BRAZIL'S FISCAL RESPONSIBILITY LAW FACES FIRST

UNCLAS SECTION 01 OF 04 BRASILIA 000321

SIPDIS

SENSITIVE

NSC FOR BREIER, RENIGAR,
TREASURY FOR OASIA - DAS LEE AND FPARODI
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOS LON
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE

E.O. 12958: N/A
TAGS: ECON PGOV EFIN SOCI BR
SUBJECT: BRAZIL'S FISCAL RESPONSIBILITY LAW FACES FIRST
REAL TEST

REF: A) RIO DE JANEIRO 076,

B) 04 RIO DE JANEIRO 1261,
C) 04 RIO DE JANIERO 1773
D) BRASILIA 317


1. (U) This cable has been coordinated with Consulates Sao
Paulo and Rio de Janeiro.


2. (SBU) SUMMARY. Brazil's Fiscal Responsibility Law
(LRF),a cornerstone of the nation's fiscal recovery, is
facing its most serious threat since its enactment in 2000.
The law, meant to enforce prudent government financial
management, requires that outgoing elected officials not
leave unpaid obligations for an incoming administration, and
it subjects officials who fail to respect its requirements
to criminal penalties. Despite these provisions, reportedly
over 2,000 of Brazil's 5,563 municipalities had uncovered
obligations on January 1, when the new mayors were sworn in.
The situation is testing the enforceability of the LRF
across the country. Most tellingly, the accounts left by
outgoing Sao Paulo mayor Marta Suplicy, a leader in
President Lula's own PT party, whose default on at least
R$1.8 billion (about $660 million) worth of contracts with
suppliers confronts Lula with a series of uncomfortable
choices regarding enforcement of the LRF. We see little
chance, however, that the GoB will risk its hard-won fiscal
gains with hasty reactions to the current outcry. End
Summary.

The LRF - Cornerstone of Brazil's Fiscal Recovery
-------------- --------------


3. (U) The LRF was born of a general debt crisis in the
late 1990s when several highly indebted state and municipal
governments threatened again to default on their debts,
forcing the GOB to step in to avert a general financial
meltdown. In return for assuming state and municipal bank
debt, the GoB forced local authorities to acquiesce to
several measures meant to place a "fiscal straightjacket" on
state and municipal governments. Originally passed in 2000,
the law ties together a series of measures, often referred
to collectively, although each has a separate legal basis.
The first of these are the debt renegotiation contracts,
signed between the federal government and the states and
municipalities. While the states and municipalities must
repay the federal government for the debt it assumed on
their behalf, payments are capped at 13% of revenues.


4. (U) The second measure is the Senate's constitutional
authority to set ceilings on state and municipality debt.
These limitations prevent highly indebted states and cities
from taking on new bank loans. The third leg of the stool
is the LRF itself, which regulates financial administration
and transparency. In particular, the LRF requires that
outgoing governors and mayors balance the accounts at the
end of their terms, and not leave uncovered financial
obligations for their successors. A complementary statute,
the law on fiscal crimes, establishes criminal penalties,
ranging from prohibition on running for public office to
four years imprisonment, for failing to respect the LRF's
requirements.

The Challenge: New Municipal Leaders Find Empty Coffers
-------------- --------------


5. (U) The January 1, 2005 swearing in of mayors and city
councils elected in October 2004 was the first municipal-
level transition after the LRF took effect in 2000, and
consequently the first municipal-level test of the LRF.
(NOTE: LRF provisions were tested at the state level after
the Brazil's gubernatorial elections two years ago. Reftels
discuss several examples of states in bad financial shape in
2002 that have gotten their financial acts together. END
NOTE.) Despite the provisions of the LRF, over 2,000 of
Brazil's 5,563 municipalities reportedly had uncovered
obligations on January 1 when the new mayors were sworn in -
- and no money in the bank with which to pay. Given the
size of Sao Paulo's uncovered obligations alone (US $660
million),the total may be over a billion dollars.


6. (U) Fortaleza, capital of the northeastern state of
Ceara, for example, is facing significant unpaid
obligations. Newly arrived mayor Luizianne Lins (PT)
reportedly found that her predecessor stopped paying city
employees after the October elections, leaving the payroll
13 million US dollars in arrears. Lins, a maverick -- and
outspokenly critical -- member of President Lula's Workers'
Party (PT),came to Brasilia to plead, unsuccessfully, for
federal assistance. In Aguas Lindas in Goais state, the
incoming officials have had to buy cleaning products for the
office out of their own pockets. Mixed in with the examples
of financial mismanagement are horror stories of mayors who
embezzled city funds in their final weeks in office, and in
some cases even stole the computers that would help the new
mayors (and prosecutors) assess the damage.

Sao Paulo at the Center of the Storm (as usual)
-------------- --


7. (SBU) The largest municipal fiscal shortfall -- and
politically most difficult case -- is Sao Paulo. Raul
Velloso (please protect),an economist and financial
consultant with ties to newly-inaugurated mayor Jose Serra
and the Social Democratic Party (PSDB),told us that when
Mayor Marta Suplicy (a PT leader close to President Lula)
left office in December, she left behind substantial unpaid
obligations to suppliers, which he estimated at R$1.8
billion. While Velloso acknowledged that Suplicy inherited
R$1 billion of supplier debt from her predecessor, she took
office before the LRF was enacted, he observed, and thus was
on notice that she had to increase fiscal discipline.
Instead, Velloso commented, Suplicy managed the city poorly
and added to Sao Paulo's overall supplier debts, making it
impossible for her to hand over the municipality with clean
books.


8. (SBU) This failure would have been a clear violation of
the LRF. To avoid liability under the law, Velloso said,
Suplicy defaulted on the R$1.8 billion in supplier credits
by voiding the municipal payment obligations, thus taking
advantage of what appears to be a loophole in the law.
While the LRF clearly prohibits an elected official from
leaving office with uncovered obligations, it does not
specifically enjoin a municipality from defaulting on those
obligations during a transition. Outgoing Suplicy
administration officials maintain that payments were
suspended in late December only on services not yet
provided, or which had not been accepted due to technical
problems. But, the contractors and the Serra administration
claim that Suplicy failed to pay for services rendered and
that there were insufficient funds left on hand to cover
upcoming payment obligations.


9. (SBU) While the defaults are subject to legal
challenge, Velloso pointed out that enforcement of judicial
decisions requiring municipal payments is spotty at best.
Even if recognized by a judge, claims based on court
judgments do not count as supplier debt under the LRF
definition. Thus, Suplicy appears to have been able to
leave office without violating the letter of the law while
nevertheless bequeathing a financial mess of massive
proportions to her successor.


10. (U) On January 31, losing mayoral candidate Paulo
Pereira da Silva of the opposition PDT delivered a petition
to the Sao Paulo state public prosecutor, Rodrigo Cesar
Rebello Pinho, requesting that Suplicy be prosecuted for
violation of the LRF. According to press reports, da Silva
stated, "If the law doesn't stick here, in Sao Paulo, it's
not going to stick anywhere." The PDT alleges a R$1.9
billion deficit in the accounts. Suplicy administration
officials deny any LRF violation, claim that the end-of-year
accounts contained R$ 376 million cash to cover outstanding
obligations and dismiss the R$ 1.9 billion deficit estimate
as including obligations which are not covered by the LRF,
such as expenditures by municipal parastatals and city
council expenses. In a related action, PSDB city councilman
Jose Police Neto will also file an action with the state
public prosecutor charging the former mayor with financial
irregularities due to the cancellation of payments on
service contracts in late December. The state prosecutor
reportedly is reviewing both petitions.

...While debt to the Feds Grows on Parallel Track
-------------- --------------


11. (SBU) Serra's penniless incoming municipal
administration had to face an immediate threat on a parallel
track: the city's debt to the federal government. According
to several accounts, Serra and Suplicy met immediately
before Serra's inauguration with federal Finance Minister
Palocci to brief him on the situation and request that the
city's December debt payment to the federal government be
postponed until mid-January. Normally, missing a payment
would result in the GoB freezing the city's assets or
canceling federal transfer payments. By all accounts,
however, the Lula administration approved the "special
consideration" and allowed the city to defer the December
payment in order to cover other obligations. Quizzed about
the apparent preferential treatment being given to Sao
Paulo, a Finance Ministry contact claimed to Emboff that
there was legal basis for the decision (though not
specifying what it was) and that the media was making too
much of the situation.


12. (U) Another strand in this affair are the limits on
municipal and state debts set by the Senate, which apply to
bank debt as well as to the renegotiated debt to the federal
government. Velloso explained that Sao Paulo's situation
had highlighted a technical problem with the manner in which
overall debt stocks were indexed for inflation in the debt
renegotiation contracts signed with the federal government
in the late 1990s. The negotiators chose to index the debt
stocks using the IGP-DI index, a mixed consumer and
wholesale inflation index. The IGP-DI is much more
sensitive to exchange rate swings -- of the sort Brazil
experienced in 2002/2003 -- than Brazil's consumer price
index (IPCA). Municipal revenue growth, however, tends to
be closely correlated with the IPCA. This mismatch means
that the growth in revenues has not kept pace with the
growth in the debt stock over the last two years. End
result: Sao Paulo's debt will be about R$7 billion over the
120% of revenues limit when the grace period for meeting the
target expires in April. Given the city's 2005 budget of
R$15.2 billion, it would be impossible for Serra to reduce
the city's debt by the R$7 billion necessary to meet the
target. Failure to meet the target would, in theory,
restrict Sao Paulo from taking on new debt and allow the GoB
to freeze transfer payments to the city.

Comment - Uncomfortable Situation
--------------


13. (SBU) The Lula administration is in a quandary. The
large unpaid obligations left by many outgoing mayors,
coupled in many cases with blatant mismanagement or even
outright embezzlement, has given rise to calls for strict
enforcement of LRF penalties. The presence of Sao Paulo at
the center of this story, however, may limit the
administration's options since, exploitation of loopholes
aside, strict LRF enforcement would require that the GoB at
least investigate Marta Suplicy's financial management. In
addition to causing intra-party heartburn, doing so would
mean dragging the details of her (alleged) financial
mismanagement through the media, undermining the PT's
efforts to burnish its image as a fiscally responsible
manager at the federal level. Moreover, the sheer size of
the Sao Paulo municipal budget, the fourth largest public
budget in Brazil, might give the Lula administration pause,
because proof of serious financial mismanagement and default
could have a ripple effect throughout the financial system.
The issue may get out of the administration's hands,
however, should prosecutors take up opposition requests for
an investigation.


14. (SBU) On a parallel track, the broad-based nature of
the municipal financial difficulties has led to the most
serious public questioning of the LRF's requirements to
date. Several measures are being floated in Congress to
soften the debt ceilings or endorse special treatment for
some municipalities, although none of these is likely to
pass without the support of the PT. However, the Lula
administration cannot associate itself with calls to revisit
the LRF's requirements (even where there would seem to be a
legitimate case for doing so, such as the indexation
mismatch problem). Doing so, in the words of the IMF
Resident Representative, would be perceived by the
international financial markets as "playing with fire." The
GoB also must tread cautiously with Serra, who is in a
position to embarrass the PT with revelations of Suplicy
mismanagement. Serra has been surprisingly circumspect to
date, perhaps hoping to make a deal with the federal
government. But giving Sao Paulo (further) special
treatment might undermine the LRF's credibility.


15. (SBU) The good news is twofold. First, despite these
political conundrums, we have seen no evidence -- including
during the Ambassador's February 1 meeting with Palocci (Ref
D) -- that the GoB is prepared to risk Brazil's hard-won
fiscal adjustment with hasty reactions. Second, when the
GOB remained firm two years ago with newly elected governors
-- who also clamored for exceptions and special treatment to
overcome their inherited financial problems -- the states
ultimately buckled down and began putting their financial
houses in order.

DANILOVICH