US embassy cable - 05BRASILIA2318

C O N F I D E N T I A L SECTION 01 OF 02 BRASILIA 002318 
 
SIPDIS 
 
STATE PASS USTR FOR LEZNY 
NSC FOR CRONIN 
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 
TREASURY FOR DAS LEE AND F.PARODI 
 
E.O. 12958: DECL: 08/28/2015 
TAGS: ECON, PGOV, EFIN, PREL, Macroeconomics & Financial 
SUBJECT: SENIOR PRIVATE BANKER ON BRAZIL'S POLITICAL SCANDAL 
 
REF: A. BRASILIA 2242, B. BRASILIA 2237, C. BRASILIA 2303, D. BRASILIA 2226 
 
Classified By: Economic Counselor Bruce Williamson, Reasons 1.4 
(b) and  (d). 
 
1. (C) Summary: In an August 23 conversation with Econoff, 
Banco Itau Executive Director Sergio Werlang, a leading 
financial markets expert and senior figure in Brazil's second 
largest private bank, dismissed market fears that Brazil's 
overall economic policy would change even if Finance Minister 
Palocci were forced to resign over allegations of financial 
misconduct during his tenure as mayor of Riberao Preto (refs 
A and B).  Palocci's tenure is of secondary importance, in 
Werlang's view, as Lula himself has made it clear over the 
course of this drawn-out political scandal, that he would not 
be opting for a populist policy course even in the face of 
sliding popularity levels (refs C and D).  Taking the 
argument a step further, Werlang stated that he is ever more 
convinced that even if Lula is impeached (a scenario which he 
assessed as only 30% probable) that there would be policy 
continuity under his successor and that the markets and 
Brazil's economy would handle the impeachment without 
significant disruptions.  End Summary. 
 
2. (C) Although the markets were unquestionably reassured by 
Palocci's credible denial of the allegations made against 
him, Werlang stated that he is personally more reassured by 
the fact that, as the political scandal grinds on, it has 
become obvious that Lula himself was not -- and in Werlang's 
view would not be -- opting for populist policies.  While 
Lula's recent speeches to workers' groups that contained 
definite populist overtones, Werlang affirmed that the 
markets would judge the Lula administration by its actions. 
For example, instead of opening the budget spigots, the 
administration had run a primary surplus of over 5.1% of GDP 
in the twelve months through July 2005 and was seriously 
considering increasing the formal primary surplus target 
(currently 4.25% of GDP) for the year to serve as an anchor 
during this period of greater market volatility.  Pointing to 
Lula's ultimate defeat of a congressional effort to raise the 
minimum wage, Werlang professed not to be worried that Lula 
would be unable to control congressional proposals for 
excessive spending. 
 
3. (C) Based on what is publicly known about the scandal and 
Lula's reactions thus far, Werlang assessed the probability 
that Lula would be impeached to be about 30%.  Werlang 
nevertheless stated that he is becoming more convinced that, 
even if Lula were impeached, Brazil's economy and financial 
markets would adjust without significant disruptions.  He 
acknowledged there would be volatility in the financial 
markets but argued these would be temporary hiccups.  The 
cornerstone of Werlang's argument was the recent statement by 
Chamber of Deputies President Severino Cavalcanti, an erratic 
populist who is second in line to replace Lula after Vice 
President Alencar, that if the presidency were to pass to him 
that he would fulfill his constitutional duties and call for 
an indirect, congressional vote to be held within 30 days to 
select a new president to serve out the remainder of Lula's 
term. 
 
4. (C) Looking at potential candidates in such an election, 
Werlang stated that some analysts interpreted a subsequent 
speech by former President and current Senator Jose Sarney as 
the platform upon which he would run.  Others had touted 
widely respected former Vice President (under Fernando 
Henrique Cardoso) Marco Maciel as a consensus choice. 
Werlang believed that Supreme Court President Nelson Jobim, 
whose name also has been mentioned in this context, would not 
run so as to keep open his option to try to seek the PMDB 
party nomination in the 2006 elections.  Any of these figures 
would be solid choices from the economic policy point of 
view, Werlang said, and the fact that the markets had time to 
game out these scenarios was "healthy" for stability during a 
transition. 
 
5. (C) The biggest potential fly-in-the-ointment for the 
markets and Brazil's economic stability, Werlang said, was 
that the Lula's political weakening and his slim chances for 
re-election opened political space for a populist candidate 
in the 2006 presidential elections such as former Rio de 
Janeiro State governor Anthony Garotinho.  While uncertain 
about the probability Garotinho would emerge as the PMDB 
candidate, he averred that it could not be discounted. 
(Note: currently, Garotinho is not eligible to make such a 
run as an electoral court judge stripped him of his political 
rights because of improper campaign practices in the October 
2004 municipal elections; Garotinho has appealed the verdict.) 
 
6. (C) Comment: We agree with Werlang that it bodes well for 
stability during a theoretical impeachment/transition that 
analysts have had time to game out these scenarios.  That 
said, international investors without detailed familiarity 
with the players and processes may be less reassured than 
Werlang.  We would therefore still expect a fair degree of 
volatility in any Lula impeachment or resignation scenario. 
Fortunately, Brazil's current solid economic fundamentals 
have given the Central Bank time to build international 
reserves.  Just as importantly, the Brazilian Treasury has a 
cash operating reserve equal to over three months of its 
financing requirements.  All this should reduce the impact of 
shorter term volatility. 
 
7. (C) While Werlang downplays the negative impact of any 
potential departure by FinMin Palocci on the economy, other 
analysts are less sanguine.  For instance, well-respected 
consultant Carlos Langoni sees Palocci's determination and 
influence with the President as "key for the success of the 
fiscal adjustment."  Without Palocci, he argues, the 
consequences would be higher country risk, increasing 
volatility, backward steps on inflationary expectations and 
postponement or suspension of much needed investment. 
Palocci, Langoni believes, is irreplaceable. 
 
DANILOVICH