This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 04 BRASILIA 000321 
 
SIPDIS 
 
SENSITIVE 
 
NSC FOR BREIER, RENIGAR, 
TREASURY FOR OASIA - DAS LEE AND FPARODI 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D 
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOS LON 
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE 
 
E.O. 12958: N/A 
TAGS: ECON PGOV EFIN SOCI BR
SUBJECT:  BRAZIL'S FISCAL RESPONSIBILITY LAW FACES FIRST 
REAL TEST 
 
REF: A) RIO DE JANEIRO 076, 
 
     B) 04 RIO DE JANEIRO 1261, 
     C) 04 RIO DE JANIERO 1773 
     D) BRASILIA 317 
 
¶1.   (U) This cable has been coordinated with Consulates Sao 
Paulo and Rio de Janeiro. 
 
¶2.   (SBU) SUMMARY.  Brazil's Fiscal Responsibility Law 
(LRF), a cornerstone of the nation's fiscal recovery, is 
facing its most serious threat since its enactment in 2000. 
The law, meant to enforce prudent government financial 
management, requires that outgoing elected officials not 
leave unpaid obligations for an incoming administration, and 
it subjects officials who fail to respect its requirements 
to criminal penalties.  Despite these provisions, reportedly 
over 2,000 of Brazil's 5,563 municipalities had uncovered 
obligations on January 1, when the new mayors were sworn in. 
The situation is testing the enforceability of the LRF 
across the country.  Most tellingly, the accounts left by 
outgoing Sao Paulo mayor Marta Suplicy, a leader in 
President Lula's own PT party, whose default on at least 
R$1.8 billion (about $660 million) worth of contracts with 
suppliers confronts Lula with a series of uncomfortable 
choices regarding enforcement of the LRF.  We see little 
chance, however, that the GoB will risk its hard-won fiscal 
gains with hasty reactions to the current outcry.  End 
Summary. 
 
The LRF - Cornerstone of Brazil's Fiscal Recovery 
--------------------------------------------- ---- 
 
¶3.   (U) The LRF was born of a general debt crisis in the 
late 1990s when several highly indebted state and municipal 
governments threatened again to default on their debts, 
forcing the GOB to step in to avert a general financial 
meltdown.  In return for assuming state and municipal bank 
debt, the GoB forced local authorities to acquiesce to 
several measures meant to place a "fiscal straightjacket" on 
state and municipal governments.  Originally passed in 2000, 
the law ties together a series of measures, often referred 
to collectively, although each has a separate legal basis. 
The first of these are the debt renegotiation contracts, 
signed between the federal government and the states and 
municipalities.  While the states and municipalities must 
repay the federal government for the debt it assumed on 
their behalf, payments are capped at 13% of revenues. 
 
¶4.   (U) The second measure is the Senate's constitutional 
authority to set ceilings on state and municipality debt. 
These limitations prevent highly indebted states and cities 
from taking on new bank loans.  The third leg of the stool 
is the LRF itself, which regulates financial administration 
and transparency.  In particular, the LRF requires that 
outgoing governors and mayors balance the accounts at the 
end of their terms, and not leave uncovered financial 
obligations for their successors.  A complementary statute, 
the law on fiscal crimes, establishes criminal penalties, 
ranging from prohibition on running for public office to 
four years imprisonment, for failing to respect the LRF's 
requirements. 
 
The Challenge:  New Municipal Leaders Find Empty Coffers 
--------------------------------------------- ----------- 
 
¶5.   (U) The January 1, 2005 swearing in of mayors and city 
councils elected in October 2004 was the first municipal- 
level transition after the LRF took effect in 2000, and 
consequently the first municipal-level test of the LRF. 
(NOTE:  LRF provisions were tested at the state level after 
the Brazil's gubernatorial elections two years ago.  Reftels 
discuss several examples of states in bad financial shape in 
2002 that have gotten their financial acts together.  END 
NOTE.)  Despite the provisions of the LRF, over 2,000 of 
Brazil's 5,563 municipalities reportedly had uncovered 
obligations on January 1 when the new mayors were sworn in - 
- and no money in the bank with which to pay.  Given the 
size of Sao Paulo's uncovered obligations alone (US $660 
million), the total may be over a billion dollars. 
 
¶6.   (U) Fortaleza, capital of the northeastern state of 
Ceara, for example, is facing significant unpaid 
obligations.  Newly arrived mayor Luizianne Lins (PT) 
reportedly found that her predecessor stopped paying city 
employees after the October elections, leaving the payroll 
13 million US dollars in arrears.  Lins, a maverick -- and 
outspokenly critical -- member of President Lula's Workers' 
Party (PT), came to Brasilia to plead, unsuccessfully, for 
federal assistance.  In Aguas Lindas in Goais state, the 
incoming officials have had to buy cleaning products for the 
office out of their own pockets.  Mixed in with the examples 
of financial mismanagement are horror stories of mayors who 
embezzled city funds in their final weeks in office, and in 
some cases even stole the computers that would help the new 
mayors (and prosecutors) assess the damage. 
 
Sao Paulo at the Center of the Storm (as usual) 
--------------------------------------------- -- 
 
¶7.   (SBU) The largest municipal fiscal shortfall -- and 
politically most difficult case -- is Sao Paulo.  Raul 
Velloso (please protect), an economist and financial 
consultant with ties to newly-inaugurated mayor Jose Serra 
and the Social Democratic Party (PSDB), told us that when 
Mayor Marta Suplicy (a PT leader close to President Lula) 
left office in December, she left behind substantial unpaid 
obligations to suppliers, which he estimated at R$1.8 
billion.  While Velloso acknowledged that Suplicy inherited 
R$1 billion of supplier debt from her predecessor, she took 
office before the LRF was enacted, he observed, and thus was 
on notice that she had to increase fiscal discipline. 
Instead, Velloso commented, Suplicy managed the city poorly 
and added to Sao Paulo's overall supplier debts, making it 
impossible for her to hand over the municipality with clean 
books. 
 
¶8.   (SBU) This failure would have been a clear violation of 
the LRF.  To avoid liability under the law, Velloso said, 
Suplicy defaulted on the R$1.8 billion in supplier credits 
by voiding the municipal payment obligations, thus taking 
advantage of what appears to be a loophole in the law. 
While the LRF clearly prohibits an elected official from 
leaving office with uncovered obligations, it does not 
specifically enjoin a municipality from defaulting on those 
obligations during a transition.  Outgoing Suplicy 
administration officials maintain that payments were 
suspended in late December only on services not yet 
provided, or which had not been accepted due to technical 
problems.  But, the contractors and the Serra administration 
claim that Suplicy failed to pay for services rendered and 
that there were insufficient funds left on hand to cover 
upcoming payment obligations. 
 
¶9.   (SBU) While the defaults are subject to legal 
challenge, Velloso pointed out that enforcement of judicial 
decisions requiring municipal payments is spotty at best. 
Even if recognized by a judge, claims based on court 
judgments do not count as supplier debt under the LRF 
definition.  Thus, Suplicy appears to have been able to 
leave office without violating the letter of the law while 
nevertheless bequeathing a financial mess of massive 
proportions to her successor. 
 
¶10.  (U) On January 31, losing mayoral candidate Paulo 
Pereira da Silva of the opposition PDT delivered a petition 
to the Sao Paulo state public prosecutor, Rodrigo Cesar 
Rebello Pinho, requesting that Suplicy be prosecuted for 
violation of the LRF.  According to press reports, da Silva 
stated, "If the law doesn't stick here, in Sao Paulo, it's 
not going to stick anywhere."  The PDT alleges a R$1.9 
billion deficit in the accounts.  Suplicy administration 
officials deny any LRF violation, claim that the end-of-year 
accounts contained R$ 376 million cash to cover outstanding 
obligations and dismiss the R$ 1.9 billion deficit estimate 
as including obligations which are not covered by the LRF, 
such as expenditures by municipal parastatals and city 
council expenses.  In a related action, PSDB city councilman 
Jose Police Neto will also file an action with the state 
public prosecutor charging the former mayor with financial 
irregularities due to the cancellation of payments on 
service contracts in late December.  The state prosecutor 
reportedly is reviewing both petitions. 
 
...While debt to the Feds Grows on Parallel Track 
--------------------------------------------- ---- 
 
¶11.  (SBU) Serra's penniless incoming municipal 
administration had to face an immediate threat on a parallel 
track: the city's debt to the federal government.  According 
to several accounts, Serra and Suplicy met immediately 
before Serra's inauguration with federal Finance Minister 
Palocci to brief him on the situation and request that the 
city's December debt payment to the federal government be 
postponed until mid-January.  Normally, missing a payment 
would result in the GoB freezing the city's assets or 
canceling federal transfer payments.  By all accounts, 
however, the Lula administration approved the "special 
consideration" and allowed the city to defer the December 
payment in order to cover other obligations.  Quizzed about 
the apparent preferential treatment being given to Sao 
Paulo, a Finance Ministry contact claimed to Emboff that 
there was legal basis for the decision (though not 
specifying what it was) and that the media was making too 
much of the situation. 
 
¶12.  (U) Another strand in this affair are the limits on 
municipal and state debts set by the Senate, which apply to 
bank debt as well as to the renegotiated debt to the federal 
government.  Velloso explained that Sao Paulo's situation 
had highlighted a technical problem with the manner in which 
overall debt stocks were indexed for inflation in the debt 
renegotiation contracts signed with the federal government 
in the late 1990s.  The negotiators chose to index the debt 
stocks using the IGP-DI index, a mixed consumer and 
wholesale inflation index.  The IGP-DI is much more 
sensitive to exchange rate swings -- of the sort Brazil 
experienced in 2002/2003 -- than Brazil's consumer price 
index (IPCA).  Municipal revenue growth, however, tends to 
be closely correlated with the IPCA.  This mismatch means 
that the growth in revenues has not kept pace with the 
growth in the debt stock over the last two years.  End 
result: Sao Paulo's debt will be about R$7 billion over the 
120% of revenues limit when the grace period for meeting the 
target expires in April.  Given the city's 2005 budget of 
R$15.2 billion, it would be impossible for Serra to reduce 
the city's debt by the R$7 billion necessary to meet the 
target.  Failure to meet the target would, in theory, 
restrict Sao Paulo from taking on new debt and allow the GoB 
to freeze transfer payments to the city. 
 
Comment - Uncomfortable Situation 
---------------------------------- 
 
¶13.  (SBU) The Lula administration is in a quandary.  The 
large unpaid obligations left by many outgoing mayors, 
coupled in many cases with blatant mismanagement or even 
outright embezzlement, has given rise to calls for strict 
enforcement of LRF penalties.  The presence of Sao Paulo at 
the center of this story, however, may limit the 
administration's options since, exploitation of loopholes 
aside, strict LRF enforcement would require that the GoB at 
least investigate Marta Suplicy's financial management.  In 
addition to causing intra-party heartburn, doing so would 
mean dragging the details of her (alleged) financial 
mismanagement through the media, undermining the PT's 
efforts to burnish its image as a fiscally responsible 
manager at the federal level.  Moreover, the sheer size of 
the Sao Paulo municipal budget, the fourth largest public 
budget in Brazil, might give the Lula administration pause, 
because proof of serious financial mismanagement and default 
could have a ripple effect throughout the financial system. 
The issue may get out of the administration's hands, 
however, should prosecutors take up opposition requests for 
an investigation. 
 
¶14.  (SBU) On a parallel track, the broad-based nature of 
the municipal financial difficulties has led to the most 
serious public questioning of the LRF's requirements to 
date.  Several measures are being floated in Congress to 
soften the debt ceilings or endorse special treatment for 
some municipalities, although none of these is likely to 
pass without the support of the PT.  However, the Lula 
administration cannot associate itself with calls to revisit 
the LRF's requirements (even where there would seem to be a 
legitimate case for doing so, such as the indexation 
mismatch problem).  Doing so, in the words of the IMF 
Resident Representative, would be perceived by the 
international financial markets as "playing with fire."  The 
GoB also must tread cautiously with Serra, who is in a 
position to embarrass the PT with revelations of Suplicy 
mismanagement.  Serra has been surprisingly circumspect to 
date, perhaps hoping to make a deal with the federal 
government.  But giving Sao Paulo (further) special 
treatment might undermine the LRF's credibility. 
 
¶15.  (SBU) The good news is twofold.  First, despite these 
political conundrums, we have seen no evidence -- including 
during the Ambassador's February 1 meeting with Palocci (Ref 
D) -- that the GoB is prepared to risk Brazil's hard-won 
fiscal adjustment with hasty reactions.  Second, when the 
GOB remained firm two years ago with newly elected governors 
-- who also clamored for exceptions and special treatment to 
overcome their inherited financial problems -- the states 
ultimately buckled down and began putting their financial 
houses in order. 
 
DANILOVICH