“The giant has awakened” was one of the most popular phrases heard during the summer of 2013, as the world learned of the massive street demonstrations in Brazil. Although many voices made themselves heard amid the protests, one common theme unified them all: the demand for better public investment and the improvement of public services.

Indeed, the world has set its sights on Brazil, with casual observers and experts alike offering a myriad of perspectives. What seemed to be a simple protest over a US$.20 increase in bus fares became one of the greatest milestones in Brazilian history. Over the course of the country’s history, Brazilians have rarely taken to the streets to demand change, and never with such resolution. Despite the scattered violence that occurred, Brazilian President Dilma Rousseff showed her support for the protests, and the government has already begun implementing key legislation that responds to the mounting pressure. More initiatives are coming.

With protesters numbering approximately 1.4 million people in 130 cities, the demonstrations quickly caught the government’s attention. Weeks of constant protests, followed by a general strike and a substantial decline in President Rousseff’s approval ratings, forced the president to acknowledge the legitimacy of the protests and to offer a set of initiatives in response to the demands. One of these, a measure that will allocate 75% of oil royalties to education and 25% to health care, is already being implemented. Another, titled Mais Médicos (More Doctors), will recruit foreign doctors to work in remote areas to help fill existing gaps in medical care.

Despite the initial replies to the protests, many Brazilians consider the government’s responses to be superficial and insufficient. Energized by the impact of the demonstrations and the wide-ranging support they received, demonstrators are likely to return to the streets as the presidential election, the World Cup, and the Olympics draw near. The result is a newly competitive political landscape and a mobilized citizenry interested in strengthening the social pact with the government. The subsequent political uncertainty has also spurred doubt about the country’s economic future, including its capacity to control rising inflation and to stimulate lagging growth. Such uncertainty on both the political and economic fronts, paired with the threat of social unrest, has resulted in a perfect storm for Brazil, the results of which will have significant implications for the country’s investment climate.

Social Unrest and Economic Implications

The demonstrations in Brazil occurred in the absence of both high unemployment and a decreasing quality of life. Reforma Politica Ja (Political Reform Now), a Brazilian social movement, points instead to corruption and impunity in politics, precarious education and healthcare systems, and income inequality as being among the leading causes of the growing discontent. Many of the protesters belong to the country’s rising middle class, whose expectations of government services have grown increasingly sophisticated. Young people also participated en masse, leveraging social media to help organize the protests. According to Cristovam Buarque, a Brazilian senator, “the awareness of the discontent and the loss of hope coincided with the knowledge of the Internet’s ability to mobilize people.”

Over the last decade,Brazil has made substantial progress in bridging the poor-rich gap. More than 40 million citizens have risen above the extreme poverty threshold in a country of 200 million. However, income inequality remains an acute problem. Brazil’s Gini index, a measure of income disparity widely used by economists (where 0 represents perfect equality and 100 perfect inequality), stood at 54.7 in the late 2000s. Its level of concentration of income is the highest among the BRIC countries (40.1 for Russia, 33.9 for India, and 42.1 for China), and lags significantly relative to OECD countries (31.4).

Despite the initial replies to the protests, many Brazilians consider the government’s responses to be superficial and insufficient.

According to Renato Janine Ribeiro, Brazilian political philosopher and a professor at the University of São Paulo, “Brazilians do not conform to being conformist.” He believes “what really matters is that from now on, the quality of public services, especially those aimed at the poor, is one of the most important items in our political agenda.” A galloping cost of living, record tax rates among emerging countries, and deficient public services contribute to rally social movements to request investment in areas that increase social benefits. One of these areas is infrastructure. A 2013 study from Bain & Company concludes that Brazil’s road infrastructure was “vastly underdeveloped and strongly focused on the economic center of Brazil, which [includes] the South-East and Southern Brazil.” The same study recommends a 10-year investment plan that could rejuvenate the national infrastructure. This type of farsighted initiative, however, might not appease the urgent social needs and might arrive too late for the upcoming World Cup and Olympic events, where Brazil hopes to woo the world.

Most critics target the perceived inaction and inefficiency of the current political system, as embodied by Rousseff’s government. Protesters urge the government to provide viable alternatives for increasing the efficiency of the political system and aligning the population’s objectives with those of the parties. Instead of low spending, the issue might reside in the inefficiency of Brazil’s public spending programs, as Marcos Mendes, legislative consultant for Brazil’s Federal Senate, points out in his 2013 article on “Efficiency of Public Spending.” Nevertheless, the government is addressing the issue with measures such as the “Transparency Portal of the Federal Government,” that, according to McKinsey & Company, is a pioneering initiative that creates a positive culture of accountability.

The unfavorable global macroeconomic environment has ultimately affected Brazil’s economy as well. After a decade of remarkable economic expansion, the so-called BRIC giants (Brazil,Russia,India and China) are slowing down. The time has come for other emerging markets such as the “Next-11” — as Goldman Sachs dubbed a list of countries including Bangladesh,Indonesia,Mexico and Turkey — to lead global growth. Brazil has long profited from soaring demand in commodities and domestic consumption. However, the broad economic weakness and China’s deceleration have reduced the appetite for commodities, and domestic demand has slumped amid rising inflation. According to the International Monetary Fund,Brazil’s GDP growth dropped from 6.1% in 2007 to an estimated 2.5% in 2013.

According to Arminio Fraga, former president of Brazil’s Central Bank, “a global slowdown is always an issue, but far from the main one in Brazil’s case. Most of the recent growth here has been driven by credit and consumption. Now Brazil must invest more and better, and focus more on the overall productivity of the economy.” In this sense, manufacturing has never been a strength of the economy. Although Brazil has low commodity prices and labor costs, the Custo Brazil (Brazil Cost) — the increased cost of doing business in Brazil due to bureaucracy, underdeveloped infrastructure, and lack of qualified labor, for example — hinders the competitiveness of Brazilian products and services. In this regard, Fraga notes that “most aspects of Brazil’s infrastructure have not kept up with recent economic growth and have in fact become a barrier to further growth. This issue must be addressed. Education is also key.” These factors have repeatedly led Brazil to experience current account deficits, when imports exceeded exports.

In the past, the current account deficit was compensated by foreign investment, a change that was reinforced by several rounds of quantitative easing — a program for long-term bond buying that floods markets with money — from the U.S. Central Bank, a strategy that debilitated the U.S. dollar and sped funds into emerging markets. However, the U.S. recovery is reversing the trend and repatriating funds from Brazil. Since the Federal Reserve indicated that the U.S. Central Bank could scale back its bond buys in May 2013, US$23 billion have flowed out of emerging market bonds, according to Barclays. This increased financing costs in Brazil, intensifying the economic slowdown and driving inflation, which ultimately depreciated the Brazilian currency.

After a decade of remarkable economic expansion, the so-called BRIC giants (Brazil,Russia,India and China) are slowing down.

For the time being, the Brazilian economy faces a dim outlook. According to a 2013 article in The Economist, “many [Brazilians] have now lost faith in the idea that their country was headed for orbit and diagnosed just another voo de galinha (chicken flight), as they dubbed previous short-lived economic spurts.” With all its current problems, analysts have little insight into what is going to happen next, creating an environment of volatility and unease. Until solid growth returns and inflation expectations decrease, investors will likely reduce their appetite for Brazilian assets.

Domestic and international effects intertwine, creating a critical socioeconomic situation. As in a perfect storm — where the combination of storm systems results in an event of colossal magnitude — inflationary pressures, social outcry, global slowdown, poor public services, and obsolete infrastructures jeopardize Brazil’s future at a time when the international outlook does not look bright for emerging economies. As Senator Buarque states, “[after] 20 years of social democratic governments and 10 years of the Workers’ Party, we expanded private consumption but we maintained the same tragedy in our public services, in the public hospitals and in the public schools.”

This perfect storm threatens to push Brazil to the edge. “I am concerned at the moment, but the solutions to our problems are in our own hands,” notes Fraga. “The government must keep the macroeconomic situation under control, while at the same time addressing the myriad microeconomic challenges that range from the regulation of most utility and infrastructure sectors, to the complexity of the tax system, to the quality of public services,” including transportation, health and education. The long-term impact could be profound. The politicians’ capacity to react against the current environment and put in place a viable and effective plan to counter these effects will determine Brazil’s future prospects.

Immediate Consequences

The climate of instability and social upheaval is serving as a catalyst. The Brazilian business confidence index plummeted to 49.9 in June 2013, nearing its record low. When analysts observe social movements of such relevance, their forecasts naturally predict a dimmer economic outlook, and markets tend to overreact. Data from Bovespa, the Brazilian stock exchange, support this behavior. In June, Bovespa decreased 11% against a 1% decline in the Dow Jones Industrial Average. However, in July it corrected its trend to stand in line with the Dow Jones, 2% versus 4%. During the first three weeks of August, it outperformed the Dow Jones, increasing 4% against a Dow Jones decrease of 3%. Thus, the data points reveal that the protests greatly increased volatility in the market and caused substantial losses in the Brazilian stock exchange. Exogenous factors, such as the global slowdown in the demand for oil and other commodities, further exacerbated Brazil’s perceived risk.

Slumping markets were not completely unrelated to losses in the real economy. The protests severely affected the stock prices of companies whose operations involve provisioning public services. For example, as a result of increased popular tension, Brazilian authorities mandated that toll-road authorities postpone planned increases in tolls. The Brazilian authorities’ desperate efforts to appease the demonstrators led the mayor of São   Paulo to suspend a lucrative public auction of bus lines.

Another proposed reform, the allocation of royalties from the recently discovered pré-sal petroleum to education (75%) and healthcare (25%) also caused controversy. Senator Buarque, a major proponent of educational reform, stated in an article published by Agência Senado that this money will help, but not solve, Brazil’s education problem because “the solution to the educational problem resides in a bigger ‘pré-sal,’ that is the GDP.” He estimates that Brazil’s educational system requires US$190 billion annually, far more than the approximately US$7.6 billion that royalties from Brazil’s oil reserves will provide.

The threat of inflation, combined with lagging growth, will continue to be a top priority for whichever administration takes power in 2015.

Leaders at Palacio do Planalto, the Brazilian president’s official workplace in Brasilia, have also suffered the consequences of the popular demonstrations. Approval of Rousseff’s government plummeted from 65% in May 2013 to 30% in June of that year, according to Datafolha, a think tank. In response to decreasing popularity, Rousseff called for a plebiscite aimed at reforming the political system. Her intentions, in line with the ideas of many of the protesters, included reforming the electoral system, modifying campaign financing, and changing the rules that oversee political alliances. This measure immediately raised controversy for what many see as a populist move. Against the President’s aim to hold the referendum in 2013, the Senate resolved to create, instead, a working group that would debate the possibilities of reforming the electoral system.

Setting Priorities

As Brazilian voters consider the upcoming electoral landscape, they will no longer face the prospect of a shoo-in candidate. Since Lula’s ascension to power in 2002, the Workers’ Party (PT) has dominated at the ballot box. Lula easily won reelection in 2006, and President Rousseff, Lula’s successor and former chief of staff, won in a run-off in 2010. Rousseff’s fall in popularity following the recent protests has opened up an unexpected opportunity for her political rivals. Her reelection once all but assured, she now faces a reenergized opposition leading up to the October 2014 presidential election, including former minister Marina da Silva, who is launching a new political party and who was the primary beneficiary of the sinking confidence in Rousseff. Yet despite the increasingly unfavorable signs for the PT, no opposition candidate is currently positioned to beat the President. According to Ribeiro, “I think we now have a new agenda. [However], it still has no political party, no proposal, nothing but a widespread feeling of discontent.”

One thing is resoundingly clear: The threat of inflation, combined with lagging growth, will continue to be a top priority for whichever administration takes power in 2015. As the election draws near, it is highly unlikely that the current administration will adopt drastic changes and risk alienating its political base. Thus far, the PT’s strategy of keeping inflation at bay — by promoting internal consumer demand and raising interest rates — has been fairly predictable. In fact, it has been sufficiently aggressive thus far. At this writing, the interest rate stood at 6.25%, just below its target rate of 6.5%. The convergence of domestic and external factors that are currently limiting the growth and future prospects of the Brazilian economy will need to be addressed by the next administration.

An alternative vision for the country’s economy, or an innovative change in policy, could produce newfound enthusiasm. The country’s overreliance on internal consumer spending has proven unsustainable. Which approach the next administration will adopt — and the accompanying policies it will implement — will be determined by changes in the political climate. If Brazil hopes to continue to attract investment by leveraging its depreciation of the real, it will need to assure international investors that, despite the demonstrations, it will continue to protect and nurture investments. A dim outlook by observers has affected the country’s economy in the short term, but Brazil can prove it is on track to reverse its recent fortunes and to regain its standing as an emerging market powerhouse.

This article was written by Yago Montenegro, Maria Franccesca Monteverde, Melissa Morales, and Jose Raffo, members of the Lauder Class of 2015.