August 26, 2016 / 3:12 PM / 2 years ago

Markets look for show of strength by Brazil's Temer after impeachment

SAO PAULO, Aug 26 (Reuters) - Brazil’s interim President Michel Temer will need to quickly demonstrate his commitment to cutting the country’s budget deficit if he is confirmed in office next week, in order to sustain investor optimism after a major rally in financial markets this year.

Suspended President Dilma Rousseff is expected to be found guilty of breaking budget laws by the Senate and dismissed from office on Wednesday, leaving former vice president Temer to serve the rest of her term until the end of 2018.

Rousseff, whose trial in the Senate began on Thursday, denies any wrongdoing and describes efforts to impeach her as a “coup”.

Hopes that Temer would reverse the interventionist policies pursued during 13 years of leftist rule by Rousseff’s Workers Party have helped Brazil’s Bovespa stock index and real currency rank among the world’s best-performing assets this year.

But traders say that if the market is to maintain confidence in Temer, he must prove before year-end that he has the political clout to push through a fragmented Congress a constitutional amendment to curb growth in public spending.

“He will not be given carte blanche for a full 18 months,” Nomura Securities strategist João Pedro Ribeiro said, referring to the countdown until the 2018 presidential elections.

Temer will need provide “a very strong signal in the second half of this year that the spending ceiling will be approved in Congress and that he will take substantial action in pension reform in the next year.”

After nominating a group of market-friendly economists to his economic cabinet, Temer has made his flagship proposal a constitutional amendment that limits annual growth of public spending to the previous year’s inflation rate.

But his efforts to curb spending and enact structural reforms have hit opposition in Congress, forcing Finance Minister Henrique Meirelles to offer costly concessions in exchange for lawmaker support.

Some hope that Temer will talk tougher after the confirmation of Rousseff’s removal.

“An interim government has to be more flexible when negotiating,” Banco Fibra chief treasurer Cristiano Oliveira said. He expects the real to strengthen to 3.10 per U.S. dollar by the end of 2016, from about 3.20 currently.

But many investors recognize there is a risk of disappointment.

According to Nomura’s Ribeiro, Temer will need to either get the amendment approved this year or gather enough support in a first-round vote in the lower house of Congress to convince investors that its passage is guaranteed in early 2017.

Immediate market reaction to the confirmation of Rousseff’s removal is likely to be muted after the rally this year. The real has strengthened more than 20 percent against the dollar so far this year, while the Ibovespa index is up 46 percent in local currency terms.

But many market participants expect Rousseff’s removal to trigger foreign capital inflows over the coming months. Despite the real’s rally, Brazil has seen nearly $40 billion in financial outflows so far this year, according to central bank data.

“The rally has been mostly local as of yet,” Absolute Investimentos manager Roberto Campos said. “We should see a further jump once foreigners buy into it.”

He said, however, that the market might be overly optimistic over the pace of inflows. The impeachment “is not the event that will suddenly change foreigners’ strategy. That will depend on each vote in Congress, day by day.” (Editing by Daniel Flynn and Frances Kerry)

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