“She wants to meet with him personally before deciding,” said the source, who was well informed on the matter but not authorized to discuss it publicly.

Her agenda shows no meeting between the two but another source in the president’s office said it could happen late afternoon or evening.

Orlando Silva is accused of arranging up to 40 million reais ($23 million) in kickbacks from government contracts to benefit himself and the Communist Party of Brazil, which is part of Rousseff’s governing coalition.

The scandal threatens to further complicate already troubled preparations for the 2014 soccer World Cup and the 2016 Olympics, which Brazil hopes will showcase its emergence as an economic power.

Rousseff met with senior aides on Thursday night to review the allegations against Silva after returning from an official trip to Africa, according to the government source.

Local newspaper Estado de S.Paulo reported on Friday that the president had made up her mind after that meeting to replace Silva with another member of his party.

Silva has denied any wrongdoing and said the accusations were started by a disgruntled contractor arrested last year in an investigation into allegedly illegal fund-raising by the Communist Party.

Five cabinet members have already resigned since Rousseff took office on Jan. 1, four of them over ethics scandals that exacerbated acrimonious disputes in the ruling coalition and led allies to briefly boycott her legislative agenda.

Given the small size of the Communist Party, the scandal is unlikely to cause the same rifts in her coalition, which includes parties from the far-left to center-right.

But the matter is likely to renew a public debate over campaign financing issues, which many analysts say is at the heart of corruption among politicians.

Rousseff’s hugely popular predecessor and mentor, Luiz Inacio Lula da Silva, came close to an impeachment process in 2005 over an illegal campaign financing scheme run by his ruling Workers’ Party. A legislative proposal to tighten rules for campaign financing has been stuck in Congress ever since.

(Writing by Ray Colitt and Brad Haynes; Editing by Will Dunham)

Orlando Silva is accused of arranging up to 40 million
reais ($23 million) in kickbacks from government contracts to
benefit himself and the Communist Party, which is part of
President Dilma Rousseff’s government.

The influential news magazine Veja reported during the
weekend that Silva headed a scheme dating back to 2004 in which
20 percent kickbacks were charged on public contracts,
including sports projects for needy children.

Despite Silva’s emphatic denials of wrongdoing, he looked
increasingly vulnerable on Tuesday as details emerged of sloppy
bookkeeping and favoritism in the Sports Ministry’s contracts
with non-governmental organizations, or NGOs.

Silva was due to testify on the matter in Congress later on
Tuesday.

A government watchdog, known by its Portuguese acronym CGU,
says 59 contracts signed by the Sports Ministry between 2006
and 2011 did not comply with regulations, according to local
media reports. It has demanded that contractors return 24.5
million reais.

“The minister must leave,” the Estado de Sao Paulo
newspaper said in an editorial.

The newspaper said remaining in office would undermine
Silva’s authority and create more turmoil for Rousseff, who has
already lost five ministers to ethics scandals this year.

The scandals, which had appeared to be abating before the
Veja report on Silva, have exposed deep rifts in the disparate
ruling coalition and delayed Rousseff’s legislative agenda.

The scandal is particularly embarrassing for Brazil as it
hopes to use the 2014 World Cup and the 2016 Olympics later to
showcase its emergence as an economic power.

HALF-HEARTED BACKING

The construction of stadiums and airport terminals for the
events has been delayed and Silva’s departure could throw
preparations into further disarray.

Even if Silva is not directly linked to corruption, he may
ultimately be held accountable for poor oversight.

“Silva’s arguments will be put to the test in coming days,”
Folha de Sao Paulo newspaper said in an editorial on Tuesday.

“But at the head of a portfolio full of suspect deals, his
political vulnerability is evident,” Folha said.

Rousseff, on a weeklong tour of Africa, has only given
half-hearted support to Silva, who was deputy sports minister
under her predecessor, Luiz Inacio Lula da Silva. She said he
was innocent until proven guilty but also acknowledged
shortcomings in the oversight of contracts with NGOs.

“It looks increasingly difficult for him to hang on to his
job,” said Jose Luciano Dias, a Brasilia-based political
consultant.

The man who made the accusations against Silva is a
disgruntled former contractor and police officer arrested last
year during an investigation into the Communist Party’s alleged
illegal fund-raising scheme. He says the minister received
bundles of cash in the garage of the ministry.

Joao Dias Ferreira, a former Communist Party activist whose
Kung Fu association received government funds, says he has
audio tapes to prove his allegations.

Silva has rejected the accusations, saying the Veja report
was based on false information provided by criminals. He told a
news conference on Monday that his predecessor at the ministry,
Agnelo Queiroz, had recommended financing Ferreira’s outfit.

(Editing by Stuart Grudgings; Editing by Bill Trott)

The accusations, made in the influential weekly magazine Veja over the weekend, are an untimely blow for Rousseff, as her administration appeared to be moving on from scandals that brought down five ministers in recent months.

The involvement of Sports Minister Orlando Silva is particularly sensitive for her government, which is struggling with a ballooning budget for the 2014 soccer World Cup and allegations of widespread padding of public works projects for the event. Brazil is also preparing to host the 2016 Olympic Games in Rio de Janeiro.

Silva, the government’s point man for investment and infrastructure projects for the mega events, denied the accusations as “farcical” and rushed back from a visit to the Pan-American Games in Mexico to defend himself.

“The information published at the weekend simply is not true,” he said in a news conference on Monday, adding that he would testify in Congress on Tuesday about the accusations.

Rousseff said she still backed Silva, the only cabinet member from Brazil’s Communist Party, which is a part of the governing coalition.

“We not only assume the integrity of minister (Silva), but he also expressed extreme outrage over the accusations made against him,” Rousseff told reporters in Pretoria, South Africa, the first stop on a week-long African trip.

But analysts said that support may erode quickly if the media digs up more concrete evidence against Silva.

The Veja report accused Silva of heading a scheme dating back to 2004 in which 20-percent kickbacks were charged on public contracts, including sports projects for needy children, and the proceeds directed to the Communist Party. The report estimated that more than 40 million reais ($22.8 million) was siphoned.

Veja cited a disgruntled former contractor arrested last year during a police investigation into the party’s alleged illegal fund-raising scheme, which began during the 2003-2010 government of former President Luiz Inacio Lula da Silva.

Silva, who was deputy sports minister under Lula, once personally received cash in a paper carton in the garage of his ministry, a chauffeur told Veja.

Brazil is hoping to use the World Cup and Olympics to showcase its emergence as an economic power. But the construction of several stadiums, airport terminals and other event-related works are behind schedule and the departure of Silva could throw preparations into further disarray.

Rousseff has taken a tougher stance against corruption than her predecessor and mentor Lula, who often turned a blind eye to graft accusations to avoid risking political support.

Her defense of clean government has seemingly earned Rousseff some support, particularly among middle-class voters.

The 63-year-old career civil servant has bounced back in opinion polls.

(Editing by Stuart Grudgings and Paul Simao)

Brazil’s states and cities have been quarreling for years over how to distribute the expected multi-trillion-dollar windfall from one of the world’s biggest recent oil finds. Former President Luiz Inacio Lula da Silva called the so-called “subsalt” fields, discovered in 2007, “a gift from God” that could make Brazil a rich country.

President Dilma Rousseff’s government is now trying to defuse the arguments by offering a cut of its own take in future royalties from the fields. Officials are confident Congress will approve the government proposal in coming days or weeks.

“We’re at ease. The interested sides are hard at work … and by the looks of it, they’re forging a quite significant majority,” Gilberto Carvalho, general-secretary of the president’s office, told Reuters.

Yet some leading politicians are still balking at the proposal or threatening legal action. The final outcome is up in the air at a time when Rousseff’s relationship with Congress has been poisoned by budget cuts and other problems.

At stake is Brazil’s plan to become one of the world’s largest suppliers of oil outside of OPEC and to ensure revenue to finance improvements in infrastructure, health programs and education, which are crucial to entering the ranks of developed nations.

The final outcome will have major implications for state oil company Petrobras (PETR4.SA: Quote, Profile, Research, Stock Buzz)(PBR.N: Quote, Profile, Research, Stock Buzz), and possibly for multinational energy companies such as Italy’s (ENI.MI: Quote, Profile, Research, Stock Buzz) and Norway’s Norsk Hydro (NHY.OL: Quote, Profile, Research, Stock Buzz), who have expressed interest in helping Brazil develop the fields.

So far Brazil is pumping only a small fraction of the subsalt fields and requires tens of billions of dollars to develop the remaining reserves.

An agreement on distributing oil revenues is needed for the government to go ahead with a planned auction next year for the rights to develop the vast oil fields.

The so-called subsalt region is believed to hold more than 50 billion barrels of oil buried under a thick layer of salt. At current prices that would be about $4 trillion in revenue.

Failure to reach agreement on the bill would spark a drawn-out legal battle, potentially stalling fresh investments for several years. Without a compromise, Congress would almost certainly overrule last year’s veto by Lula of a law that would have distributed more revenue to non-producer states.

The three largest oil producing states — Rio de Janeiro, Sao Paulo and Espirito Santo — are keen to uphold the veto.

Sergio Cabral, governor of Rio de Janeiro, said he would go all the way to the Supreme Court to ensure his state’s oil income. Losing it would generate a political backlash for him and President Dilma Rousseff, Cabral warned.

“The electoral tragedy in Rio would be dramatic,” said Cabral, wary of losing cash before hosting the 2016 Olympics.

Rio de Janeiro pumps the vast majority of Brazil’s roughly 2 million barrels per day of crude.

TAX RISK

Cabral proposes hiking a separate oil excise tax, which state oil company Petrobras in turn has said would violate existing contracts and force it to go to court.

New framework legislation passed last year heightened state control over the subsalt region and made state-led oil company Petrobras (PETR4.SA: Quote, Profile, Research, Stock Buzz). But private investors can still take a stake of up to 70 percent in joint-ventures.

Mauricio Pedrosa, a partner with asset management group Queluz Asset in Rio de Janeiro, said any changes to existing contracts would be a blow to the company.

“If the royalty agreement alters existing contracts it could affect Petrobras’ cash flow. It’s another risk factor for the company,” said Pedrosa, who helps manage around 300 million reais ($158 million in assets).

The proposal by Rousseff’s administration would cut the federal government’s cut of royalties by almost a third and distribute that to non-producer states.

Producer states like Rio de Janeiro would see a small cut.

The offer was rebuffed by some players, particularly by municipal governments, which would see the biggest losses.

“We don’t understand why the government is punishing the municipalities. We are the ones who suffer the economic and social effects of oil operations,” said Riverton Mussi, mayor of the city of Macae — the country’s main oil hub.

Mussi, who estimates Macae would lose a quarter of its annual budget under the government’s plan, also said he would defend his city’s oil income in court.

“Right now this debate is holding hostage the whole development of the sector,” said Latin America analyst Christopher Garman of the Eurasia consultancy in Washington.

(Additional reporting by Jeferson Ribeiro; Editing by Bob Burgdorfer)

Brazil’s states and cities have been quarreling for years
over how to distribute the expected multi-trillion-dollar
windfall from one of the world’s biggest recent oil finds.
Former President Luiz Inacio Lula da Silva called the so-called
“subsalt” fields, discovered in 2007, “a gift from God” that
could make Brazil a rich country.

President Dilma Rousseff’s government is now trying to
defuse the arguments by offering a cut of its own take in
future royalties from the fields. Officials are confident
Congress will approve the government proposal in coming days or
weeks.

“We’re at ease. The interested sides are hard at work …
and by the looks of it, they’re forging a quite significant
majority,” Gilberto Carvalho, general-secretary of the
president’s office, told Reuters.

Yet some leading politicians are still balking at the
proposal or threatening legal action. The final outcome is up
in the air at a time when Rousseff’s relationship with Congress
has been poisoned by budget cuts and other problems.

At stake is Brazil’s plan to become one of the world’s
largest suppliers of oil outside of OPEC and to ensure revenue
to finance improvements in infrastructure, health programs and
education, which are crucial to entering the ranks of developed
nations.

The final outcome will have major implications for state
oil company Petrobras (PETR4.SA: Quote, Profile, Research)(PBR.N: Quote, Profile, Research), and possibly for
multinational energy companies such as Italy’s (ENI.MI: Quote, Profile, Research) and
Norway’s Norsk Hydro (NHY.OL: Quote, Profile, Research), who have expressed interest in
helping Brazil develop the fields.
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Graphic of oil discoveries: link.reuters.com/fyh84m

Factbox on Brazil oil finds [ID:nN23274907]
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

So far Brazil is pumping only a small fraction of the
subsalt fields and requires tens of billions of dollars to
develop the remaining reserves.

An agreement on distributing oil revenues is needed for the
government to go ahead with a planned auction next year for the
rights to develop the vast oil fields.

The so-called subsalt region is believed to hold more than
50 billion barrels of oil buried under a thick layer of salt.
At current prices that would be about $4 trillion in revenue.

Failure to reach agreement on the bill would spark a
drawn-out legal battle, potentially stalling fresh investments
for several years. Without a compromise, Congress would almost
certainly overrule last year’s veto by Lula of a law that would
have distributed more revenue to non-producer states.

The three largest oil producing states — Rio de Janeiro,
Sao Paulo and Espirito Santo — are keen to uphold the veto.

Sergio Cabral, governor of Rio de Janeiro, said he would go
all the way to the Supreme Court to ensure his state’s oil
income. Losing it would generate a political backlash for him
and President Dilma Rousseff, Cabral warned.

“The electoral tragedy in Rio would be dramatic,” said
Cabral, wary of losing cash before hosting the 2016 Olympics.

Rio de Janeiro pumps the vast majority of Brazil’s roughly
2 million barrels per day of crude.

TAX RISK

Cabral proposes hiking a separate oil excise tax, which
state oil company Petrobras in turn has said would violate
existing contracts and force it to go to court.

New framework legislation passed last year heightened state
control over the subsalt region and made state-led oil company
Petrobras (PETR4.SA: Quote, Profile, Research). But private investors can still take a
stake of up to 70 percent in joint-ventures.

Mauricio Pedrosa, a partner with asset management group
Queluz Asset in Rio de Janeiro, said any changes to existing
contracts would be a blow to the company.

“If the royalty agreement alters existing contracts it
could affect Petrobras’ cash flow. It’s another risk factor for
the company,” said Pedrosa, who helps manage around 300 million
reais ($158 million in assets).

The proposal by Rousseff’s administration would cut the
federal government’s cut of royalties by almost a third and
distribute that to non-producer states [ID:nS1E78D28F].
Producer states like Rio de Janeiro would see a small cut.

The offer was rebuffed by some players, particularly by
municipal governments, which would see the biggest losses.

“We don’t understand why the government is punishing the
municipalities. We are the ones who suffer the economic and
social effects of oil operations,” said Riverton Mussi, mayor
of the city of Macae — the country’s main oil hub.

Mussi, who estimates Macae would lose a quarter of its
annual budget under the government’s plan, also said he would
defend his city’s oil income in court.

“Right now this debate is holding hostage the whole
development of the sector,” said Latin America analyst
Christopher Garman of the Eurasia consultancy in Washington.

(Additional reporting by Jeferson Ribeiro; Editing by Bob
Burgdorfer)

Rousseff will have to face rebellious allies wanting more
government spending and a greater say in policies as well as
unions demanding higher wages. Other challenges include rising
inflation, currency volatility, and resistance to long-term
structural reforms.

A FADING ECONOMY

Compared to many developed countries, Brazil’s expected 3.5
percent economic growth this year looks attractive. But after
the boom under former President Luiz Inacio Lula da Silva, that
culminated in last year’s dizzying expansion of 7.5 percent, it
feels disappointing.

Bank and postal workers striking for higher wages to offset
inflation are the latest groups to become unhappy with the
course of the economy. While cheap credit and rising real wages
fueled the consumption boom under Lula, real wages have fallen
marginally and lending rates are sharply higher since Rousseff
took office on Jan. 1. That has fueled discontent in the rising
middle class that forms the cornerstone of her support base.

Rousseff’s disapproval rating doubled to 25 percent in July
but eased to 21 percent in September, an Ibope opinion survey
showed. Rousseff performed worst on health care and easing the
country’s high tax burden.

To prevent pessimism from spreading, Rousseff stepped up
ribbon-cutting events designed to showcase improvements in
public services and social welfare. Her aides privately say
they expect worse economic data in the third quarter.

What to watch for:

– A fall in Rousseff’s approval ratings.

– More industrial action for wage hikes that could pressure
inflation.

COALITION CRACKS

Budget cuts designed to ease inflationary pressure have
turned some of Rousseff’s allies against her, eroding what was
at least nominally a massive majority in Congress. A series of
corruption and ethics scandals that led to the resignation of
five cabinet members exacerbated discontent and caused deep
divisions in her coalition. Her refusal to make political
appointments to key jobs angered her main ally, the PMDB.

The clearest sign of internal divisions was the defeat of a
government proposal to implement a financial transaction tax to
finance health spending [ID:nS1E78K0PN]. Her ruling Workers’
Party was alone in her 16-party alliance to vote in favor of
the bill.

Rousseff, 63, has tried to govern without Congress as much
as possible but relies on legislators for a series of bills.
They include an overhaul of an unwieldy tax code, framework
legislation for the mining sector and a bill regulating oil
royalties, all aimed at easing legal uncertainty and attracting
investment. [ID:nN1E75L0H2]

Other projects on hold include bills aimed at ensuring that
Brazil builds stadiums, airports and other infrastructure
needed not only for the World Cup and the 2016 Olympics but
also to overcome bottlenecks holding back the entire economy.

With the sporting events drawing nearer and a slowing
economy exposing problems from unwieldy labor laws to heavy
taxes, Rousseff may need to engage Congress to approve
structural reforms and emergency bills to speed up government
procurement. In doing so, she may have to ease some of the
austerity measures adopted so far.

One pivotal case is whether she can continue to withstand
demands for a massive wage increase for civil servants in the
judiciary. At stake is a 7.7 billion reais hole in the budget
and a possible domino effect on wage negotiations throughout
the public sector and beyond, as judges’ salaries are often
used as a reference.

What to watch for:

– Signs that Rousseff will increase spending or make
appointments to please allies.

– New media revelations of scandal among top officials.

INFLATION

Consumer price pressure has remained surprisingly strong
and is perhaps one of the biggest headaches for Rousseff.
Annual inflation in the 12 months through mid-September rose to
7.3 percent, well above the 6.5 percent upper limit of the
government’s target range. [ID:nS1E78P04M].

The central bank formally forecast year-end inflation at
6.4 percent but one director said it could miss the target.

The bank’s job has become more difficult since it cut rates
in August in an apparent attempt to help economic growth.

Industrial action for wage hikes, a depreciating currency
that makes imported goods more expensive, and an economy that
is still highly inflation-indexed all add to the burden.
This has potentially serious political implications for the
government. Inflation tends to hit hardest the poorer classes
who form Rousseff’s political base and sustained price rises
could erode her approval rating.

What to watch for:

– 12-month inflation rate failing to fall significantly.

– Signs of further rate cuts ahead.

CURRENCY POLICY

Rousseff’s government has been particularly active in
intervening in the currency market, first to prevent the real
BRBYBRL= from gaining further and more recently to prevent
its depreciation amid fallout from global financial turmoil.

Through its interventions, the government has indirectly
signaled what it considers a “suitable range” for the currency
- a ceiling of 1.6 and a floor of 1.9 against the U.S. dollar.

Among the measures the government adopted to prevent a
further rise of the real was a tax on currency derivatives,
potentially the most aggressive measure so far to stem a
currency rally [ID:nN1E76Q01I]. To stem losses in the real in
September, the central bank sold currency swaps in the futures
markets.

Any fresh measures could hit fixed income and currency
investors, including manufacturers or farmers seeking to hedge
against currency fluctuations.

FARMING AND MINING

A proposal changing environmental regulations for farmers
passed the lower house of Congress and could become law later
this year. While the Forestry Code, which sets the percentage
of native forest that farmers must preserve, reduces overall
environmental liabilities for farmers, they would have to
finance costs they have been putting off for years to reforest
or invest in protected areas.

The government also intends to send a new bill to Congress,
regulating the purchase of farm land by foreigners. It has
tightened restrictions over the past year but is now likely to
fine-tune rules to allow for more foreign investment in some
farming sectors.

A mining bill Rousseff is expected to send to Congress this
year would likely reduce the time companies have to develop
mines to discourage speculation in mineral properties. It would
also hike royalties and slash taxes in an effort to promote
mineral processing.

ROUSSEFF’S HEALTH

Concerns over Rousseff’s health have faded but remain on
investors’ radar screens since her hospitalization and lengthy
recovery from pneumonia in May. Such concerns first surfaced in
April 2009 when she announced she was being treated for
lymphoma. [ID:nN01161483] [ID:nN12259498]

She has been given a clean bill of health by doctors but is
reported to also suffer from diabetes, hypothyroidism, and high
blood pressure. Were Rousseff’s health to worsen, markets could
slump due to uncertainty over economic policy under Vice
President Michel Temer.
(Editing by Kieran Murray)

The worsening global outlook has caught up with Latin America’s largest economy this month, battering Brazil’s equity and currency markets. The central bank also revised its 2011 growth projections downward to 3.5 percent this week.

Still, the government expects the debt sale to showcase Brazil’s strong fundamentals at a time when many fear the global economy could slip back into recession.

“The fact we’re in a crisis reinforces the importance for Brazil to prove its fundamentals,” Arno Augustin said in an interview on Friday in Brasilia.

The yield spread, or difference, between 5-year Brazilian global bonds and 5-year U.S. Treasuries fell to 214.8 basis points on Friday from a two-year high of 221.9 basis points on Sept. 23, a sign that Brazilian debt is being considered less risky compared with U.S. debt than it was previously.

IT’S ALL ABOUT THE CURVE

Brazil’s objective was not to raise capital or to capture foreign currency, but to broaden Brazil’s yield curve, Augustin said.

“The issue has the sole purpose of shaping a good curve for the country so that the companies have a good reference.”

A yield curve is a measure of market borrowing costs for Brazilian debt issuers over time.

Brazil’s yield curve runs from about 1.53 percent a year in dollars for debt maturing in two years to 5.12 percent a year for 30-year debt, based on the yields of the country’s global bonds.

Through 2030, Brazil has at least one large international bond in dollars maturing every year except 2023, 2026 and 2029, allowing investors and companies to set a benchmark for borrowing . As companies and individuals are believed to be higher-risk borrowers than the government, they usually pay the rate expressed by the curve plus a premium.

The government still hasn’t decided whether the bonds would be denominated in dollars or reais . The local currency lost over 15 percent so far this month against the greenback.

A weaker real could attract long-term investors who, in addition to the bond yield, see a potential currency gain once global financial markets settle.

The size of the sale would depend on the point on the yield curve the government chooses. The date would depend on market conditions and an effort to avoid coinciding with the announcement of major economic indicators.

BUDGET DISCIPLINE

Augustin also said that Brazil’s primary budget surplus — a key indicator of the government’s ability to honor debt payments — will likely end the year at or above the target.

The government last month increased its primary surplus target by 10 billion reais to 128 billion reais in an effort to reduce inflationary pressure and allow for an easing of monetary policy.

If state and municipal governments fell short of their goal, the central government would make up for the difference, Augustin said.

The soft-spoken trained economist said the government would stand firm in the face of pressure to hike public-sector wages.

Bankers, postal workers and other civil servants have been striking in recent weeks, raising the threat of new inflationary pressure.

The 12-month inflation rate through mid-August reached 7.3 percent — well above the government’s target ceiling of 6.5 percent.

(Additional reporting by Walter Brandimarte in New York and Jeb Blount in Rio de Janeiro; Editing by Diane Craft and Jan Paschal)

Yet there are signs that some of these Brazilians — known here as the “new C Class” — are in danger of sliding back into poverty.

The consequences are potentially dire for President Dilma Rousseff, some of Brazil’s major companies, and an economy that has in recent years been one of the world’s few powerful engines of growth.

There are several causes behind the incipient reversal of fortune, including an economy slowing in tandem with the rest of the world, rising inflation and high household debt.

While it inherited the problems, Rousseff’s government has struggled to limit the fallout — and has arguably made some of them worse.

“If we don’t watch out, a worsening of the international scenario can cause a setback,” said Strategic Affairs Minister Wellington Moreira Franco, who is charged with coordinating long-term planning. “What we want is a type of brake to prevent these Brazilians from falling back into poverty.”

That “brake” could take several forms, and Rousseff and senior economic officials have repeatedly said they have policy tools available to protect the gains of recent years.

During the last crisis in 2009, Brazil responded to a fall in consumer demand with a massive fiscal stimulus program.

Yet its options are much more limited this time, since it is still suffering side effects from that budget splurge — including inflation that now sits at about 7.3 percent on an annual basis, well above-target.

Any erosion of the gains in Brazil’s fight against poverty would weaken Rousseff’s political base, and her response may determine her chances for re-election in 2014.

It would also hit Brazilian and multinational companies. For example, car manufacturers such as Hyundai (005380.KS: Quote, Profile, Research, Stock Buzz) and Fiat (FIA.MI: Quote, Profile, Research, Stock Buzz) came to depend on Brazil — now the world’s No. 5 auto market — in recent years to help fuel sales growth. At the first signs of a weakening market in Brazil, Fiat shares slumped in August [ID:nLDE77H09N].

Economic growth is expected to slow to at least half last year’s 7.5 percent rate amid a menacing global scenario.

MAKING ENDS MEET

Consumer debt defaults jumped 3 percent in August and are now up 29.2 percent from a year ago [ID:nS1E78B0KR]. Credit demand is slowing from last year, in part because the central bank hiked interest rates 175 basis points through August.

At the lower end of the “C” income category, which ranges from 1,200 to 5,174 reais ($656-$2,827) per month, credit growth is half the national average.

Experts say most at risk are those who for the first time have disposable income to consume beyond basic needs.

“People have been dazzled by the consumption craze; they need financial education,” says Alessandra Ninis, who runs the “new middle class” project at the strategic affairs ministry.

So far, neither tighter monetary nor fiscal policy have been able to tame above-target inflation of 7.3 percent per year, which hits particularly lower-income households. The lack of structural reforms to tackle price-indexed salaries and utility prices have compounded the problem.

“There are signs the emerging middle class is stagnating – that’s bad news for Brazil. If it contracts, it would be a disaster,” says Professor Marcelo Neri, an expert on social mobility at the FGV business school’s Center for Social Policies in Rio de Janeiro.

People say they are feeling the effects.

“The budget is getting tight. Food and clothing is going up and I’ve got those car payments,” said Edinaldo dos Santos, who works at a catering company in Brasilia. “Many of my neighbors are struggling with debt.”

If, as some economists forecast, economic growth slows more sharply in the short term and unemployment begins to rise, the government may have to take aggressive measures to protect the lower middle class.

“Right now they’re looking more at trampolines into the middle class but soon they may have to look at parachutes for those falling out,” said Neri.

Rousseff has already launched a micro-credit program designed to lower capital costs for small entrepreneurs and a job training program designed to form future professionals who will continue to fuel consumer demand.

Another measure the government is eyeing is a monthly stipend for employees receiving on-the-job training and earning up to 1,100 reais, the strategic affairs ministry said.

Rousseff also moved to liberalize the cable TV market, expand low-cost Internet coverage, and improve private health care — all concerns to Brazil’s new upwardly mobile.

ELECTION INTERESTS

Roughly 55 percent of Brazil’s population now belongs to the middle class, nearly the same amount that was classified as poor when former President Luiz Inacio Lula da Silva took office in 2003.

Rousseff was Lula’s hand-picked successor and it was his government’s achievements in attacking poverty that carried her to power in last year’s election.

But Lula’s high spending has forced Rousseff into austerity measures and they have hit her popularity. Her disapproval ratings doubled in August, partly because of frustration over slow progress in improving public services [ID:nN1E7791S8].

“Demands on policy-makers have shifted; people care about more than just jobs and income,” said Christopher Garman, Latin America analyst with Eurasia Group consultancy in New York.

“The new public agenda is the quality of public services and that’s what’s going to drive the next elections.”

Rousseff has recently shifted from poverty-eradication talk to a focus on middle-class issues. “When people surge into the middle class, they demand quality public services: education, health, security,” she said at a recent ceremony.

But with economic and political constraints, such as a tight budget and volatile support for her policies in Congress, it will be difficult in the short term for Rousseff to significantly improve long-neglected public services or boost the living standards of the new middle class.

“It’s hard to see Rousseff’s approval ratings not falling more in coming months,” said Garman.

(Editing by Brian Winter and Kieran Murray)

Yet there are signs that some of these Brazilians — known here as the “new C Class” — are in danger of sliding back into poverty.

The consequences are potentially dire for President Dilma Rousseff, some of Brazil’s major companies, and an economy that has in recent years been one of the world’s few powerful engines of growth.

There are several causes behind the incipient reversal of fortune, including an economy slowing in tandem with the rest of the world, rising inflation and high household debt.

While it inherited the problems, Rousseff’s government has struggled to limit the fallout — and has arguably made some of them worse.

“If we don’t watch out, a worsening of the international scenario can cause a setback,” said Strategic Affairs Minister Wellington Moreira Franco, who is charged with coordinating long-term planning. “What we want is a type of brake to prevent these Brazilians from falling back into poverty.”

That “brake” could take several forms, and Rousseff and senior economic officials have repeatedly said they have policy tools available to protect the gains of recent years.

During the last crisis in 2009, Brazil responded to a fall in consumer demand with a massive fiscal stimulus program.

Yet its options are much more limited this time, since it is still suffering side effects from that budget splurge — including inflation that now sits at about 7.3 percent on an annual basis, well above-target.

Any erosion of the gains in Brazil’s fight against poverty would weaken Rousseff’s political base, and her response may determine her chances for re-election in 2014.

It would also hit Brazilian and multinational companies. For example, car manufacturers such as Hyundai and Fiat came to depend on Brazil — now the world’s No. 5 auto market — in recent years to help fuel sales growth. At the first signs of a weakening market in Brazil, Fiat shares slumped in August.

Economic growth is expected to slow to at least half last year’s 7.5 percent rate amid a menacing global scenario.

MAKING ENDS MEET

Consumer debt defaults jumped 3 percent in August and are now up 29.2 percent from a year ago. Credit demand is slowing from last year, in part because the central bank hiked interest rates 175 basis points through August.

At the lower end of the “C” income category, which ranges from 1,200 to 5,174 reais ($656-$2,827) per month, credit growth is half the national average.

Experts say most at risk are those who for the first time have disposable income to consume beyond basic needs.

“People have been dazzled by the consumption craze; they need financial education,” says Alessandra Ninis, who runs the “new middle class” project at the strategic affairs ministry.

So far, neither tighter monetary nor fiscal policy have been able to tame above-target inflation of 7.3 percent per year, which hits particularly lower-income households. The lack of structural reforms to tackle price-indexed salaries and utility prices have compounded the problem.

“There are signs the emerging middle class is stagnating – that’s bad news for Brazil. If it contracts, it would be a disaster,” says Professor Marcelo Neri, an expert on social mobility at the FGV business school’s Center for Social Policies in Rio de Janeiro.

People say they are feeling the effects.

“The budget is getting tight. Food and clothing is going up and I’ve got those car payments,” said Edinaldo dos Santos, who works at a catering company in Brasilia. “Many of my neighbours are struggling with debt.”

If, as some economists forecast, economic growth slows more sharply in the short term and unemployment begins to rise, the government may have to take aggressive measures to protect the lower middle class.

“Right now they’re looking more at trampolines into the middle class but soon they may have to look at parachutes for those falling out,” said Neri.

Rousseff has already launched a micro-credit program designed to lower capital costs for small entrepreneurs and a job training program designed to form future professionals who will continue to fuel consumer demand.

Another measure the government is eyeing is a monthly stipend for employees receiving on-the-job training and earning up to 1,100 reais, the strategic affairs ministry said.

Rousseff also moved to liberalize the cable TV market, expand low-cost Internet coverage, and improve private health care — all concerns to Brazil’s new upwardly mobile.

ELECTION INTERESTS

Roughly 55 percent of Brazil’s population now belongs to the middle class, nearly the same amount that was classified as poor when former President Luiz Inacio Lula da Silva took office in 2003.

Rousseff was Lula’s hand-picked successor and it was his government’s achievements in attacking poverty that carried her to power in last year’s election.

But Lula’s high spending has forced Rousseff into austerity measures and they have hit her popularity. Her disapproval ratings doubled in August, partly because of frustration over slow progress in improving public services.

“Demands on policy-makers have shifted; people care about more than just jobs and income,” said Christopher Garman, Latin America analyst with Eurasia Group consultancy in New York.

“The new public agenda is the quality of public services and that’s what’s going to drive the next elections.”

Rousseff has recently shifted from poverty-eradication talk to a focus on middle-class issues. “When people surge into the middle class, they demand quality public services: education, health, security,” she said at a recent ceremony.

But with economic and political constraints, such as a tight budget and volatile support for her policies in Congress, it will be difficult in the short term for Rousseff to significantly improve long-neglected public services or boost the living standards of the new middle class.

“It’s hard to see Rousseff’s approval ratings not falling more in coming months,” said Garman.

(Editing by Brian Winter and Kieran Murray)

The government’s defeat signals growing pressure for the
administration to increase spending on public services without
raising taxes, already among some of the highest in the world.

It also shows that Rousseff has not yet managed to patch up
relations with her main allies, after months of political
turmoil.

Despite her large nominal majority in Congress, the bill
was defeated by a vote of 355 to 76, with 4 abstentions.

None of the parties in Rousseff’s broad coalition backed
the proposal, except for her own Workers’ Party.

The political crisis in Brazil included last week’s
resignation of Tourism Minister Pedro Novais, the fifth cabinet
member to depart in just over three months. Austerity measures
and a series of corruption scandals had rattled the ruling
coalition and caused allies to openly boycott Rousseff’s
legislative agenda.

Investors are paying particularly close attention to the
government’s budget after the central bank’s surprise interest
rate cut in late August. [ID:nE5E7IM05G]

With 12-month consumer price rises still well above the
upper limit of the government’s 6.5 percent target for this
year, inflation control will depend increasingly on tight
government spending.

TAX DEFEATED BEFORE

Rousseff and other cabinet members in recent days lobbied
in favor of a new tax to finance health spending.

The financial transaction tax would have brought back one
of the country’s most controversial levies. Before it was
defeated by Brazil’s opposition parties in 2007 in a rare loss
for Rousseff’s predecessor Luiz Inacio Lula da Silva, the tax
raised about 40 billion reais ($21 billion) a year.

All government allies, including the centrist PMDB party,
the largest in Rousseff’s coalition, backed an amendment by the
opposition DEM party to eliminate the tax.

“Don’t talk to us about creating new taxes, we won’t back
it,” said Eduardo Henrique Alves, PMDB leader in the lower
house.

The PMDB was at the center of Rousseff’s disputes with her
allies in recent weeks. Its leaders demanded more second-tier
government jobs and bigger funds for legislators to spend in
their constituencies.

But widespread opposition among tax payers and industry
leaders swayed legislators to oppose the new tax.

“During the (election) campaign President Rousseff promised
a thousand times she wouldn’t raise taxes and now she wants to
raise taxes — an amazing turnaround,” said Ronaldo Caiado, a
lower-house deputy of the DEM party.

At around 37 percent of gross domestic product, Brazil has
one of the highest tax burdens of any major economy.

The head of the Chamber, Marco Maia, created a committee
that is to propose alternative sources to finance health.
(Additional reporting by Maria Carolina Marcello; Editing by
Cynthia Osterman)