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Investors on edge: Brazil to scale back austerity?

The resignation of Brazil's pro-austerity finance minister has left markets on edge as amid concerns over whether his replacement will continue with a program of fiscal consolidation.

On Friday, Brazilian President Dilma Rousseff replaced Finance Minister Joaquim Levy, a fiscal conservative appointed just over a year ago, with a close ally, Budget and Planning Minister Nelson Barbosa, the Brazilian leader's office said in a statement.

Levy's resignation was not a surprise to many analysts as his austerity plan had come under increasing criticism, but markets did not take kindly to the news of his replacement with stocks falling 3 percent and the Brazilian real declining 2.6 percent against the dollar.

While markets reacted badly to the news on concerns that Barbosa could pull the plug on his predecessor's austerity policies, he pledged to maintain fiscal stability, cut spending and said that in 2016, the government expected "to spend the same that we spent six years ago." He said that he remained confident that Brazil, a country hit by recession this year, would return to growth.

San Paulo, Brazil.
Rodrigofroschini | Getty Images

Andrew Kenningham, senior global economist at Capital Economics, told CNBC that while it was good news that Barbosa had said had said he wanted to stick to the austerity course broadly speaking, even his predecessor Levy had trouble implementing reforms, such as capping pensions or introducing a financial transactions tax.

"The outlook is bleak for fiscal reform," he told CNBC Europe's "Squawk Box" on Monday. "The problem is that Congress is not in agreement with these suggestions (for reforms) and is distracted by other issues so I think it's quite reasonable that the markets remain skeptical."

Economic woes

The job of finance minister in Brazil is something of a poisoned chalice, given that Brazil's once-booming economy, which was predicated on commodity exports, is now struggling with weaker demand and a plunge in commodity prices.

The International Monetary Fund (IMF) forecasts that the country's economy would shrink 0.3 percent in 2015 before rebounding in 2016 to grow 0.8 percent, according to its latest predictions in the fund's "World Economic Outlook."

Rampant inflation has exacerbated Brazil's domestic problems with the rate of price rises at a 12-year high. In December, annual inflation accelerated to 10.71 percent from 10.28 percent in the previous month. Fueling the rise in goods in the country is the decline in the currency too with the Brazilian real down around 31 percent against the dollar from a year ago.

With a vulnerable economic backdrop, Capital Economics' Neil Shearing noted at the weekend that any move away from austerity by Barbosa could rattle markets further.

"Given the sheer size of the budget deficit that the government is grappling with (currently 9.5 percent of GDP), (a move away from austerity) would be likely to rattle investors," Shearing, senior emerging markets economist, said in a note Saturday.

Shearing said it was important not to write Barbosa off, however. "It's worth noting that Barbosa is unlikely to be a pushover on the fiscal front. He is supportive of the general need for fiscal retrenchment (albeit at a slower pace than that proposed by Levy) and has been especially critical in the past of the accounting tricks used by the government to obscure the true size of the budget deficit."

Rocky politics

If its economic woes were not enough to contend with, Brazil is facing large political problems too with a potential impeachment of President Rouseff. She is accused of violating budget laws to increase spending during her 2014 re-election campaign. In addition, a corruption scandal surrounding state-run oil company Petrobras has not helped restore faith in the government.

Jim McCaughan, chief executive of Principal Global Investors, told CNBC that if a new government could be more "market and business friendly."

"At the moment is, it that with President Dilm Rouseff effectively fighting impeachment, there's no policy decisions being made and she's put in a relatively accommodative, well-aligned finance minister. But you've got so much going wrong with an economy and no real policy judgments coming through."

With widespread uncertainty over Brazil's economic and political future, the investment scene looks murky. McCaughan said that it could be too early to re-invest there.

"Some investors have been looking for stressed opportunities in Latin America but it seems a bit early to me because the economies of Latin America and Brazil in particular, are very dependent on commodities which are still in structural oversupply (and that's) not finished yet," he told CNBC Europe's "Squawk Box."

"Structurally, there's very little Brazil can do to improve trade, they've got a very high inflation rate and a severe recession which is exacerbated by the volatility in the real…so it's very difficult to see what they do to pull out of that."

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