BRASILIA/SAO PAULO, Feb 3 (Reuters) - A severe drought is accelerating Brazil's expected descent into recession, adding to President Dilma Rousseff's woes as she takes unpopular austerity measures and faces economic fallout from a corruption scandal at state-run oil company Petrobras.
Sao Paulo, Brazil's largest city, has nearly run out of water and the whole country faces power rationing as the worst drought in more than 80 years dries up hydroelectric reservoirs.
The water and energy shortages are hitting just as the government moves to cut spending and raise taxes to restore business confidence shaken by her interventionist policies and revelations of a massive kickback scheme at Petrobras.
Executives at leading engineering firms have been arrested in the corruption case and thousands of construction workers have been laid off, further hampering the economy as work is slowed or halted on major infrastructure projects.
The economy appears on the verge of its second recession in a year and even low unemployment numbers, a bright spot of the economy in the last decade, are expected to start rising.
Inflation is expected to top 7 percent despite double-digit interest rates.
"We know this first quarter will be terrible. We're not hiding that fact," a member of Rousseff's cabinet told Reuters.
The minister, who asked not to be named, said water rationing looks inevitable in the three largest metropolitan areas - Sao Paulo, Rio de Janeiro and Belo Horizonte - home to nearly 40 million people.
The government may also need to ration electricity for the first time since 2001, before Rousseff's leftist Workers' Party took power.
That would be a fresh blow to Rousseff's credibility. A former energy minister who began her second term as president last month, she has repeatedly boasted that Brazil would never again face the kind of energy shortages that crippled the economy 14 years ago.
To ensure power supplies during peak demand hours, the government plans to call on private businesses such as shopping malls and hotels to use their own generators, Energy Minister Eduardo Braga said.
Economists estimate water rationing in southeast Brazil, which accounts for 60 percent of economic output, could cut growth by up to 1 percent and hurt key export crops like sugar cane and coffee.
In Sao Paulo, authorities have already lowered water pressure for up to 18 hours a day, prompting many residents to stockpile bottled water.
Large shopping centers and some apartment complexes are expanding water storage capacity in preparation for rationing, a local trade association said.
"First our largest city faced supply problems. Now the second, Rio de Janeiro, is lacking water and we also are looking at an energy failure," said Antonio Carlos Zuffo, a civil engineering professor at the state university in Campinas who led a study on Sao Paulo's reservoirs last year.
He said Sao Paulo's largest reservoir system, Cantareira, could dry out by the end of March if rains remain below average. A rationing plan of five days off and two days on could extend that by three months, though it is considered a last resort by water utility Sabesp.
Experts like Zuffo say the crisis could have been avoided but Sao Paulo's state government, ruled by the main opposition PSDB party, and federal authorities opted against rationing in the run-up to elections in October. They then lost their bets on rains returning to normal levels in January.
If forecasts for February rainfall of just half the historical average prove accurate, electricity rationing will become a real risk, especially for industry which consumes 40 percent of generating capacity.
Thymos Energia, a local consultancy, now sees a 66 percent chance of power rationing, up from 40 percent just two weeks ago.
Some say unofficial rationing is already underway. Two weeks ago, the government ordered rolling power cuts in eight states to avoid a larger crisis as Brazilians cranked up air conditioning on the hottest day of the year in Sao Paulo. Brazil had to import electricity from Argentina for two days as a result.
The dry spell has prompted some companies in the southeast to voluntarily cut water usage and truck water in to keep operations stable, the Sao Paulo state industry association FIESP said. Ramping up production is out of the question.
"No industries in these areas are allowed to expand their activity if that means increasing water consumption," said Anícia Pio, of FIESP's environmental department.
Sao Paulo state's water department said it recently denied companies permits to use certain kinds of wells but that industrial output had not been affected.
While drought and the specter of energy rationing hang over industry, it is the corruption scandal at Petroleo Brasileiro SA that has thrown the engineering and construction sector into crisis.
Some smaller construction firms are going bankrupt as a result of investigations that also led to corruption charges against 39 people, including executives of prominent companies such as Camargo Correa, UTC Engenharia, OAS, Galvao Engenharia, Mendes Junior and Engevix.
Petrobras, Brazil's largest company and a major source of capital investment, has halted payments to firms implicated in the graft scheme and barred them from bidding for new contracts.
Economists at Tendencias consultancy say investment cutbacks at Petrobras and ensuing delays on infrastructure projects could shave between 1 and 1.9 percent off growth in 2015.
The investigation is expected to soon implicate Workers' Party politicians and some allies in Congress for allegedly receiving money funneled from overpriced Petrobras contracts.
Yet the government is more concerned about the impact on the economy, calling on prosecutors and judges to punish anyone found guilty of corruption but spare the companies so that they can continue operating.
"We are more worried about the economic impact than the political accusations, because if the big companies are hurt that would be bad for the economy," the minister said. (Additional reporting by Anna Flavia Rochas; Editing by Todd Benson and Kieran Murray)