Brazil Defence and Security Report Q2 2009

Brazil has embarked on a major programme to upgrade its armed forces, planning to buy and build equipment to defend offshore oil riches and a porous border in the Amazon jungle. Brazilian President Luiz Inacio Lula da Silva has pushed for an increase of more than 50% in Brazilian defence spending through to 2010. The country is now in the process of developing a national defence plan. In it, Brazil indicates it will increase the troops in the Amazon, build nuclear and conventional submarines to protect offshore oil fields and modernise its weapons industry. In late December 2008, Brazil signed an agreement with France to buy 50 military helicopters and five submarines, including one nuclear-powered vessel, the value of which could exceed $11bn. However the backdrop to this new defence programme is a significantly deteriorating economy will may force a cut back in spending. The political situation is also fluid with an election coming up in 2010.

President Luiz Inácio Lula da Silva is increasingly losing political control to the coalition Partido Movimento Democrático Brasileiro (PMDB), which now controls both houses of parliament. We see growing risks to the cohesion of the coalition and are beginning to doubt the PMDB's likely support for Lula's presidential candidate, Dilma Rousseff. We believe that all cards remain on the table, and expect Brazilian politics to remain eventful ahead of the 2010 election. Indeed, back in October, we first flagged up the possibility that Neves may leave the PSDB to become the PMDB's candidate in 2010. Neves began his political career at the PMDB. Moreover, we have, for some time now, suggested that Lula could be making overtures to Neves, however, a scenario of Lula backing an outside candidate is now looking less likely given that the president has openly confirmed his backing for Rousseff following the October poll.

An alternative risk to our outlook would be for Lula, in an act of desperation or political shrewdness, to propose a change of Brazil's constitution – in light of the severe economic challenges facing the country – allowing the most popular president in Brazilian history to run for re-election.

The record quarter-on-quarter 3.5% contraction in real GDP during the last quarter of 2008 is indicative of the severity of Brazil's ongoing economic downturn and has prompted us to adopt our most pessimistic scenario for the economy: We believe consumption levels will keep falling during the early stages of 2009. We see little scope for overall output to recover for most of the year, and expect Brazil's negative output gap to worsen. With only a government stimulus package to fall back on, we now believe a fullyear recession will be unavoidable in Brazil and have pencilled in a real contraction of 0.6%.

BMI's baseline outlook for the Brazilian economy has fundamentally shifted towards our most pessimistic scenario. Having assessed the fourth quarter GDP data published by Brazil's Geographic and Statistical Institute (IBGE), we now see a sharper decline in output levels in the economy during the upcoming quarters. With little for the economy to fall back on aside from public spending programmes, we now feel that a prospective recovery during the final quarter of 2009 will not be sufficient to keep the full-year real GDP growth rate positive. As such, we are revising our economic growth outlook for Brazil to -0.6% (from positive 0.8% previously).