BRAZIL - POLITICAL SCANDAL HAS NOT DAMAGED THE

C O N F I D E N T I A L SECTION 01 OF 03 BRASILIA 001968

SIPDIS

STATE PASS USTR
NSC FOR CRONIN
TREASURY FOR OASIA - DAS LEE AND FPARODI
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSON/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON

E.O. 12958: DECL: 07/20/2025
TAGS: ECON EFIN ETRD
SUBJECT: BRAZIL - POLITICAL SCANDAL HAS NOT DAMAGED THE
ECONOMY, SO FAR

REF: A. BRASILIA 1456

B. BRASILIA 521

C. BRASILIA 1631

D. BRASILIA 1290

E. BRASILIA 682

F. BRASILIA 1662

Classified By: Economic Counselor Bruce Williamson, reasons 1.4
(b) and
(d).


1. (C) Summary: The mounting political scandal over
(alleged) Lula Administration vote buying/influence peddling
in Congress has had negligible effects to date on the
financial markets or Brazil's overall economic performance.
Market participants and economic analysts told visiting
regional Treasury Attache and Econoff in a series of meetings
the week of July 11 that the credibility of GoB macroeconomic
policy, high Brazilian real interest rates and record
liquidity flowing to emerging markets had combined to
insulate Brazilian markets from the political scandal. They
expected this would continue unless a smoking gun emerges
linking President Lula or Finance Minister Antonio Palocci in
any illegal acts. Brazilian companies and banks have
stronger balance sheets than they did ahead of the 2002
crisis, better positioning them to deal with the as yet
unlikely event that the scandal (or an external event)
triggers a financial crisis. Our interlocutors dismissed the
possibility that any major economic reform measures,
necessary to increase productivity and Brazil's growth
potential, would make it through Congress before the 2006
elections. End Summary.

Twin Surpluses, Benign External Environment
--------------


2. (C) Financial market participants and economic analysts
delivered a consistent message to visiting regional Treasury
Attache Haarsager and Econoff in a series of meetings in Sao
Paulo, Brasilia and Rio de Janeiro the week of July 11: the
ongoing vote-buying scandal has had only negligible impacts
on financial markets and economic performance. Three
principal factors have combined to insulate Brazilian markets
from the scandal. First are Brazil's gravity-defying export
growth and its solid current account surplus. The
credibility of GoB macroeconomic policy and its strong fiscal
stance (5% of GDP primary surplus in the 12-month period
through May) also have played a role. These factors, along
with record international liquidity, which has flowed to
Brazil to take advantage of double-digit real interest rates,
have insulated the markets from the political crisis. For
these reasons, Odair Abate of BankBoston explained, external
events such as U.S. interest rate changes, have had a greater
impact on Brazilian currency markets than the political
scandal.

How Far Will it Go?
--------------


3. (C) CSFB Chief Economist Nilson Teixeira said that, given
the current benign international economic environment, it
would take proof that Lula or Palocci were personally
implicated in the scandal to spook his bank's foreign
clients. A smoking gun that implicated Palocci would be,
according to JP Morgan President Charles Wortman, a
"nightmare" scenario. Central Bank Director for Monetary
Policy Rodrigo Azevedo was more sanguine. Lula and his
Workers' Party (PT),Azevedo averred, had only achieved
election by moving to the center and promising orthodox
macroeconomic policies. This illustrated that there exists a
national consensus on what economic policy should be. In the
unlikely event that Lula had to depart before his term
expired, Azevedo argued, this consensus would constrain his
successor's policy choices. IMF Resident Representative
(Resrep) Max Alier echoed this point, arguing that Vice
President Alencar, an outspoken critic of GoB monetary policy
and high interest rates, would be forced to change his tune
if he assumed the presidency.


4. (C) Few see the scandal leading to Lula's early departure
from the presidency. Alier argued that, absent undeniable
evidence of Lula's involvement, the opposition has little
interest in provoking an institutional crisis in an effort to
try to assume the presidency amidst political chaos. From
their perspective, he said, it would be better simply to
bleed and discredit Lula and the PT ahead of the 2006
elections, making him an easier target. Based on present
trends, however, the economy looks likely to aid Lula in his
reelection drive. Our interlocutors predicted strengthening
growth in the second half of 2005. While first quarter 2005
performance was dismal (0.3% growth quarter on quarter),
Teixeira predicted 1% growth (4.1% annualized) in the second
quarter. The Central Bank's Azevedo noted that industrial
production in May was up significantly and several coincident
indicators of economic growth for June looked quite positive.
The Central Bank, he said, is maintaining its growth
forecast for the year at 3.4%. Teixeira and Abate noted
separately that, with inflation now firmly under control,
they expect a monetary easing within a few months. The
effects of this easing would begin to be seen in the first
half of 2006, well ahead of the October 2006 elections.

Better Positioned to Deal with Financial Crisis
-------------- --


5. (C) JP Morgan's Wortman noted that Brazil was in a better
position to deal with a financial setback than it was going
into the 2002 crisis of confidence, which was triggered by
concerns over the policies Lula would pursue. Companies had
reduced their dollar debt and increased its tenor. Companies
are less leveraged than in 2002, he said, and there has been
a boom in the domestic debentures market as companies
diversify their funding sources. The main banks, Wortman
stated, are well-capitalized, with Itau and Bradesco (the two
largest) holding capital reserves double what they need to
under Bank for International Settlements (BIS) capital
adequacy standards. The Central Bank's Azevedo added that
the current account surplus makes a huge difference in
Brazil's vulnerability. Moreover, the Central Bank now has
US$40 billion in net reserves and intends to continue
building reserves ahead of the 2006 election. The Finance
Ministry has been able to purchase dollars to cover its
external debt service in the market, without recourse to
Central Bank reserves. Given the weakness of the dollar,
Azevedo said, the Finance Ministry, intends to pre-purchase
US$9 billion to cover its amortization schedule. Meanwhile,
in mid-July the GoB announced that it would pre-pay US$ 5.12
billion in IMF payments due by March 2006.

Economic Risks in the Short Term -- Salami Effect
-------------- --------------


6. (C) IMF Resrep Alier warned there exists a risk the GoB
will attempt to bolster its Congressional base through
increased pork barrel spending, although he has not yet seen
signs that this is happening. Likening the effect to slicing
away at a large salami until it gone, he argued that even
though the individual slices from the primary surplus might
be thin, collectively they could undermine the GoB's current
strong fiscal stance. Moreover, even if the GoB maintains
fiscal discipline, there remains a risk that the Congress
will advance a negative agenda (in fiscal terms) that a
weakened GoB would be less able to resist. Prominent fiscal
expert and commentator Raul Velloso was not as concerned as
Alier, observing to Econoff in a July 18 conversation that
Congress itself was significantly politically weakened and
would be hard pressed to advance its own agenda.
Longer Term Risks -- Opportunity Lost
--------------

7. (C) The biggest cost of the crisis, Wortman said, would be
losing the opportunity to move economic reforms through the
Congress for the last two years of the Lula administration.
Texeira agreed that there was little prospect for
microeconomic reforms, necessary to spur investment and
improve productivity, to make it through the Congress.
Abate, however, pointed out that the markets already had
discounted the possibility of significant reforms after the
PT bungled the election for the presidency of the Chamber of
Deputies earlier this year. The loss of the Chamber
presidency to bombastic populist Severino Cavalcanti crippled
the PT's ability to set the agenda with Congress. Indeed,
Minister of Industry Furlan recently confided to the
Ambassador that the GoB, realizing that the microeconomic
reform agenda was on life support, had begun to study what
reform measures it could pursue without recourse to
legislation in order to generate jobs and increase
productivity.

Comment
--------------


8. (C) Barring revelations that Lula and/or Palocci played a
role in the vote-buying scandal, the Brazilian economy looks
to be out of scandal-related danger, in the near term.
Although this may prove to be only a temporary calm should
international financial winds shift, Brazil does appear to be
less vulnerable now than in 2002, with more solid
fundamentals. More troubling is the fact that, without
reform measures necessary to attract investment, relieve
infrastructure bottlenecks and improve the functioning of
Brazil,s distorted financial markets, the country will find
it difficult to break out of its current low potential growth
path (which most analysts estimate to be around 3%).

MANGANIELLO