will deliver economic, political, and social gains to the country – and to any others that emulate them.

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