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E você, Brazil?

The economy is struggling. Presidential elections are around the corner, and the left has a real shot at winning. Could things get any worse?

The economy is struggling. Presidential elections are around the corner, and the left has a real shot at winning. Could things get any worse?

By Judith Evans
September 2001
Institutional Investor Magazine

After the Brazilian soccer team's humiliating 2-0 defeat at the hands of lowly Honduras on July 24, coach Luiz Felipe Scolari admitted that a defensive strategy of play had resulted in the team's ouster from the Americas Cup.

As with soccer, so with government. Buffeted most of the year by economic crises and heading into an election, Brazil's President Fernando Henrique Cardoso and his administration had responded only with defensive posturing. This passivity lent credence to the growing belief that the coalition government would be ousted next fall by the left.

But in recent weeks Cardoso and his economic team have sounded more pugnacious. The president has begun attacking his resurgent leftist opposition, as has Finance Minister Pedro Malan. Central bank president Armínio Fraga secured a $15 billion aid package from the International Monetary Fund in August, moving quickly to protect Brazil from continued spillover from the economic crisis in Argentina.

The change of stance comes not a moment too soon. With Argentina careering off the economic rails, Brazil has been fighting off fiscal contagion. Bankers are more reluctant to roll over Brazil's staggering $246.6 billion in foreign debt, so interest costs are rising. Brazil's currency, the real, has depreciated 25 percent against the U.S. dollar since the beginning of the year. Inflation is growing, the once-robust economy is slowing, and there is a major energy shortage. Worse still, Cardoso's four-party, center-right governing coalition has recently been hammered by a pair of high-profile corruption scandals. Elections are little more than a year away, and Brazil's constitution forbids Cardoso from running again.

Brazilians are reputed to be optimistic, patient and willing to sacrifice for the national good. The response to the government's call for voluntary energy cuts - surpassing the 20 percent target - is proof of the latter. But optimism and patience are in short supply these days. São Paulo heart specialist Dr. Lucas Bercht says that, as a Brazilian, he feels like a lab rat. "Fixed exchange rates, pegged exchange rates, floating exchange rates. Its as though some cabal were saying, 'Brazilians can survive anything; let's try this new experiment on them.' " Having studied in the U.S., the 42-year-old father of two now says, "I would rather work in the U.S. as a medical technician than as a doctor in Brazil."

Guilherme Peirao Leal, chairman and CEO of Natura, a kind of Brazilian Body Shop that manufactures upmarket natural beauty products, concludes: "The economic model is not answering the questions that Brazilians have. Let's face it, the Washington Consensus [that an open market will lead to prosperity] was not true. Where is growth?"

The impact of economic problems is "clear to the naked eye," says Fraga. "Two elements are clashing: the very positive underlying long-term trends in Brazil's economy and the major shocks to short-term performance."

Brazil now faces an uncertain turning point in its political life: the prospect that the leftist opposition might win the October 2002 elections. That possibility has made investors wary. "There's a 2002 [upward] kink in the yield curve [in Brazilian government bonds]," says John Welch, chief economist for Latin America at Barclays Capital in New York. "And, just as clearly, the government [is having] enormous difficulty financing into 2003, both in local and foreign debt markets."

How real are the left's chances of winning? Luiz Inácio da Silva of the leftist Partido dos Trabalhadores - known to all as "Lula" - currently leads in the polls by a wide margin and is gaining strength. He's been in that position before, but never before has the governing coalition been in such disarray.

One fear dominates all others. "A Lula victory would be a risk to Brazil's weak democracy," asserts São Paulo private-fund manager Igor Cornelsen, who foresees capital flight, weak investment and closed international financial markets. If those events were to take place, Cornelsen predicts an economic crisis that would provoke a political crisis of the magnitude that occurred in 1964 when populist president João Goulart was overthrown by the military. Central bank president Fraga is more sanguine. "I can't imagine anyone being elected saying, 'I'm against fiscal responsibility, economic stability [and] holding the line on inflation.' There's no turning away from basic principles."

The PT is projecting itself as more centrist than it has previously shown itself to be, although it still believes in increased public spending, a higher minimum wage, lower domestic interest rates and easier agrarian credit. So far, at least, Brazilians are buying it. Riordan Roett, director of the Western Hemisphere Program at Johns Hopkins School of International Studies in Washington, D.C., says: "The Cardoso era is over. Brazilians are ready to vote for a populist."

The PT expects hostility from financial markets if it wins in 2002. "We've had very productive conversations with industrialists," says Ricardo Carneiro, a professor of modern Brazilian economics at Campinas State University and one of the authors of the party's platform. "But I must admit that our talks with bankers have been more difficult. Still, they will have a place in a PT government."

That's not likely to assuage bankers' fears. "The PT's sketchy manifesto is internally inconsistent and doesn't fit with Brazil's budgetary or balance-of-payments constraints," says Paulo Leme, head of emerging-markets research at Goldman, Sachs & Co. in New York. "They may be well intentioned, but a Lula victory would set us back so much - five or ten years at least."

This is surely not the environment that Cardoso planned on for his last year in office. Celso Pinto, editor of Valor Econômico, a daily newspaper, explains that Cardoso attempted something no Brazilian president ever has. "He tried to make the political cycle be in sync with the economic cycle." By that Pinto means that for the first two years of Cardoso's second term, the government's priorities were adjusting to and absorbing the impact of the 1999 currency devaluation. The second two years were supposed to enable him to launch new programs and regain the popularity necessary for him to be able to choose his successor and keep the governing coalition in power.

But the economy is not cooperating. Marcelo Carvalho, chief economist for Brazil at J.P. Morgan Chase & Co. in São Paulo, estimates that GDP will decline in the second half of this year and notes that retail sales and consumer confidence have plunged to levels not seen since 1999. Employment and wage growth are quickly heading south, while inflation, at 6.8 percent, is overshooting the central bank's year-end target of 4 percent and even the 6 percent agreed on with the IMF. Exports have not met projections, and foreign direct investment is expected to decline to $20 billion, missing forecasts of $24 billion at the beginning of the year.

When Brazil's economy was growing strongly, financing its huge foreign debt was manageable. But as Argentina's problems grew, so did the concern over other emerging-markets debt - particularly Brazil's. Fund manager Cornelsen says that Brazil needs $25 billion to cover its debt service and has to roll over $40 billion in maturities each year. "Where is this money going to come from if Argentina defaults?" he asks.

Said one banker of Brazil's new agreement with the IMF: "Pedro [Malan] and Armínio [Fraga] look at themselves and say, 'We won't be able to control the fiscal arena without the Fund, so let's do it now while we still have Argentina to blame.' "

The economic problems have also put the central bank's actions under scrutiny and, for the first time since Fraga took over in 1999, have generated considerable controversy about his and the bank's vaunted abilities. "When the real began to fall and they hiked rates 50 basis points for the first time after two years of cutting, observers were caught off guard," J.P. Morgan's Carvalho says. A series of four more hikes followed, including a big hike of 150 basis points in June. According to Carvalho, the Bank's erratic moves eroded confidence in Fraga and the bank.

Brazil, of course, has other problems. It has a critical energy shortage, owing in part to a prolonged drought. The country depends on hydroelectricity for more than 90 percent of its energy, but the real culprit is a lack of investment. In the 1970s power-generating capacity increased by an average of 11.8 percent annually. It fell to 4.1 percent in the 1980s and to 2.9 percent in the 1990s, while demand grew much faster. The three-year drought has made things worse, causing power cuts and slowing growth further - the estimate is by as much as 2 to 5 percent of GDP.

Corruption is endemic in many emerging-markets nations, but rarely has it so reached so high at so critical a time. Senate president Jader Barbalho, leader of the Partido do Movimento Democrático Brasileiro, was forced to take a leave of absence because of corruption charges. Another of Cardoso's legislative allies, Senator Antônio Carlos Magalhães, leader of the rightist Partido da Frente Liberal, resigned from the Senate in disgrace. Both the PMDB and the PFL are key partners of Cardoso's Partido da Social Democracia Brasileira in the governing coalition, and Cardoso's support for Barbalho and Magalhaes is one reason for his low public approval rating - barely 15 percent.

Cardoso's coalition seems to be coming unglued. Former president Itamar Franco, who boosted Cardoso's political career in 1993 when he appointed him finance minister, wants the PMDB's nomination. Cardoso is rumored to favor current Finance Minister Malan as his successor. Malan is presently unaffiliated with any party but must join one by October 4 if he wishes to run. If he gets the nod from the coalition, Franco may bolt to another party and run under its banner.

Ciro Gomes of the small Partido Popular Socialista could also be a real contender if Cardoso's candidate ends up lacking popular appeal. Gomes, now running as a leftist, could then move to the right. He recently allied himself with the center-right Partido Trabalhista Brasileiro. Gomes, who preceded Cardoso as finance minister and was a successful state governor, has been attacking the government and Cardoso. He favors strong government intervention and the restructuring of Brazil's public debt and is against privatization and trade liberalization. Johns Hopkins' Roett notes that he has the "Collor factor," referring to Fernando Collor de Mello, whose good looks helped make him Brazil's youngest president in 1990. Gomes is young, handsome, has an actress girlfriend and is the only candidate who would look good on TV.

Then there is Lula. At this point, he is the only candidate assured of nomination by a party. The longtime chief of the metalworkers' union goes into the campaign with more than 30 percent of voters favoring him. He's had similar support three times before, only to lose the race at the post. This time, however, most analysts believe that his chances of actually winning in a second round - a runoff is considered likely - are high.

The impact of dreary economic numbers and middle-class anger can be seen in the July CNT/Sensus political poll of voter intentions. Lula is gaining slightly - 34.2 percent compared with 33.1 in June. CNT's simulations of a second-round runoff show the leftist leader winning over every other possible candidate. In 1989 Lula went into the second round with only 16 percent of the vote but ended up with more than 44 percent.

Four months ago the press got hold of a copy of the draft proposals for the PT's economic platform. Very much in line with the party's efforts to present itself as a reasonable, modern, social democratic, European-style center-left party, the proposal is now being modified after discussions with party leaders. The draft platform is hardly "PT Lite," notes O Globo daily newspaper commentator Elio Gaspari. "If you read the program closely, it still contains strong anti-free-market thinking," he says.

Campinas State University's Carneiro, one of the platform's authors, with PT deputy Aloizio Mercadante and economist Guido Mantega, explains the party's main positions. The failure of liberalization policies, he argues, has left Brazil with a number of tight restrictions on growth, including servicing debt, low export levels, low productivity and a lack of infrastructure investment. It is a theme already picked up on by Lula. "FHC [Cardoso] has tried to kill national industry bit by bit, throwing away its competitiveness," he told the local press.

The PT plan calls for the use of public trust funds, such as pension plans, to invest in assets like energy generation and housing to boost employment and spur growth. "We are Keynesians and therefore, for example, we oppose the idea of a quantitative limit on public debt without taking into consideration what it is spent for and how it is financed," says Carneiro. The three economists question whether inflation targeting alone will work in Brazil or any other country with a weak currency. "Even the U.S. Federal Reserve has two targets: inflation and unemployment," Carneiro says.

In his first major interview since he began campaigning, Lula told Brazilian daily Jornal do Commércio in mid-August that if elected, he would do "almost everything" differently from the present government. Agrarian reform with access to credit "is not negotiable," he promised. "Contracts can't be broken, but Brazil can issue debt with longer maturities and lower interest rates." Criticizing Cardoso for failing to get an income-distributing tax reform passed when the success of the Real Plan made it possible, he also guaranteed a higher minimum wage, lower domestic interest rates, more access to food baskets and school supplies for the poor and government aid to produce generic drugs.

Lula also listed some things his government will not do: It will not tamper with any budget that has congressional approval, it will not renationalize any privatized entities, and it will not govern using provisional measures (executive orders issued by the president). Lula appealed for opposition unity and stressed the PT's pragmatism with regard to political alliances. Asked about his radical image, the conservatively suited candidate said, "We won't have any pity from the media or the international financial system, so I will only be radical in my efforts to fight hunger and unemployment, to generate wealth and to improve education."

Despite Lula's efforts to sound reassuringly reasonable, his own lack of experience in governing - other than the presidency of the PT, he has held only one elective office as deputy to the Constitutional Convention in 1988 - scares many. Factionalism in the PT, which has radical and vocal elements, bodes ill for the kind of coalition-building that Brazil's fractured political system makes mandatory. A PT government, many believe, would not be able to exercise fiscal discipline, risking the return of Brazil's demon, runaway inflation.

To calm jittery investors, economist Mantega echoes Lula in being unequivocal on the question of the foreign debt. "We will comply with all contracts," he affirms. "No moratoriums, no swaps, nothing of the kind." But he does question the Fund's requirement that the primary surplus, before debt service, increase. "The collateral consequences [more belt-tightening and fiscal austerity] may be the worst medicine," he warns.

The 2000 Fiscal Responsibility Law - which requires government leaders at all levels to stay within budgets or face loss of financial transfers and even personal criminal charges - is often cited by analysts as a bulwark against spending binges by populist politicians. It is supported by the PT economic brain trust, but with some hedging. "We certainly believe that no political group has the freedom to leave a bad heritage to its successor, but we think it needs to be modified radically," says professor Carneiro. "The price of fiscal responsibility cannot be social irresponsibility."

The PT maintains that it can implement a set of economic policies that will be friendly to the middle class and industrialists. "Brazilian businesspeople - even those who don't vote for the PT - know that the party is the only chance the country has to see its economy grow," Lula told the local press.

Middle-class voters, Lula's advisers believe, can be won over by the party's reputation for honesty and administrative efficiency. Corruption in government is perceived to have risen dramatically, a perception fueled in part by savage press coverage. With unethical behavior among politicians a major topic of public concern, the PT's clean reputation is a strong advantage.

The PT expects to square off against Itamar Franco in a second round. Describing the former president - now governor of Minas Gerais state - as a traditional politician, Carneiro predicts that he will get support from the right and from angry middle-class voters. Franco supported Cardoso's successful fight to break the back of inflation and is also credited with not having increased the public debt and continuing with privatizations. "Itamar is easy to underestimate, but I think of him as our Harry Truman - a president who became good in the minds of the people only after he was no longer president," says O Globo's Gaspari.

So what do Cardoso and the government have on their side?

Valor Econômico's Pinto puts Cardoso's feisty character high on the coalition's list of campaign advantages. "The president always becomes greater when there is a crisis," he said. In 1994 Cardoso threatened to resign twice in one weekend to save his Real Plan, Pinto recalls. He also credits the president for standing firm in 1999 when pressured by his allies to abandon the liberalization programs to recover his sagging poll ratings.

Rising to the occasion once again, Cardoso is going after the PT. In a July 9 interview with Valor, he told the newspaper: "The PT wants to capture a part of the middle class but isn't effectively proposing anything. It has directed states and cities; it's another thing to govern Brazil."

Another advantage is incumbency. Barclays's Welch estimates that the government could have up to 1 percent of GDP with which to woo votes. "The budget that will be submitted at the end of August is very important in all of this," he says. "By October you'll start to see how people shift party loyalties, and that will tell you the shape of the coalition."

If the economy improves, the government could get some wind in its sails by claiming that, once again, it managed to navigate the crisis. Unfortunately, there is much that is not under its control. "Brazil can grow with this exchange rate [2.5 reals to the dollar], but only if there's energy, if there's foreign direct investment and if interest rates fall," says fund manager Cornelsen. All three of these are question marks, the latter two directly connected to the impact of the Argentina crisis on the perception of emerging-markets risk.

The most important factor favoring a coalition victory for the government is Brazil's history of political instability. After eight years of continuity in policy direction, economist Sergio Werlang is certain that Brazilians will vote their hope for stability rather than their anger with Cardoso's failings.

The most unpredictable factor is the energy shortage. As a Brazilian banker put it, "The thing that really could kill [the government] is for blackouts to happen while Brazil is playing in the World Cup next year, so no one can watch them on TV!"

Then again, given how Brazil is faring on the soccer field these days, that may be a blessing.