THE BRAZILIAN MACRO-ECONOMY: SOARING HIGH BUT NO

UNCLAS SECTION 01 OF 02 BRASILIA 002477

SIPDIS

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/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON
AID/W FOR LAC/SA

SENSITIVE

E.O. 12958: N/A
TAGS: ECON PGOV EFIN
SUBJECT: THE BRAZILIAN MACRO-ECONOMY: SOARING HIGH BUT NO
NETS BELOW

REF: A) Brasilia 2242, B) Brasilia 2467


1. (SBU) Summary. The past 30 days have seen a wealth of
good news for the Brazilian economy as a number of fiscal,
growth, and financial indicators are trending up. Given
this positive turn of events, some market watchers are
beginning to wonder whether the conventional wisdom is
correct - i.e., that direct involvement by the President or
Finance Minister Palocci in the ongoing political scandal
are key economic tripwires. Without doubt, investors are
correct in rewarding Brazil for establishing solid economic
fundamentals. But while we would like to sign on to the
emerging theory that the economy is immune from political
contamination, for now our preference is to wait and see
where (and to whom) the scandal leads. End Summary.


2. (U) Notwithstanding the ongoing political scandal, the
Brazilian economy is racking up some remarkable
achievements. Last week the Sao Paulo Stock Exchange
(BOVESPA) hit another record high and is up 13.82 percent
for the year. The Finance Ministry has just successfully
issued US$750 million in real-denominated Eurobonds (10 year
maturity/13.8 percent annual interest rate). Meanwhile, for
dollar-denominated issuances, Brazil risk has fallen to its
lowest level since 1997: 369 basis points. The real has
continued to strengthen against the dollar, with the
dollar/real exchange rate dropping from 2.46 three months
ago to 2.29 as of September 16). Seasonally-adjusted 2d
quarter GDP growth figures registered a healthy 3.7 percent
increase over last year, up from 3.3 percent in the first
quarter. After a surge of inflation in the first semester,
recent months of deflation have market watchers predicting
the yearly total will come in at 5.2 percent - a hair over
the government's 5.1 percent target. Analysts forecast a
2005 trade surplus of US$40.5 billion, up from US$32 billion
in 2004. And a recent UNCTAD study, ranked Brazil in fifth
place as the preferred destination for multinational
investment for 2005/2006, after China, India, the United
States and Russia.


3. (SBU) All this comes against the backdrop of a raging
political scandal, which since it first erupted in May, has
seen much of President Lula's inner circle resign, a massive
loss of faith in the credibility of both Lula as well as the
governing PT party, and the imminent demise of the
controversial President of the Chamber of Deputies -
Severino Cavalcanti. To date, both foreign investors and
domestic market watchers have coalesced around the argument
that two scenarios might lead the ongoing political
instability to infect the economy: i.e., the replacement of
Lula (via resignation, impeachment or electoral defeat) with
a populist figure, or the departure of Finance Minister
Palocci from the government. Indeed, in late August when
allegations of corruption touched Palocci, the dollar spiked
and the BOVESPA fell. Ref A. However, Palocci's spirited
denials, combined with the lack of documentary evidence to
support the contract-skimming charges, ended up settling the
markets and restoring public trust in his economic
stewardship.


4. (SBU) Over the past few weeks, a new theory has begun to
emerge contending that the Brazilian economy is immune from
scandal-related political contamination. Most prominently
enunciated in the September 14 edition of the leading
newsweekly magazine Veja, this theory holds that the eleven
years of responsible economic management since the
initiation of the Plano Real in 1994 has institutionalized
sound economic policies. A continual reform process has
opened up the economy and limited the ability of both the
federal and state governments to spend beyond their limits.
According to this line of argument, neither the public nor
officials within the federal bureaucracy would brook a
return to populist policies - given all the advances that
have taken place during the 1994 to 2002 Fernando Henrique
Cardoso administration and the first three years of the Lula
administration. Sound economic policies, in other words,
now have a powerful constituency.


5. (SBU) Palocci himself was one of the first to give voice
to these sentiments. During his late August press
conference rebutting the allegations against him, he
repeatedly declared that the health of the Brazilian economy
does not depend upon his presence at the Ministry. "No one
is irreplaceable," he emphasized. For his part, in remarks
to foreign investors at a September 15 breakfast in New
York, Lula made a similar point. He stated that the ongoing
investigations into political corruption would continue on
their course and would not affect the economy. Meanwhile, a
number of market analysts, both foreign and domestic, are
now openly wondering whether the political crisis will ever
seep into the economy. In September, the market shrugged
off two separate allegations against Palocci and his
brother, one involving property held by the Minister (which
was supposed undervalued for tax purposes) and the other
involving possible influence-peddling by the Minister's
brother. Ref B.


6. (SBU) Comment. While we agree that now more than ever
acceptance of sound economic policies is entrenched among
the Brazilian governing classes, we do not believe that this
necessarily means that the debate over the country's future
macroeconomic path is over. First, while most here do not
espouse the platform of the unrepentant left (i.e.,
restrictions on capital flows, price controls, unrestrained
government spending),there are those here who still support
these discredited recipes of the past. Second, the reason
that prudent policies have reigned over the past 11 years is
because responsible political leaders have made it so.
Should Lula (or his successor) abruptly decide to take a
different approach, then all bets are off.


7. (SBU) While the odds of an economic populist gaining the
presidency are modest, given the current environment they
cannot be discounted - and certainly are greater now than
they were four months ago before the scandal erupted. No
one knows where the mushrooming scandal will lead or whom it
might touch. Should voters decide that conventional-style
politicians have made a mess of things, they could well turn
towards more populist figures. Right now, the
political/economic orthodoxy that will emerge after the dust
settles is anyone's guess. Like a bucking bronco, we'll all
need to wait and see where this horse goes.

CHICOLA