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