Brazil’s President Rousseff made history on Thursday evening when she announced that she was partially dismantling yet another legacy of the country’s former inflation-led economy.

The poupança, the popular government-guaranteed savings accounts that have rewarded holders with a minimum of about 6 per cent since they were created in the 19th century, will no longer be as rigid in their returns.

Under the new rules, and it is still unclear whether they apply to all accounts or just new ones, the poupança will return only 70 per cent of the central bank’s benchmark Selic rate when this falls to 8.5 per cent or less.

Why is this important? The Selic, presently at 9 per cent, is one of the world’s highest real benchmark rates for a large economy. With inflation presently at just over 5 per cent, the Selic is providing a real rate of nearly 4 per cent.

President Dilma Rousseff is struggling with an economy that is rapidly slowing on the back of a contraction in the industrial sector, which has become uncompetitive because of an inflated exchange rate and high costs domestically. 

One answer to the problem is to reduce interest rates, which the central bank has been doing with gusto, cutting them by 350 basis points since August. But with rates poised to fall below a 15-year low of 8.75 per cent when the central bank meets again late this month, there is one problem – the return on the poupança.

If the government continues cutting, the fear is that investors will abandon government and corporate bonds for the tax-free guaranteed returns of the savings accounts. Tony Volpon of Nomura describes the dilemma well:As Selic continues to fall, most fixed-income funds, which pay income taxes and sometimes very high fees, will return less than poupança for the first time. This could cause instability within the system as investors move from traditional fixed-income funds to poupança. This fear effectively puts a “floor” on to how low the Selic policy rate could go.

He is predicting that with the dismantling of the poupança rate, the Selic could fall as low as 8 per cent. He also cautions, though, that the government’s rush to bring interest rates down could be related to much more than just trying to stimulate the economy.

The latest central bank credit report was not as bad as some feared, but the subsequent release of results by some large commercial banks, showing large increases in loan loss reserves, is a signal there may be some very bad news to come. Anecdotal evidence also points to some serious problems in certain lending segments, such as automobiles (which could negatively impact the already weak industrial sector). If these fears materialize Brazil could be facing, if not a full-blown credit crunch, at least unexpected weakness in credit markets, which would further dampen prospects for economic growth.

But are President Rousseff and her ministers just tinkering with the dials on the dashboard rather than fixing the engine? Many economists think so.

Bringing rates down while encouraging a weaker exchange rate – Brazil’s currency, the real has been tumbling in recent weeks – will provide some relief for the economy.

But the only long-term way forward for Brazil will be real reform. That means the government taking a good hard look at itself. It needs to reduce its bloated budget, lower the tax burden on the economy, boost its own productivity and increase investment in education and infrastructure.

Do not hold your breath. The government may be a firm advocate of others lowering their costs and reducing their returns. But it has proven lukewarm when it comes to slashing its own spending.