| RIO DE JANEIRO/BRASILIA
RIO DE JANEIRO/BRASILIA President Dilma Rousseff will swing the budget axe this week but probably not hard enough to convince markets that inflation stoked by Brazil's public spending splurge is under control.
In the most closely watched decision of her young presidency, Rousseff's government will detail cuts expected to total about 40 billion to 50 billion reais (£15-£18.6 billion), seeking to turn the page on a fiscal mess left by her popular predecessor.
The cuts, expected to be announced this week, may sound impressive. But a closer look is likely to reveal more modest reductions as Rousseff seeks a balance between pleasing markets and maintaining investments that Brazil sorely needs to unplug its infrastructure bottlenecks.
The stark choice she faces is a testament to Brazil's rigid budget, most of which is fixed by law. Spending ripe for cuts that would raise efficiency, such as the bloated wage bill for civil servants, can't be axed quickly.
"The easiest thing is to make cuts in investment spending, which is the last thing Brazil's economy needs," said Neil Shearing, an economist at Capital Economics in London.
"I don't expect the cuts will be deep enough for the inflation overheating problem to go away," he added.
A surge in spending during former President Luiz Inacio Lula da Silva's last year in office pushed inflation to a six-year high in 2010. That posed an early test of Rousseff's pledge to maintain the economic stability that has made Brazil one of the world's hottest investment destinations.
Inflation stood at 5.99 percent in the 12 months through January, above the middle of the central bank's target of 4.5 percent, with a 2-percentage-point tolerance band.
Substantial cuts are crucial to ease upward pressure on Brazil's double-digit interest rates, which are stoking a currency rally and drawing cries of pain from exporters.
The cuts would also help shore up what many economists see as Brazil's flagging fiscal credibility. The government resorted to what is widely regarded as creative accounting to meet last year's primary budget surplus target of 3.1 percent of gross domestic product.
NO EASY CHOICES
Any assessment of the real impact of budget cuts must start by discounting about 20 billion reais from the figure that is announced this week. That is the amount by which Congress has inflated its budget proposal and which Rousseff can chop before making tough decisions on spending.
She has vowed not to touch the flagship infrastructure program known as PAC, leaving the door open to cutting the substantial public investments that fall outside the program.
Congressman Marcio Reinaldo Moreira, a former planning ministry official who has formulated budgets, expects the government to first try to cut operating costs, then congressional earmarks and finally investments.
"They will get to a point where the infrastructure budget will be affected. I have no doubt about that," he said.
A real cut of more than 16 billion reais would start to affect crucial projects such as ones involving the 2014 World Cup and 2016 Olympic Games, the Eurasia Group consultancy said, adding that Rousseff was unlikely to put them at risk.
The result was likely to be either a headline figure for cuts that disappoints or a pleasing figure of about 50 billion reais that the government won't fully implement, it said.
"The problem is that Rousseff doesn't have any easy choices," it said in a report.
After crunching the numbers, economist Alexandre Schwartsman at Santander found the government would need to slash at least 70 billion reais to hit the primary surplus target for this year without using accounting tricks. The primary surplus -- revenues minus spending before interest payments -- gauges Brazil's ability to service its debt.
Only cuts on that scale, he said, could keep the central bank's benchmark interest rate from rising to 12.50 percent this year from the current 11.25 percent.
One way Rousseff could get away with a smaller cut and still ease investors' concerns about inflation is to firmly commit to rein in the pampered civil service, which has some of the world's most generous benefits.
She has already shown a determination to keep public spending in check by rejecting demands from unions for a bigger increase in the national minimum wage.
The Folha de Sao Paulo newspaper reported this week that the government is considering proposing a cap of 2 percent above inflation on annual personnel expenses. That would be a big savings, given that expenses surged nearly 10 percent on top of inflation between 2009 and 2010.
A cap on expense growth could bring the best of both worlds -- falling interest rates and an increase in public investments that remain low compared to emerging market rivals India and China.
(Editing by Jeffrey Benkoe)