Brazil’s New Leadership

It took Luiz Inacio Lula da Silva, a former shoe-shine boy who never earned a high school diploma, four attempts to become president of Brazil. But the personal and political struggles that he has waged to reach the top may seem mild compared to the problems he now confronts.

 

Wharton faculty members and analysts who specialize in Latin American economies say that Lula, as he is popularly known, must find a way to prevent Brazil from defaulting on its debt and keep the world s ninth largest economy from going the way of Argentina, Brazil s crisis-stricken neighbor.

 

They say that da Silva, 57, may very well rise to the occasion, despite fears on the part of many investors that the election of Brazil s first president from a left-wing party would spell catastrophe for the economy. But da Silva will have to walk a fine line between his populist history and his newfound responsibility as head of the world s fourth-largest democracy, a job that can require tough economic decisions that may not sit well with his traditional leftist allies. Financial markets had been leery for months about a pending da Silva victory. As proof, look no further than the real, Brazil s currency, which has lost some 40% of its value against the dollar this year, despite rising a bit since the election on Oct. 27.

 

Wharton management professor Gerald A. McDermott says apprehension about da Silva has been  overblown. Although some investors worried about da Silva s election, McDermott notes that  there are other people on Wall Street who believe that da Silva is the right man for this time.

 

Walter Molano, who follows developments in Latin America as head of research for BCP Securities in Greenwich, Conn., says da Silva  is the best man that could have been elected. I know a lot of people in the marketplace were & leery about him but that s probably because not a lot was known about him. His leftist rhetoric, his leftist history, the fact that he comes from the Workers Party, scared a lot of people. But I think he s the best for the market.

 

Ana Eiras, a Latin American policy analyst at the Heritage Foundation in Washington and a native of Argentina, reacted to da Silva s landslide victory over Jose Serra, the current health minister, with neither  fear nor pessimism. Politicians who were on the far left in the 1970s and 1980s have moved toward the center in recent years, she says.  Our world is so integrated nowadays  with the Internet, new technologies, more trade  that few countries can really afford to be closed up to the rest of the world. So my attitude is more  wait and see. Perhaps [political leaders] like Lula would engage in redistributing wealth, extending the budget and so forth if they could, but now their choices are very narrow, given the growing recognition on the left that economic stability is key in countries with troubled economies.

 

According to Wharton finance professor Armando Gomes,  the election shows that Brazil has a mature democracy in which there is true political competition. You now see the Workers Party becoming really important in Brazilian politics. Gomes anticipates positive developments coming out of that competition.  If Lula doesn t do a good job in the next four years, at least people can expect better things from other parties.

 

Da Silva appears to have taken the correct public posture on economic issues since his election to allay any concerns the financial markets may have had about his rise to power.  He s been moderate and has said he won t repudiate the debt, says Wharton finance professor Richard Kihlstrom, who spent several weeks as a guest lecturer last summer at Getulia Vargas Foundation, a management school in Rio de Janeiro.  Those are the kinds of things that investors have been looking for. If you re an outside investor and you re thinking of investing in Brazil, you don t want to lose your investment. That s a big concern given what s happened in Argentina where the Spanish banks have taken huge losses as a result of the repudiation of Argentina s debt.

 

The Debt Burden

Indeed, Wharton faculty and others say that Brazil s debt is the most significant challenge facing the president-elect, who will take office in January. Default could lead to a recession and economic chaos.

 

The Brazilian government announced on Oct. 31 that the country s net debt load stood at a record 63.9% of GDP in September, or 885.19 billion reais, up from 58.1% in August. During the same period, the gross debt burden increased from 77% to 84% of GDP. Nearly half of Brazil s debt is either linked to or denominated in dollars. It has been estimated that at least 50%, and perhaps as much as 65%, of the country s debt is held by domestic banks and pension funds.

 

 The biggest holders of this domestic debt are the local banks, and they have a very strong loyalty to Serra, Molano says.  Lula never had their support and has no loyalty to them. If Serra had been elected, he would have gone out of his way to help the banks and the domestic debt issue probably at the expense of the external debt-holders. That s one reason I m glad Lula won the election rather than Serra.

 

One way to stave off default is to take measures to grow the Brazilian economy by 4% to 5% annually, according to those interviewed. But it is unlikely that Brazil can achieve those kinds of figures, at least for now.

 

 In the last five or six months the depreciation of the real has increased the burden of the debt, and in this respect Lula has almost no choice but to implement policies that generate growth, explains Eiras.  If Brazil doesn t generate growth, it runs a serious risk of getting into default. In August, the IMF gave Brazil a [$30 billion] loan package with a whole list of conditions attached to it. Many experts in Brazilian debt say even if Brazil right now met all of the IMF conditions & it will still need a significant amount of growth in order to sustain the debt payments.

 

Because growth of 4% or 5% is not in the cards anytime soon, there has been some discussion of making the debt easier to manage by forcing debt holders to accept a restructuring plan.

 

Another big issue: how to curtail government spending. It remains unclear just how committed da Silva is to fiscal discipline. At the same time that da Silva has promised to keep spending in check, he also has promised to boost spending on education and health care, increase the wages of civil servants and ensure that everyone in Brazil has three meals a day.

 

 Brazil can decrease fiscal costs in two ways: one is to inflate the economy, the other is to redo nominal interest rates, says Wharton s McDermott, who also is a research fellow at the IAE Business and Management School in Buenos Aires.  There s a belief they re going to do both. Allowing inflation isn t necessarily a bad idea because some believe that the government s current economic team has way overshot on keeping inflation down at 5% or less by keeping interest rates high. Lowering interest rates may allow them to reactivate the economy.

 

Banks may not take kindly to such a policy, fearing that lower rates will weaken their balance sheets and reduce their profitability, but McDermott believes that such a move can achieve positive results without igniting a banking crisis.

 

Molano agrees.  That s the biggest thing: to reduce rates. They should continue the reform process, streamline the tax code  and not much more than that. Da Silva and his team will have a good chance of maintaining economic stability and keeping investors calm  if they stay the line and hold their course, and as long as Lula does not do anything extreme. If he starts to restore his link with [supporters of radical land reform], that would be very scary. If he starts talking rhetoric about nationalizing companies, asking for debt forgiveness  those would be scary statements for me.

 

The Free Trade Factor

Brazil s economy has a lot of potential and achieving stronger growth is only possible if the country becomes more receptive to free trade, says Eiras, one of the co-authors of Heritage s annual Index of Economic Freedom, done in conjunction with the Wall Street Journal. The index ranks 161 countries on how well they embrace free-market principles. In addition, growth must be accompanied by structural reforms. Brazil ranked 79 in the 2002 index, its economy classified as  mostly unfree.

 

 With Brazil one clearly can see a very closed economy in terms of its trade and investment climate, Eiras says.  Brazil gets away with a lot of anti-market [policies] because it s a huge market. You will always find investors who find it profitable to go to Brazil regardless of the environment. But to generate the growth it needs it will have to trim the bureaucracy it has. It will have to create a much more friendly business environment, not just for foreign investors but for local businesses. It will have to put some serious effort into controlling its fiscal budget. It will have to streamline taxes. But, most importantly of all, it will have to open itself up to trade.

 

Molano believes that da Silva s history as a leftist may work to his benefit at least in one way.  The expectations for Lula are so low that anything he does, as long as it s not a catastrophe, is good and will be OK with the markets. With Serra, anything he had done would be seen as [inadequate]. It s definitely an expectations game.

 

McDermott notes that the Workers Party has a good record in governing some provinces and large cities. One of the best-managed municipalities is Porto Alegre, a city of three million that has a high standard of living relative to other parts of the country and whose government is fiscally prudent.

 

Molano calls the election of da Silva  a very important opportunity for Brazil to demonstrate to the world that it can cycle through the political spectrum without abandoning its macroeconomic model. We ve had the threat of Lula for the last 13 years. Well, now Lula is there. If Lula doesn t do anything extreme, there s no reason not to trust Brazil in the long run. This is a historic moment for Brazil. Whether they realize it is another matter.

Adds McDermott:  They have a long way to go because Brazil is a mess politically. There are hundreds of parties. Lula will not have a majority in congress; no party does. He ll have to cut deals with the right to get things done. There are many checks on him. It s difficult for him to exert his authority in any unilateral way. Not only has he moved to be much more centrist, but there s an awful lot of political and institutional constraints on what he can do & People are looking for an articulation of what it means to be progressive in Latin America and govern. At this very difficult moment, the question is can this guy come in and articulate another important chapter in the economic and social development of the country. That s why everybody will be watching him.

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