Left turn

New Brazilian president Lula shifted to the center to get elected, and he may find himself stuck there a while as he struggles with huge debts, IMF dictates and recalcitrant governors. But be sure he will push his reform agenda at the first chance.

New Brazilian president Lula shifted to the center to get elected, and he may find himself stuck there a while as he struggles with huge debts, IMF dictates and recalcitrant governors. But be sure he will push his reform agenda at the first chance.

By Lucy Conger
December 2002
Institutional Investor Magazine

Three weeks after union leader Luiz Inácio Lula da Silva scored a commanding electoral victory and fulfilled, after three failed attempts, a lifelong ambition of becoming president of Brazil, reality intruded on his campaign promise to end the country’s grinding poverty. A November 12 government economic report revealed that inflation was running at an annual rate of nearly 7 percent, well above the 5.5 percent target for the year. Although the gap should be manageable, even a whiff of inflation brings back frightening memories of the 40 percent monthly price hikes that wracked Brazil’s economy in the 1980s and early 1990s.

The president-elect and his top lieutenants moved quickly to quash rekindled fears of hyperinflation. Though Lula, the candidate of the Partido dos Trabalhadores, had pledged to double the purchasing power of the minimum wage within the next four years -- a guaranteed crowd pleaser on the stump -- a few days after the report was released, José Dirceu, PT party president and a key Lula deputy, proposed a modest 15 percent hike that would take effect in 2003. The message: A Lula regime will fight to keep inflation in check.

The first leftist ever elected to rule Brazil, Lula has tried to reassure both foreign investors and local businessmen that he is no radical and that he has, in fact, moved solidly to the center. “Our administration will honor the contracts signed by the government, it will not overlook the control of inflation, and it will maintain a position of fiscal responsibility,” Lula said in a speech the day after he amassed a remarkable 63 percent of the October 27 runoff vote. “The hard crossing that Brazil faces requires austerity in the use of public money and an implacable fight against corruption.”

Whatever Lula’s real agenda may turn out to be after he takes office January 1, for his first year his hands will be tied, partly by International Monetary Fund loan constraints that demand, for release of $24 billion in IMF funds in 2003, a primary surplus (the budget surplus before interest payments) equivalent to 3.75 percent of GDP. He will also be bound by his own desire to calm foreign investors, whose capital Brazil so desperately needs. “The objective of the new government is to win investor confidence,” says Guido Mantega, an economic adviser to Lula since 1993 and a former budget director in the municipal planning department of São Paulo.

Although the incoming administration is expected to initially resist the temptation to boost government spending to stimulate growth, in his second year Lula will likely try to make good on some of the promises that helped him win such a resounding victory. His greatest ambition is to eliminate hunger, and the thrust of his economic policy will be to stimulate growth to create jobs, reduce poverty and lessen the nation’s economic inequality, which is among the worst in the developing world. (In Brazil the richest 20 percent of the population commands 63 percent of the country’s income, while the lowest 20 percent receives just 2.6 percent.) Many analysts fear that Lula will attempt to effect reforms that could threaten Brazil’s fragile financial stability.

“I see no contradiction between stability and growth,” Lula said during the campaign. “Growth has the virtue of increasing tax revenues and, therefore, improving public accounts. The nub of the question is to reduce interest rates, which impede greater growth of investments and GDP while increasing public debt.” Adds Mantega, “Inflation cannot return.”

For the moment, at least, Wall Street is reconciled to a Lula regime. During the campaign, foreign investors held out hope for a victory by José Serra, the right-center candidate endorsed by President Fernando Henrique Cardoso, long after polls showed Lula consistently holding a lead of 20 points or more. Indeed, in the first-round ballot on October 6, Lula nearly won the required 50 percent, taking 46.7 percent in a four-way race, double the 23.6 percent polled by Serra, his leading opponent.

At the height of investor anxiety, before the first-round presidential vote, spreads on Brazil’s benchmark C-bonds reached more than 2,400 basis points over U.S. Treasuries. After Lula’s strong showing in the first round, a sell-off in currency markets drove the real down to 3.99 to the dollar on October 10, a drop of more than 35 percent for the year. Beginning in mid-October, spreads began to narrow, and the real began to gain ground. By mid-November spreads had dropped to 1,655 basis points over Treasuries, and the real had strengthened to 3.56 to the dollar.

Says Abigail McKenna, a portfolio manager at Morgan Stanley Investment Management: “Investors seem willing to give Lula the benefit of the doubt because they have been actively trying to increase the risk and return potential of their investments. The market could go either way -- there is still a reasonable amount of uncertainty.”

Investors may be skittish, but the IMF handed Lula a firmer-than-expected vote of confidence. “The economic policies being proposed are very prudent and appropriate,” said IMF mission chief Jorge Márquez-Ruarte after a November 19 meeting in Brasília with Antônio Palocci, the chief of Lula’s transition team. “There is a golden opportunity for the PT,” Finance Minister Pedro Malan told a São Paulo newspaper. “If they give appropriate signals now regarding the future course of policies, there is an enormous space for an appreciation of the real.”

To be sure, Brazil confronts daunting economic problems that any president would be hard-pressed to resolve. The nation is saddled with an onerous public sector debt of $240 billion, the equivalent of 58 percent of GDP, and 80 percent is payable in the local currency. With 30 percent of the debt linked to the dollar and an additional 50 percent tied to short-term interest rates, the country’s ability to service its debt is vulnerable to shifts in currency values and interest rates. Brazil is running a current-account deficit of $9 billion, about 2 percent of GDP.

Attracting foreign capital and restraining inflationary pressures requires high interest rates, but such rates make it more expensive to finance the public debt. More significantly for the average Brazilian, they stifle economic growth and depress job creation. Balancing those competing claims will be a major challenge for Lula and his team. They argue that the spread on Brazilian bonds can fall to about 700 basis points with a stronger real once the specifics of the government’s agenda become known in early January. If investors extend more credit, they say, interest rates can fall.

Although Lula has not yet announced his full cabinet, he has identified two of the advisers who will help define his economic and political agenda. Both men were favorably received by local businessmen and foreign investors. In late November Lula announced that transition team chief Palocci, 42, will be tapped for a key cabinet post, most likely Planning or Finance minister. As the popular mayor of Ribeirão Prêto, a prosperous city in the state of São Paulo, Palocci named businessmen to his cabinet and sold off a 50 percent stake in the municipal telecommunications company to private investors. During the campaign the medical school graduate acted as a liaison to Brazilian businessmen and financiers. He also pressed for Lula to issue his June 2002 “Letter to the Brazilian People,” which for the first time committed Lula to uphold Brazil’s IMF obligations. It proved to be a decisive moment in the campaign. “The letter made the party legitimate,” says Delfim Neto, a conservative opposition congressman and former Finance minister.

The president-elect has also announced that Dirceu, his chief political operative, will take the job of his choice, probably chief of staff. President of the PT party since 1995, Dirceu was the leading force in nudging the party to the center, convincing his colleagues of the necessity of honoring IMF contracts and pursuing sound fiscal management. He also led the party to form alliances across the political spectrum.

Acknowledging that shift to the center, many businessmen rallied to the working-class Lula -- born in poverty, deprived of a high school education -- and they are cheering him on today as a leader whom they believe can spark economic growth without risking financial instability. According to United Nations statistics, Brazil’s economy would have to grow consistently at 6 percent a year until 2015 to reduce by half the poverty that afflicts 22 million Brazilians. Says Eugênio Staub, CEO of Gradiente Eletrônica, a consumer electronics company, “Lula impressed me as a self-made leader, and he’s very honest. He has no formal education, but he has a Ph.D. in Brazil, and he has emotional intelligence. That makes all the difference.”

Foreign direct investors in Brazil are more restrained, but some express guarded optimism about a Lula presidency. “If the external environment helps and the incoming government achieves the promised reforms, there can be moderate growth,” Antônio Maciel Neto, president of Ford Brasil, said at a November 18 meeting of the American Chamber of Commerce in São Paulo.

Of course Lula will need any and all votes of confidence as he tries to manage the burden of public debt, the current-account deficit and the constraints imposed by the IMF. These are real dangers, but they need not reach crisis proportions. Says Paul Krugman, a professor of economics at Princeton University and a columnist for The New York Times: “Brazil faces a serious risk of a self-fulfilling fiscal crisis, and it doesn’t have to happen. If the Lula administration can convince people it is sensible, it wouldn’t take much to turn the dynamic into a good dynamic.”

THE MAN AT THE HELM OF Brazil’s new government lived his first seven years in desperate poverty in the sertão, the country’s parched Northeast. As a young man Lula worked as a lathe operator and union organizer; in 1976, at age 31, he was elected president of the metalworkers union.

Four years later he founded the Partido dos Trabalhadores, which soon became the largest left-wing party in Latin America. Since the end of Brazil’s military dictatorship in 1989, the PT has gradually increased its popularity. It has moved slowly away from its radical roots -- early on it denounced foreign debt and threatened higher taxes on financial profits -- adopting more-centrist positions, including repudiation of debt default. “This is a post-Communist and postSocial Democratic party,” says Marco Aurélio Garcia, one of the founders of the PT and the longtime head of international relations for the party.

In recent years, notes Luiz Carlos Bresser Pereira, an economist with the Fundação Getulio Vargas in São Paulo and a former Finance minister under president José Sarney, PT administrations in 180 municipalities and three states “have been quite fiscally conservative. They know fiscal deficits mean weakening government.”

During the recent presidential campaign, Lula moved both his rhetoric and his platform to the center. He courted the industrial establishment by advocating a proposal to lift taxes on production and exports while stimulating import substitution and housing construction. In addition to naming textiles magnate José Alencar Gomes da Silva as his running mate, Lula met frequently with bankers and brokers. His visit to the floor of Bovespa, the country’s main stock exchange, made headlines and galvanized the business community. “It was like the collapse of the Berlin Wall,” says Raymundo Mogliano Filho, the exchange’s president, who believes that Lula has decisively broken with his radical past.

Under the wing of Duda Mendonça, a shrewd political marketer, Lula chucked his jeans and T-shirts and donned dark business suits. That was a superficial change, of course, but it symbolized a genuine shift in Lula’s philosophy, and in the end, it helped him win the mostly conservative middle class.

Still, the radicals in his party, who represent perhaps 30 percent of the membership, may soon be clamoring for a voice in his administration. Among the extremists are members of Movimento dos Sem-Terra, the landless rural workers movement, who invade country estates as a form of political protest.

Lula will face a different kind of pressure from the country’s state governors, who wield considerable power in Brazil’s political system. The PT did poorly in the state elections, winning only three of 27 governorships. In the wake of that showing, a group of eight opposition governors made a bid in early November to renegotiate the terms of the states’ debt payments to the federal government.

Under current law, the states must generate surpluses that, combined, total the equivalent of 1 percent of GDP, or nearly one fourth of the 3.75 percent federal surplus. Without their funds, the federal government would be forced to make up the shortfall, which is why Lula’s advisers publicly attacked the proposal. “A renegotiation would oblige the federal government to generate an even greater primary surplus,” says adviser Palocci.

The greatest pressure on Lula will come from the country’s massive debt. Servicing the loans will consume about 9 percent of GDP this year, Standard & Poor’s estimates. At the same time, Lula also hopes to raise social spending by $1.7 billion, on top of the roughly $7 billion a year budgeted by the Cardoso government.

An increase in exports would strengthen Lula’s hand. Thanks to the currency devaluation and a sharp drop in imports, Brazil’s trade balance is projected to reach $12 billion this year, up from $2.6 billion in 2001. A stronger trade surplus for 2003 seems likely.

The U.S., of course, is a critical trading partner, and Lula has made it clear that he will continue Brazil’s ongoing efforts to persuade Washington to eliminate trade barriers that impose tariffs on Brazilian orange juice and steel. The “good atmosphere” currently surrounding U.S.-Brazil relations should help at the negotiating table, says Lula adviser Garcia, an academic who spent ten years as Lula’s international relations adviser. “The U.S. government realizes that we are not trying to take any ideological problem to the government-to-government relationship,” Garcia says.

Lula’s transition team met with U.S. officials, including Otto Reich, now special envoy for the Western Hemisphere, in Brasília on November 21. Reich described the meetings as “very constructive, very positive.” He added, “We look forward to working with president-elect Lula’s government.” Lula and President George Bush are scheduled to meet for the first time on December 10 -- testimony, Reich says, to “the particular importance that the U.S. places on its relations with Brazil.”

On the domestic front, Lula supports a “mini” tax reform that would ease levies on production and exports. Says Luciano Dias, an analyst with de Goes e Consultores Associados, a political consulting firm in Brasília: “Forming a majority is not a formal problem in Brazil. It’s a problem of how much it costs.” The PT’s coalition with at least eight other parties falls short of a simple majority in Congress and lags even further behind the three-fifths supermajority Lula needs for constitutional amendments, which would be necessary for social security, labor and major tax reforms.

Even more politically fraught is Lula’s ambition to reform the government pension system. An entrenched presence in Brazilian society since 1962, the pay-as-you-go system mandates generous government pensions for 2.5 million public workers and runs at a deficit of more than $10 billion a year (Institutional Investor, September 2002).

Although foreign investors would applaud any real pension reform, they are for the moment far more concerned with the status of the central bank. Under Cardoso appointee Armínio Fraga, the bank has been both effectively independent and a force for monetary restraint, and investors hope that Lula names a moderate to replace Fraga.

Recalling the hyperinflation of the late ‘80s and early ‘90s, Brazilians of every class want prices to remain under control. But many urgently demand more jobs, better wages and more equitable income distribution. In a coffee bar off Avenida Paulista in São Paulo’s financial district, waitress Regina Mireilles Moreira, 44, voices a common refrain: “We voted for more jobs and better education. We voted for hope -- and for change.”

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