SENIOR PRIVATE BANKER ON BRAZIL'S POLITICAL SCANDAL

C O N F I D E N T I A L SECTION 01 OF 02 BRASILIA 002318

SIPDIS

STATE PASS USTR FOR LEZNY
NSC FOR CRONIN
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
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TREASURY FOR DAS LEE AND F.PARODI

E.O. 12958: DECL: 08/28/2015
TAGS: ECON PGOV EFIN PREL
SUBJECT: SENIOR PRIVATE BANKER ON BRAZIL'S POLITICAL SCANDAL

REF: A. BRASILIA 2242, B. BRASILIA 2237, C. BRASILIA 2303, D. BRASILIA 2226

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


1. (C) Summary: In an August 23 conversation with Econoff,
Banco Itau Executive Director Sergio Werlang, a leading
financial markets expert and senior figure in Brazil's second
largest private bank, dismissed market fears that Brazil's
overall economic policy would change even if Finance Minister
Palocci were forced to resign over allegations of financial
misconduct during his tenure as mayor of Riberao Preto (refs
A and B). Palocci's tenure is of secondary importance, in
Werlang's view, as Lula himself has made it clear over the
course of this drawn-out political scandal, that he would not
be opting for a populist policy course even in the face of
sliding popularity levels (refs C and D). Taking the
argument a step further, Werlang stated that he is ever more
convinced that even if Lula is impeached (a scenario which he
assessed as only 30% probable) that there would be policy
continuity under his successor and that the markets and
Brazil's economy would handle the impeachment without
significant disruptions. End Summary.


2. (C) Although the markets were unquestionably reassured by
Palocci's credible denial of the allegations made against
him, Werlang stated that he is personally more reassured by
the fact that, as the political scandal grinds on, it has
become obvious that Lula himself was not -- and in Werlang's
view would not be -- opting for populist policies. While
Lula's recent speeches to workers' groups that contained
definite populist overtones, Werlang affirmed that the
markets would judge the Lula administration by its actions.
For example, instead of opening the budget spigots, the
administration had run a primary surplus of over 5.1% of GDP
in the twelve months through July 2005 and was seriously
considering increasing the formal primary surplus target
(currently 4.25% of GDP) for the year to serve as an anchor
during this period of greater market volatility. Pointing to
Lula's ultimate defeat of a congressional effort to raise the
minimum wage, Werlang professed not to be worried that Lula
would be unable to control congressional proposals for
excessive spending.


3. (C) Based on what is publicly known about the scandal and
Lula's reactions thus far, Werlang assessed the probability
that Lula would be impeached to be about 30%. Werlang
nevertheless stated that he is becoming more convinced that,
even if Lula were impeached, Brazil's economy and financial
markets would adjust without significant disruptions. He
acknowledged there would be volatility in the financial
markets but argued these would be temporary hiccups. The
cornerstone of Werlang's argument was the recent statement by
Chamber of Deputies President Severino Cavalcanti, an erratic
populist who is second in line to replace Lula after Vice
President Alencar, that if the presidency were to pass to him
that he would fulfill his constitutional duties and call for
an indirect, congressional vote to be held within 30 days to
select a new president to serve out the remainder of Lula's
term.


4. (C) Looking at potential candidates in such an election,
Werlang stated that some analysts interpreted a subsequent
speech by former President and current Senator Jose Sarney as
the platform upon which he would run. Others had touted
widely respected former Vice President (under Fernando
Henrique Cardoso) Marco Maciel as a consensus choice.
Werlang believed that Supreme Court President Nelson Jobim,
whose name also has been mentioned in this context, would not
run so as to keep open his option to try to seek the PMDB
party nomination in the 2006 elections. Any of these figures
would be solid choices from the economic policy point of
view, Werlang said, and the fact that the markets had time to
game out these scenarios was "healthy" for stability during a
transition.


5. (C) The biggest potential fly-in-the-ointment for the
markets and Brazil's economic stability, Werlang said, was
that the Lula's political weakening and his slim chances for
re-election opened political space for a populist candidate
in the 2006 presidential elections such as former Rio de
Janeiro State governor Anthony Garotinho. While uncertain
about the probability Garotinho would emerge as the PMDB
candidate, he averred that it could not be discounted.
(Note: currently, Garotinho is not eligible to make such a
run as an electoral court judge stripped him of his political
rights because of improper campaign practices in the October
2004 municipal elections; Garotinho has appealed the verdict.)


6. (C) Comment: We agree with Werlang that it bodes well for
stability during a theoretical impeachment/transition that
analysts have had time to game out these scenarios. That
said, international investors without detailed familiarity
with the players and processes may be less reassured than
Werlang. We would therefore still expect a fair degree of
volatility in any Lula impeachment or resignation scenario.
Fortunately, Brazil's current solid economic fundamentals
have given the Central Bank time to build international
reserves. Just as importantly, the Brazilian Treasury has a
cash operating reserve equal to over three months of its
financing requirements. All this should reduce the impact of
shorter term volatility.


7. (C) While Werlang downplays the negative impact of any
potential departure by FinMin Palocci on the economy, other
analysts are less sanguine. For instance, well-respected
consultant Carlos Langoni sees Palocci's determination and
influence with the President as "key for the success of the
fiscal adjustment." Without Palocci, he argues, the
consequences would be higher country risk, increasing
volatility, backward steps on inflationary expectations and
postponement or suspension of much needed investment.
Palocci, Langoni believes, is irreplaceable.

DANILOVICH