Identifier
Created
Classification
Origin
05BRASILIA2149
2005-08-12 17:08:00
CONFIDENTIAL
Embassy Brasilia
Cable title:  

BRAZIL - POTENTIAL ECONOMIC SCENARIOS AS THE

Tags:  EFIN ECON PGOV 
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This record is a partial extract of the original cable. The full text of the original cable is not available.
C O N F I D E N T I A L SECTION 01 OF 04 BRASILIA 002149 

SIPDIS

STATE PASS USTR FOR LEZNY/YANG
NSC FOR CRONIN
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON
TREASURY FOR DAS LEE AND F.PARODI

E.O. 12958: DECL: 08/11/2015
TAGS: EFIN ECON PGOV
SUBJECT: BRAZIL - POTENTIAL ECONOMIC SCENARIOS AS THE
POLITICAL SCANDAL MOVES FORWARD

REF: A. BRASILIA 1968

B. BRASILIA 2082

C. BRASILIA 1979

D. BRASILIA 1874

E. BRASILIA 1973

F. BRASILIA 1631

G. BRASILIA 2025

Classified By: Charge d'Affaires Patrick Linehan, reason 1.4 (b)
and (d
).

C O N F I D E N T I A L SECTION 01 OF 04 BRASILIA 002149

SIPDIS

STATE PASS USTR FOR LEZNY/YANG
NSC FOR CRONIN
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON
TREASURY FOR DAS LEE AND F.PARODI

E.O. 12958: DECL: 08/11/2015
TAGS: EFIN ECON PGOV
SUBJECT: BRAZIL - POTENTIAL ECONOMIC SCENARIOS AS THE
POLITICAL SCANDAL MOVES FORWARD

REF: A. BRASILIA 1968

B. BRASILIA 2082

C. BRASILIA 1979

D. BRASILIA 1874

E. BRASILIA 1973

F. BRASILIA 1631

G. BRASILIA 2025

Classified By: Charge d'Affaires Patrick Linehan, reason 1.4 (b)
and (d
).


1. (C) Summary: Financial markets have, to date, largely
taken in their stride the interlocking set of vote-buying and
corruption scandals currently engulfing Brazil's political
class (ref A). Several factors are working together to
insulate the economy against the political turbulence,
including the credibility of GoB macroeconomic policy, record
liquidity flowing to emerging markets, Brazil's strong fiscal
stance (5.1% of GDP primary surplus) and its continuing
current account surplus (1.9% of GDP). We see few
indications that the markets' mood is changing. Indeed, over
the last two years Brazil has done much to reduce its
vulnerability to shocks, both external and domestic.
Nevertheless, Brazil's economy is far from invulnerable to a
shift in market sentiment and could suffer should the
scandals deepen or the country suffer a sharp external shock.
This cable looks at several possible political outcomes and
the potential consequences for the economy with respect to
each. In neither of the two most likely scenarios (Lula
remaining until the 2006 elections or his
resignation/impeachment and replacement by Vice President
Alencar) would we expect a sharp change in economic policy,
reflecting the overall consensus among Brazilians in favor of
orthodox economic policies. While it is clear that
Brazilians are fed up with the corruption of their political
class, there is little evidence that they are calling for a
sharp break with the current institutional framework and its
economic policies. Under no set of circumstances, however,
is the microeconomic reform agenda, necessary to boost
potential GDP growth, likely to be retaken until after the

October 2006 elections. End Summary.

Scenario One: Weak Lula Remains until 2006 Elections
-------------- --------------


2. (C) Our base case scenario is that Lula will serve out the
remainder of his term, albeit in a severely weakened state.
Former Chief of Staff Dirceu's decision to deny all in his
recent Congressional testimony placed some distance between
Lula and the main body of the scandal for a time, although
more recent allegations are moving the spotlight closer to
Lula (septel). Despite Lula's weakened state and his
diminished reelection prospects, multiple factors should help
keep him from breaking sharply with the existing, orthodox
economic policy line. First, after eight years of sound
economic policies under the previous Cardoso administration
and three years of such measures under Lula, the majority of
Brazilians, who still remember the "bad old days" of
hyperinflation, support an orthodox policy line. Indicative
of this is the fact that Lula and his Workers' Party (PT) had
to move to center on economic policy in order to become
electable, and will need to remain there if they are to have
any hope of reelection. Second, Lula's closest remaining
advisor, Finance Minister Palocci, has been the architect of
this set of policies and analysts here believe he can be
counted on to strongly resist any break with the current
line. Third, Lula's principal policy success to date has
been the restoration of economic stability. Few expect him
to risk this achievement (and perhaps his legacy) by turning
to populist solutions late in the game. Indeed, many
analysts expect GDP growth to pick up in the second half of
2005, perhaps giving Lula a political boost as well.


3. (C) Meanwhile, Lula's political weakness and the
Congress's own lack of credibility look likely to prevent
passage of major microeconomic reform legislation. While
this will not endanger economic growth in the short term,
over the long-run it will condemn Brazil to a lower potential
growth path until such time as political forces align to
allow passage of tax reform, Central Bank independence,
financial sector reform and expenditure reform (i.e.
loosening constitutional earmarks). As the markets already
have written off the microeconomic reform agenda, we would
not expect any sharp changes to their assessment at this
point of Brazil risk. However, some observers worry that
Lula's political weakness will make it harder for him to
fight off unhelpful (from the fiscal discipline point of
view) congressional initiatives, such as the annual/current
effort in the Senate to increase the monthly minimum wage to
Reals 384 (about US$165),instead of the Reals 300 that the
GoB proposed. Another worrisome example is an amendment
inserted into this year's budget directives law, which
provides the broad framework for the drafting of the budget
and which is still pending in Congress, that would restrict
the Executive's discretion to freeze expenditures for
pork-barrel projects sponsored by individual legislators (the
so-called "individual amendments"). The GoB also recently
approved a 23% pay raise for the military phased in over two
years.


5. (C) The area of most uncertainty in our base case scenario
is what future GoB economic policies will come out of the
October 2006 presidential elections. Although Lula still
remains popular, he is becoming increasingly vulnerable.
Extended corruption investigations no doubt would lower
Lula's poll numbers even further. Any decision by Lula not
to run in 2006, combined with his PT party's degraded image,
would open political space for some of the more radical
elements on the left. Indeed, some polls show former Rio de
Janeiro governor and erratic populist Anthony Garotinho
(currently ineligible to run because of his own, unrelated
scandal problems) of the PMDB picking up some of Lula's
left-wing supporters in a Lula-less race. Garotinho,
however, would have to win against one of several credible
PSDB candidates, including Sao Paulo Mayor Jose Serra (whose
poll numbers have been strengthening),Sao Paulo Governor
Geraldo Alckmin or Minas Gerais Governor Aecio Neves (son of
the still popular Tancredo Neves). Based upon their past
records, these latter three would very likely embrace a
continuation of the Cardoso/Lula orthodox policy line.

Scenario Two - VP Alencar Succession
--------------


6. (C) The word "impeachment" floats in the air with
increasing frequency in Brasilia. While not calling for
impeachment, even major news weekly Veja used the cover of
its most recent edition to draw parallels to the period prior
to the 1992 impeachment of President Collor on corruption
charges. Should Lula resign or be impeached, Brazil has a
very clear constitutional mechanism for the transfer of power
to the Vice President, Jose Alencar of the Liberal Party
(PL). The strength of Brazilian democratic institutions and
the country's successful use of these mechanisms in the
Collor case suggest the transition to a new president would
occur without major difficulties.


7. (C) Even in these difficult circumstances, there are
reasons to believe that Vice President Alencar, although an
outspoken and frequent critic of Brazil's current high
interest rates, would not break sharply from Lula's orthodox
economic policies upon taking office. First, as is argued
above, a majority of Brazilians support sound economic
policies and demand such from their leadership. Given his
lack of experience in economic policy, Alencar would
presumably turn to wiser heads for counsel -- with the likely
candidates being responsible veterans of the Cardoso economic
team or perhaps even former military government FinMin Delfim
Netto (who is currently propounding a plan limiting
government spending). Credit Suisse/First Boston (CSFB) chief
economist Nilson Teixeira put the probability of Alencar
pursuing orthodox policies at 70% in a recent conversation
with Econoff. Other observers, including the IMF resident
representative, have echoed this assessment (without
assigning probabilities). Second, as was the case after
Lula's election in 2002, Alencar would receive considerable
pressure from the markets to support orthodox policies and
would need to act quickly upon assuming the presidency to
reassure investors. Most of the Brazilian public and the
Congress, likely would view Alencar as a caretaker until the
next elections, limiting even further his scope of action to
pursue a heterodox policy mix.


8. (C) Given the caretaker nature of a putative Alencar
presidency, we do not believe he would have the clout
necessary to push the microeconomic reform agenda through
Congress. This would be no worse than under scenario one
above, though, as the markets would have already discounted
the chances of major reform before the 2006 elections. Given
congressional disarray in this scenario, however, we do not
expect the Congress effectively to advance significant policy
changes. Instead, we look for Congress to erode fiscal
discipline opportunistically where it can in support of
individual members' re-election campaign efforts.
Unfortunately, Alencar would be in an even weaker position
than Lula to resist spending pressures originating in
Congress. Still, such erosion should not fatally undermine
overall fiscal discipline given the healthy growth of tax
revenues, the Executive Branch's discretion to sequester
excessive expenditures, and Fiscal Responsibility Law (LRF)
restrictions on the budget process.

Scenario Three -- Lula Survives, but Opens Floodgates
-------------- --------------


9. (C) This scenario, which we do not believe is likely to
occur, posits that Lula, feeling threatened, decides to open
the fiscal floodgates and abandon high interest rates in an
attempt to shore up his congressional support base to survive
politically or perhaps to stave off an impeachment effort.
This would require the dismissal of the champions of these
policies, Finance Minister Palocci and Central Bank President
Meirelles, an event that markets would greet with sharp
downturns. (As Meirelles told D/NSA Shirzad in November
2004, "if you see Palocci and me leaving the GoB -- watch
out".) Brazil currently is less vulnerable to external
shocks than it was in the lead-up to the 2002 crisis of
confidence sparked by the likelihood of Lula's election.
Nevertheless, a protracted loss of faith by the financial
markets likely would be characterized by a similar set of
events to those that unfolded in 2002: sharp depreciation of
the Real, capital flight, GoB difficulty in rolling over
domestic debt (except at increased interest rates),spiking
inflation, etc. Such a financial crisis would doubtless play
a big part in the 2006 election campaigns, with parties such
as the PSDB campaigning for a return to orthodox economic
policies.


10. (C) Brazil has institutional safeguards limiting a
president's ability to open the spending floodgates in
scenarios such as this. Foremost is the LRF, which requires
that specific revenue sources be identified to fund new
spending commitments. These requirements can be manipulated
to a degree (e.g. by unrealistically inflating predicted
revenue flows in the budget),but since this requires
congressional complicity, there are limits to what extent the
safeguards can be undermined. The LRF also prescribes
criminal penalties for those who violate it, a fact that acts
as a brake on the economic policy bureaucracy, which
naturally tends to resist spending pressures.
Scenario Four ) PT Splinters; A Thousand Flowers Bloom
-------------- --------------

11. (C) Our last scenario, the probability of which is at
this time difficult to assess, contemplates a discredited
Lula causing the PT to disintegrate ) with the radical
elements of the party joining forces with past PT refugees
and other fringe elements to form a new leftist party.
Figures like Senator Heloisa Helena (expelled from the PT in
2003 for voting contrary to the party line) and Carlos Lessa
(President of the National Development Bank until dismissed
by Lula in 2004) would likely rally to this new political
entity. Freed from the shackles of Palocci-imposed economic
orthodoxy, this amalgam might well embrace traditional
leftist economic stances ) such as imposing a moratorium on
foreign debt payments, increased corporate taxes, and
combatative relations with the IFIs. Should the
disintegration of the PT generate market upheaval ) with the
accompanying adverse affects on exchange, interest, and
inflation rates ) public debate on these heterodox
"solutions" could well begin in earnest. This is not to say
that any successor government to the Lula administration
would adopt such measures. As noted earlier, currently there
is an extraordinary degree of societal consensus on orthodox
economic policies. With the moderate Campo Majoritaria wing
of the PT reining in the party,s radicals, the left side of
the political spectrum in Brazil embraces more or less the
same macro-economic line as the center and the right.
However, should the PT splinter and radicals regain their
voice, while the consensus would not disappear, it would
certainly fray.


12. (C) Although there is some risk that a Lula downfall
could ultimately lead the left to unite around a less
pragmatic figure than Lula, there is little reason to suspect
that this reamalgamated left would be any more successful
come election time than Lula was prior to his move to the
political center. This could change should the scandal
become so deep as to undermine public confidence in the
institutions of Brazilian democracy themselves, leading to an
institutional crisis that creates space for some of the
untainted politicians on the left. So far, however, while it
is clear that Brazilians are fed up with the corruption of
their political class, there is little evidence that they are
calling for a sharp break with the current institutional
framework and its economic policies.

LINEHAN