US embassy cable - 05BRASILIA2477

UNCLAS SECTION 01 OF 02 BRASILIA 002477 
 
SIPDIS 
 
NSC FOR CRONIN 
TREASURY FOR OASIA - DAS LEE AND FPARODI 
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 
AID/W FOR LAC/SA 
 
SENSITIVE 
 
E.O. 12958: N/A 
TAGS: ECON, PGOV, EFIN, Macroeconomics & Financial 
SUBJECT:  THE BRAZILIAN MACRO-ECONOMY: SOARING HIGH BUT NO 
NETS BELOW 
 
REF: A) Brasilia 2242, B) Brasilia 2467 
 
1. (SBU) Summary.  The past 30 days have seen a wealth of 
good news for the Brazilian economy as a number of fiscal, 
growth, and financial indicators are trending up.  Given 
this positive turn of events, some market watchers are 
beginning to wonder whether the conventional wisdom is 
correct - i.e., that direct involvement by the President or 
Finance Minister Palocci in the ongoing political scandal 
are key economic tripwires.  Without doubt, investors are 
correct in rewarding Brazil for establishing solid economic 
fundamentals.  But while we would like to sign on to the 
emerging theory that the economy is immune from political 
contamination, for now our preference is to wait and see 
where (and to whom) the scandal leads.  End Summary. 
 
2. (U) Notwithstanding the ongoing political scandal, the 
Brazilian economy is racking up some remarkable 
achievements.  Last week the Sao Paulo Stock Exchange 
(BOVESPA) hit another record high and is up 13.82 percent 
for the year.  The Finance Ministry has just successfully 
issued US$750 million in real-denominated Eurobonds (10 year 
maturity/13.8 percent annual interest rate).  Meanwhile, for 
dollar-denominated issuances, Brazil risk has fallen to its 
lowest level since 1997:  369 basis points.  The real has 
continued to strengthen against the dollar, with the 
dollar/real exchange rate dropping from 2.46 three months 
ago to 2.29 as of September 16).  Seasonally-adjusted 2d 
quarter GDP growth figures registered a healthy 3.7 percent 
increase over last year, up from 3.3 percent in the first 
quarter.  After a surge of inflation in the first semester, 
recent months of deflation have market watchers predicting 
the yearly total will come in at 5.2 percent - a hair over 
the government's 5.1 percent target.  Analysts forecast a 
2005 trade surplus of US$40.5 billion, up from US$32 billion 
in 2004.  And a recent UNCTAD study, ranked Brazil in fifth 
place as the preferred destination for multinational 
investment for 2005/2006, after China, India, the United 
States and Russia. 
 
3. (SBU) All this comes against the backdrop of a raging 
political scandal, which since it first erupted in May, has 
seen much of President Lula's inner circle resign, a massive 
loss of faith in the credibility of both Lula as well as the 
governing PT party, and the imminent demise of the 
controversial President of the Chamber of Deputies - 
Severino Cavalcanti.  To date, both foreign investors and 
domestic market watchers have coalesced around the argument 
that two scenarios might lead the ongoing political 
instability to infect the economy:  i.e., the replacement of 
Lula (via resignation, impeachment or electoral defeat) with 
a populist figure, or the departure of Finance Minister 
Palocci from the government.  Indeed, in late August when 
allegations of corruption touched Palocci, the dollar spiked 
and the BOVESPA fell.  Ref A.  However, Palocci's spirited 
denials, combined with the lack of documentary evidence to 
support the contract-skimming charges, ended up settling the 
markets and restoring public trust in his economic 
stewardship. 
 
4. (SBU) Over the past few weeks, a new theory has begun to 
emerge contending that the Brazilian economy is immune from 
scandal-related political contamination.  Most prominently 
enunciated in the September 14 edition of the leading 
newsweekly magazine Veja, this theory holds that the eleven 
years of responsible economic management since the 
initiation of the Plano Real in 1994 has institutionalized 
sound economic policies.  A continual reform process has 
opened up the economy and limited the ability of both the 
federal and state governments to spend beyond their limits. 
According to this line of argument, neither the public nor 
officials within the federal bureaucracy would brook a 
return to populist policies - given all the advances that 
have taken place during the 1994 to 2002 Fernando Henrique 
Cardoso administration and the first three years of the Lula 
administration.  Sound economic policies, in other words, 
now have a powerful constituency. 
 
5. (SBU) Palocci himself was one of the first to give voice 
to these sentiments.  During his late August press 
conference rebutting the allegations against him, he 
repeatedly declared that the health of the Brazilian economy 
does not depend upon his presence at the Ministry.  "No one 
is irreplaceable," he emphasized.  For his part, in remarks 
to foreign investors at a September 15 breakfast in New 
York, Lula made a similar point.  He stated that the ongoing 
investigations into political corruption would continue on 
their course and would not affect the economy.  Meanwhile, a 
number of market analysts, both foreign and domestic, are 
now openly wondering whether the political crisis will ever 
seep into the economy.  In September, the market shrugged 
off two separate allegations against Palocci and his 
brother, one involving property held by the Minister (which 
was supposed undervalued for tax purposes) and the other 
involving possible influence-peddling by the Minister's 
brother.  Ref B. 
 
6. (SBU) Comment.  While we agree that now more than ever 
acceptance of sound economic policies is entrenched among 
the Brazilian governing classes, we do not believe that this 
necessarily means that the debate over the country's future 
macroeconomic path is over.  First, while most here do not 
espouse the platform of the unrepentant left (i.e., 
restrictions on capital flows, price controls, unrestrained 
government spending), there are those here who still support 
these discredited recipes of the past.  Second, the reason 
that prudent policies have reigned over the past 11 years is 
because responsible political leaders have made it so. 
Should Lula (or his successor) abruptly decide to take a 
different approach, then all bets are off. 
 
7. (SBU) While the odds of an economic populist gaining the 
presidency are modest, given the current environment they 
cannot be discounted - and certainly are greater now than 
they were four months ago before the scandal erupted.   No 
one knows where the mushrooming scandal will lead or whom it 
might touch.  Should voters decide that conventional-style 
politicians have made a mess of things, they could well turn 
towards more populist figures.  Right now, the 
political/economic orthodoxy that will emerge after the dust 
settles is anyone's guess.  Like a bucking bronco, we'll all 
need to wait and see where this horse goes. 
 
CHICOLA