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Stalling for time

São Paulo­-based Leandro's president Eduardo Weisberg has watched 20 percent of his revenues melt away this year as Brazil's sputtering economy keeps middle-class restaurant-patrons at home.

Ice cream maker Eduardo Weisberg has watched 20 percent of his revenues melt away this year as Brazil's sputtering economy keeps middle-class restaurant-patrons at home. The president of São Paulo-­based Leandro's, which sells to eateries nationwide, has been scratching his head trying to figure out how to bolster his business, but like most of his countrymen, he is paralyzed, unwilling or unable to make a move until he sees who will succeed Fernando Henrique Cardoso as president next month. "It's suicidal to plan," laments Weisberg. "Our strategy is to wait. We'll see who wins the race."

October's presidential election is shaping up as one of the most decisive in Brazilian history. At stake is nothing less than the economic future -- immediate and long range -- of Latin America's biggest country. After eight years of Cardoso's neoliberal economic orthodoxy, which tamed inflation and reduced the budget deficit, the country has begun reeling, a victim of volatile global markets and the weakening U.S. economy. Those conditions have Brazilian voters now on the brink of electing their very first leftist president.

In a tight presidential race (an October 6 first round will surely be followed by an October 27 run-off), Cardoso's chosen successor, former minister of Health José Serra, the candidate of the coalition of Brazil's two largest parties, now claims just 11 percent of the vote, according to recent polls. He trails a pair of center-leftist candidates, Luiz Inácio (Lula) da Silva, a union leader and founder of the Partido dos Trabalhadores who registers 35 percent; and the Frente Trabalhista's Ciro Gomes, a former state governor and minister of Finance, who has 26 percent. A fourth candidate, Antônio Garotinho, who is widely expected to fade, registers 11 percent. One third of voters say they could change their preference, and a large number remain undecided.

Serra's poor showing to date stands as a distinct repudiation of the unglamorous candidate and, increasingly, of the economic polices that have shaped Brazil over the past eight years. And the specter of a leftist president unraveling Cardoso's legacy coupled with lackluster economic fundamentals -- an onerous debt burden and weak growth -- has cast a pall over Brazil's economic future. Spooked by Gomes's provocative antimarket rhetoric and Lula's radical past, investors have driven down the value of the real and pushed up the spreads on the country's sovereign bonds, threatening to trigger a potentially devastating liquidity crisis. Their greatest fear: Brazil, the eighth-largest economy in the world and the generator of 40 percent of Latin America's GDP, will follow Argentina's lead and default on its $264 billion public debt.

The burden is crippling. Brazil's debt-to-GDP ratio is a daunting 60 percent. With 30 percent of the domestic loans linked to the dollar and a further 50 percent of domestic debt tied to short-term interest rates, Brazil's ability to service its debt is critically dependent on currency moves and economic pressures that could cause an interest rate hike. At the same time, Brazil is running a $22 billion current-account deficit, representing more than 4 percent of GDP. As investors well know, this keeps the Brazilian economy dependent on foreign capital flows.

"Investors are much more sensitive because of what happened in Argentina," says Mohamed El-Erian, emerging-markets director at Pacific Investment Management Co., the Newport Beach, California­based fixed-income money manager.

A dangerous cycle has already begun. Sensitive to the political uncertainty and apparent strength of the left-of-center opposition candidates, investors fear a debt restructuring. They've responded by selling off the real. The currency is down 35 percent since the start of the year, with most of the decline coming in July, when U.S. Treasury Secretary Paul O'Neill suggested that foreign lending to Brazil might be siphoned off into Swiss bank accounts. He caused a 14 percent decline in the value of the real in three days.

To keep inflation in check and lure investors, the government must keep interest rates high (overnight rates recently hit 18 percent, up slightly from levels that prevailed in 2000 and 2001). This makes it more expensive to service the debt, chokes off credit and stifles economic growth. Brazil will register a second straight year of weak GDP in 2002, anywhere from 0.6 percent to 1.8 percent, analysts estimate. Amid a global downturn, GDP grew 1.5 percent in 2001, down from 4.4 percent in 2000.

Such was the mounting anxiety that the International Monetary Fund -- supported by a U.S. government that moved to reverse its stand against bailouts -- last month swooped in with a $30 billion rescue package (about twice what was expected). The pact should secure the country's finances at least through year-end, enabling Cardoso to deliver a functioning economy to his successor.

Nervous market participants worry that despite the IMF aid, Brazil will be unable to dig itself out of its hole -- and may slide into default, no matter who wins the election. "Brazil's debt path is simply unsustainable," says Christian Stracke, head of emerging-markets debt strategy at CreditSights, a Wall Street research firm. "The amount of debt is so high, and the interest rates on the debt are so high, that Brazil will be forced to borrow more money to make its interest payments. The economy won't grow fast enough and eventually Brazil will hit the wall and be unable to service its debt." He expects a default within the next 24 months.

Walter Molano, head of research at BCP Securities, predicts a default in the first half of 2003. "Brazil will have trouble extracting the financing it needs. The electoral process [will make] investors demand too much of a premium for Brazilian risk to make the debt sustainable," he says.

Arminio Fraga, the highly regarded central bank chief since 1999 and a staunch advocate of fiscal sobriety, dismisses the possibility of default as extremely remote. Anticipating a default, he says, "is a prediction that Brazil as a society will commit suicide. That scenario requires a series of serious mistakes on the part of this and the next administration that are highly unlikely." The central banker also hailed last month's commitment by 16 banks to maintain their current level of lending to Brazil.

Clearly though, a default could have devastating consequences for Brazil -- and beyond. "The impact of crises like Argentina and potentially Brazil is that bond markets shut down, and that's already basically happened, and foreign direct investment gradually withers away," says Pedro Pablo Kuczynski, former Finance minister of Peru. Adds Jim Barrineau, vice president of emerging markets for Alliance Capital Management, "If Brazil falls off the cliff, that's the southern cone in its entirety, and you have Mexico and the rest of Latin America in a mess."

The numbers tell the story: Brazil accounts for 20 percent of the emerging-markets bond index. Foreign exposure to Brazil totals more than $400 billion, including $210 billion in external debt, $125 in direct investment and $68 billion in commercial bank debt, according to CreditSights. U.S. banks have about $25 billion in outstanding loans to Brazilian borrowers. Citigroup has $9.3 billion in Brazilian loans, or about 7 percent of the bank's book value. FleetBoston Financial Corp. has $6.5 billion in loans to Brazil, representing 39 percent of its book value.

Certainly, the IMF pact marks a clear turnabout for the Bush administration, which had opposed bailouts for developing countries and has been holding out on extending new aid to Argentina, despite the country's economic collapse.

Under the terms of the Brazil agreement -- which the opposition candidates were not required to endorse, as had been the case when past IMF bailouts were negotiated during a run-up to a presidential election -- Brazil can draw on $6 billion in new money this year. The government could also tap an additional $10 billion freed up by the IMF decision to lower Brazil's minimum level of net foreign currency reserves from $15 billion to $5 billion. At midyear, reserves totaled $38 billion. That assures the government enough liquidity to service public debt "for a long time," says Fraga, "and for the private sector, under terrible scenarios, until deep into next year." He adds, "For the first year of the next president's term, he will have an extra cushion to establish his game plan and reconfirm that he will stick to sound macroeconomic policies, rule of law and sanctity of contracts."

Next year Brazil may begin to access the remaining $24 billion, as long as the new government keeps the primary surplus (the government surplus before interest payments) at no less than 3.75 percent of GDP, a condition that remains in place through 2005. The tranches of the $24 billion may only be disbursed after quarterly IMF reviews with the new government, according to sources at the Fund. The first talks between the IMF and the new government-elect are expected to take place in November or December. Advisers to Lula, along with other economists, suggest that the primary surplus target might be raised to more than 4 percent of GDP as part of those talks.

Investors cheered the IMF package. The real gained 3.8 percent against the dollar, the Brazilian stock market rose 4.5 percent and shares of Citigroup and FleetBoston each jumped 6 percent the day after the pact was announced. But gloominess soon set in as the three leading candidates played to form in reacting to the deal.

Serra, who proclaims himself Cardoso's rightful heir and is the investors' favorite, hailed the pact as "strongly positive." But Lula and Gomes gave investors ample reason to doubt their commitment to free-market policies. Lula described the IMF deal as "inevitable: It allows markets to calm and gives a chance for the country to return to growth." But the candidate also attacked "the errors committed by the government [that] adopted a model that kept Brazil stagnant and dependent on volatile international liquidity." Gomes decried Brazil's indebtedness as "a tragedy." "Our country has no way out," he said. "The simple act of not paying provokes going broke and a brutal and definitive devaluation." It was largely the evidence of Gomes's growing popularity -- his poll numbers surged from 9 percent in June to 27 percent a month later -- that drove down the value of the real in late July.

Although Brazilians were alarmed by the market reaction, many are ready for some kind of change. In addition to their fears about growing crime, they blame Cardoso's eight-year regime for modest annual growth averaging 2.3 percent and high interest rates that have choked off credit. "The economy is in bad shape, and it's very difficult to get work," says Enrico Paisani, 18, a law student looking for a job as a legal intern. For the moment, at least, Brazilians are resisting the urge to panic. Capital flight in the first half of the year rose slightly, to $3.66 billion, but is no cause for alarm. Many businessmen express confidence that Cardoso's market-friendly policies will be sustained under Lula or Gomes.

"There might be differences between Cardoso and his successor, but nothing that endangers our business," says Volker Barth, president of South American operations for Troy, Michigan­based Delphi Corp., the world's largest auto-parts maker.

Says Octavio de Barros, chief economist at BBV Banco in São Paulo: "As president, Lula and Gomes would act differently than they do as candidates. They would be responsible and establish confidence immediately after the announcement of the victory."

Would they? Foreign investors feel far less secure. "The bond market is discounting a loss by Serra and a restructuring that includes a haircut on debt," says Charles Cassel, portfolio manager for Standard Asset Management, a Miami-based investment advisory firm specializing in global sub-investment-grade debt. John Williamson, a senior fellow at the Institute for International Economics in Washington, cautions investors about the power of self-fulfilling prophecies. "If the market insists on a default," he says, "it will get a default."

Brazil's resilience to deteriorating conditions cheered investors for the past few years. Thanks to astute crisis management, the country weathered its January 1999 devaluation and produced strong growth and modest inflation in 2000. It survived the multiple threats of 2001 -- a domestic energy crisis, the shocks of September 11, a worldwide economic slowdown. At the start of this year, Brazil defied tough odds when it escaped the grave risk that contagion from Argentina's economic collapse would choke off its own access to capital markets. In early January, just a few weeks after Argentina defaulted on its $141 billion debt, Brazil attracted strong demand for a $1.25 billion, ten-year bond offering.

Then the election campaign started to heat up, with unexpected turns and party alliances proving to be as fluid as World Cup star Ronaldo's kicks. In May, when polls showed Lula holding a 20-point lead over Serra, investors began to focus on what a Lula regime might mean. Their alarm grew six weeks later when Gomes overtook Serra.

During four presidential campaigns, Lula, 47, a lifelong union activist, has routinely won a solid 30 percent of the vote, drawing his strongest support from Brazil's working class. He has survived the first round three times, only to see his chances evaporate in the second-round election.

This time around he has tried to moderate his rhetoric and steer closer to the center. (He even spruced up his wardrobe and stumped on the floor of the São Paulo stock exchange). While campaigning on a populist program that pledges to increase jobs, improve income distribution and boost small businesses and family farms, he has also taken pains to assure skeptics that he would not abandon Cardoso's policies of fiscal and monetary restraint and debt stabilization. How that will enable him to create jobs is another question. To underscore his new centrism, he named José Alencar, owner of Brazil's leading textile firm, Coteminas, as his vice presidential candidate. Like Gomes and Serra, Lula proposes boosting exports. His goal is to double the trade surplus to $10 billion by 2004. He aims to get there in part by expanding credits and creating a trade ministry.

"We offer the possibility of a junction between capital and labor," Lula said in the first televised presidential debate, on August 4. But investors worry that his party's platform still calls for a break with the current economic model. Lula's greatest point of vulnerability is his lack of governmental experience and his modest level of formal education. (He completed one year of technical school and was trained as a mechanical lathe operator.) "The problem is not only experience in government, the problem is character and commitment to the people," Lula said in that debate.

Growing up as the son of a middle-class professional in a small town in Brazil's northeast, Gomes trained as a lawyer and became the youngest governor in Brazilian history when he was elected to govern Ceará in 1989 at 33. As governor, Gomes restructured the state's debt, adopted pro-business policies to lure manufacturers to the state and boosted investment to record levels. He also won a Unicef prize for a program that lowered infant mortality.

In September 1994 then-president Itamar Franco tapped Gomes to take over the Ministry of Finance, where he helped implement the real plan, which introduced a new currency.

The outspoken Gomes has railed against "high [domestic] interest rates that strangle local businessmen" and has denounced neoliberalism as a "fifth-rate ideology sold as a science." According to Brazilian press accounts, at a private dinner on August 13, some 35 powerful financiers and businessmen heard Gomes proclaim: "To hell with the markets! I would cut off my own hand to avoid signing Brazil away to the bankers!" But four days later Gomes calmed investors when he announced that Chicago-trained economist José Alexandre Scheinkman, a supporter of the IMF program, had joined the campaign to coordinate his economic program.

The most remarkable story in the election remains that of Serra. Lacking in charisma and charm, the 60-year-old engineer with a Ph.D. in economics from Cornell University has steadily lost ground to his rivals. A longtime Cardoso cabinet member, the market-friendly Serra promises "secure change." But he is widely seen as the continuity candidate.

On the campaign stump Serra has pledged to create 8 million jobs and attract enough foreign investment to Brazil to allow a drop in interest rates. "Brazil's dependency on foreign capital is a central problem of our economy. One of my priorities will be to reduce our current-account deficit," he said in a written reply to questions from Institutional Investor. He also aims to enhance credit availability for small farmers and promote exports by fighting foreign protectionism. "I will be an exporting president," he says.

All three candidates hope to boost economic growth (and thereby better manage the country's debt) through a rise in exports and a continued decline in imports. This year Brazil expects to post a trade surplus of more than $4 billion, largely because of a sharp drop in imports. Serra believes that stronger exports can attract capital, create new jobs and ultimately lower interest rates. Lula advocates structural measures to boost exports, such as export credits for small and medium businesses. He would also increase trade financing from Banco Nacional de Desenvolvimento Econômico e Social, the national development bank. Gomes would offer tax breaks to exporters.

The next Brazilian president will fight to build a voting coalition in Congress to pass an economic package, but that won't be easy. "It will be a big challenge to have a stable majority that could support the president on the toughest issues," says political consultant Murillo de Aragão, director of Arko Advice in Brasília.

Whoever wins the election will preside over a fragile economy hobbled by debt.

Of the $264 billion in public debt, $110 billion is foreign debt. In addition, the Brazilian private sector has $99 billion in outstanding loans. In July Standard & Poor's calculated that servicing the government debt will consume 9 percent of GDP. To keep debt payments under control, the Cardoso administration managed to generate a primary surplus of 3.75 percent of GDP last year.

Because 80 percent of the public sector debt is linked to either the dollar or local interest rates, the payment obligations can, and do, suddenly rise and fall. Although the Cardoso government has been extending Brazil's debt maturities, about $38 billion in internal debt must be rolled over in the second half of this year and another $56 billion in 2003. An additional 19 percent of the debt will fall due within the next two years. "We can manage. Unfortunately, we have this kind of expertise in Brazil,"says José Antônio Pena, chief economist at Bank Boston in São Paulo.

In recent years Brazil has comfortably met its payment schedule, thanks to steady capital flows. But for the past four months Brazil, like many emerging markets, experienced a dramatic decline in these flows. Analysts expect the liquidity crunch to continue for the foreseeable future. "This could be an endless shock for Brazil," says Mauro Schneider, the São Paulo­based local market strategist for investment bank ING.

Says CreditSight's Stracke: "Foreign bankers are so nervous of getting hit like they did with Argentina. Directives from on high say, 'Get rid of exposure to Brazil wherever you find it.'"

For the first six months of the year, net bank lending to Brazil was a negative $6.5 billion, versus a positive $1.5 billion for the first half of 2001. In June banks reported net outflows of $1.4 billion and the July figure was expected to be even higher, contributing to the liquidity crunch.

Foreign direct investment has also declined significantly. For the first six months of 2002 it totaled $8.6 billion, down from $12 billion in the first half of last year. The June numbers were even worse: Foreign companies made $1.4 billion in direct investments, down from $3.6 billion in June 2001.

With the economy slowing and unemployment running at more than 7 percent, up from 6.5 percent in 2001, Brazilians are increasingly demanding pro-growth policies. "The government should set up microenterprises because big companies are reducing the number of their employees," says Ana Cristina, 33, a computer data processor who lost her job at a bank a year ago.

The new president won't find it easy to boost growth. One reason: the demands of Brazil's social security system. Generous government pensions cost 11 percent of GDP for retirees who comprise only 6 percent of the population but are nonetheless a powerful political force. Gaining approval for social security reform will be politically charged, no matter who wins the election. All three candidates pledge to preserve "acquired rights" in the current system, protecting the pensions accumulated to date. Beyond that, Serra is considering a fixed ceiling on pensions, phased in over the medium term, while Gomes proposes a transition that would establish a new system for new workers. Lula would preserve the current system for workers and government employees and create a complementary pension system for other laborers.

Despite the long shadow of debt, the Brazilian economy is displaying some newfound strengths. Privatizations have pulled in $100 billion; transparency is vastly improved. "Institutions work in Brazil," says Claudio Haddad, a former central bank director and head of the Ibmec, an executive training school. He cites the government's improved ability to collect taxes, a greater disclosure of information, checks and balances on the presidency and gains from privatization.

Certainly institutions work better than they did when Cardoso took office eight years ago. When his successor takes the reins of the economy on January 1, the IMF deal will buy him some time. But he will face daunting challenges that may well prove overwhelming. "The IMF pact does not resolve Brazil's underlying problems," says Kenneth Maxwell, director of Latin American Studies at the Council on Foreign Relations in New York. "It just delays the day of reckoning."

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