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

C O N F I D E N T I A L SECTION 01 OF 04 BRASILIA 002149 
 
SIPDIS 
 
STATE PASS USTR FOR LEZNY/YANG 
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: 08/11/2015 
TAGS: EFIN ECON PGOV
SUBJECT: BRAZIL - POTENTIAL ECONOMIC SCENARIOS AS THE 
POLITICAL SCANDAL MOVES FORWARD 
 
REF: A. BRASILIA 1968 
     ¶B. BRASILIA 2082 
     ¶C. BRASILIA 1979 
     ¶D. BRASILIA 1874 
     ¶E. BRASILIA 1973 
     ¶F. BRASILIA 1631 
     ¶G. BRASILIA 2025 
 
Classified By: Charge d'Affaires Patrick Linehan, reason 1.4 (b) 
and (d 
). 
 
¶1. (C) Summary:  Financial markets have, to date, largely 
taken in their stride the interlocking set of vote-buying and 
corruption scandals currently engulfing Brazil's political 
class (ref A).  Several factors are working together to 
insulate the economy against the political turbulence, 
including the credibility of GoB macroeconomic policy, record 
liquidity flowing to emerging markets, Brazil's strong fiscal 
stance (5.1% of GDP primary surplus) and its continuing 
current account surplus (1.9% of GDP).  We see few 
indications that the markets' mood is changing.  Indeed, over 
the last two years Brazil has done much to reduce its 
vulnerability to shocks, both external and domestic. 
Nevertheless, Brazil's economy is far from invulnerable to a 
shift in market sentiment and could suffer should the 
scandals deepen or the country suffer a sharp external shock. 
 This cable looks at several possible political outcomes and 
the potential consequences for the economy with respect to 
each.  In neither of the two most likely scenarios (Lula 
remaining until the 2006 elections or his 
resignation/impeachment and replacement by Vice President 
Alencar) would we expect a sharp change in economic policy, 
reflecting the overall consensus among Brazilians in favor of 
orthodox economic policies.  While it is clear that 
Brazilians are fed up with the corruption of their political 
class, there is little evidence that they are calling for a 
sharp break with the current institutional framework and its 
economic policies.  Under no set of circumstances, however, 
is the microeconomic reform agenda, necessary to boost 
potential GDP growth, likely to be retaken until after the 
October 2006 elections.  End Summary. 
 
Scenario One: Weak Lula Remains until 2006 Elections 
--------------------------------------------- ------- 
 
¶2. (C) Our base case scenario is that Lula will serve out the 
remainder of his term, albeit in a severely weakened state. 
Former Chief of Staff Dirceu's decision to deny all in his 
recent Congressional testimony placed some distance between 
Lula and the main body of the scandal for a time, although 
more recent allegations are moving the spotlight closer to 
Lula (septel).  Despite Lula's weakened state and his 
diminished reelection prospects, multiple factors should help 
keep him from breaking sharply with the existing, orthodox 
economic policy line.  First, after eight years of sound 
economic policies under the previous Cardoso administration 
and three years of such measures under Lula, the majority of 
Brazilians, who still remember the "bad old days" of 
hyperinflation, support an orthodox policy line.  Indicative 
of this is the fact that Lula and his Workers' Party (PT) had 
to move to center on economic policy in order to become 
electable, and will need to remain there if they are to have 
any hope of reelection.  Second, Lula's closest remaining 
advisor, Finance Minister Palocci, has been the architect of 
this set of policies and analysts here believe he can be 
counted on to strongly resist any break with the current 
line.  Third, Lula's principal policy success to date has 
been the restoration of economic stability.  Few expect him 
to risk this achievement (and perhaps his legacy) by turning 
to populist solutions late in the game.  Indeed, many 
analysts expect GDP growth to pick up in the second half of 
2005, perhaps giving Lula a political boost as well. 
 
¶3. (C) Meanwhile, Lula's political weakness and the 
Congress's own lack of credibility look likely to prevent 
passage of major microeconomic reform legislation.  While 
this will not endanger economic growth in the short term, 
over the long-run it will condemn Brazil to a lower potential 
growth path until such time as political forces align to 
allow passage of tax reform, Central Bank independence, 
financial sector reform and expenditure reform (i.e. 
loosening constitutional earmarks).  As the markets already 
have written off the microeconomic reform agenda, we would 
not expect any sharp changes to their assessment at this 
point of Brazil risk.  However, some observers worry that 
Lula's political weakness will make it harder for him to 
fight off unhelpful (from the fiscal discipline point of 
view) congressional initiatives, such as the annual/current 
effort in the Senate to increase the monthly minimum wage to 
Reals 384 (about US$165), instead of the Reals 300 that the 
GoB proposed.  Another worrisome example is an amendment 
inserted into this year's budget directives law, which 
provides the broad framework for the drafting of the budget 
and which is still pending in Congress, that would restrict 
the Executive's discretion to freeze expenditures for 
pork-barrel projects sponsored by individual legislators (the 
so-called "individual amendments").  The GoB also recently 
approved a 23% pay raise for the military phased in over two 
years. 
 
¶5. (C) The area of most uncertainty in our base case scenario 
is what future GoB economic policies will come out of the 
October 2006 presidential elections.  Although Lula still 
remains popular, he is becoming increasingly vulnerable. 
Extended corruption investigations no doubt would lower 
Lula's poll numbers even further.  Any decision by Lula not 
to run in 2006, combined with his PT party's degraded image, 
would open political space for some of the more radical 
elements on the left.  Indeed, some polls show former Rio de 
Janeiro governor and erratic populist Anthony Garotinho 
(currently ineligible to run because of his own, unrelated 
scandal problems) of the PMDB picking up some of Lula's 
left-wing supporters in a Lula-less race.  Garotinho, 
however, would have to win against one of several credible 
PSDB candidates, including Sao Paulo Mayor Jose Serra (whose 
poll numbers have been strengthening), Sao Paulo Governor 
Geraldo Alckmin or Minas Gerais Governor Aecio Neves (son of 
the still popular Tancredo Neves).  Based upon their past 
records, these latter three would very likely embrace a 
continuation of the Cardoso/Lula orthodox policy line. 
 
Scenario Two - VP Alencar Succession 
------------------------------------ 
 
¶6. (C) The word "impeachment" floats in the air with 
increasing frequency in Brasilia.  While not calling for 
impeachment, even major news weekly Veja used the cover of 
its most recent edition to draw parallels to the period prior 
to the 1992 impeachment of President Collor on corruption 
charges.  Should Lula resign or be impeached, Brazil has a 
very clear constitutional mechanism for the transfer of power 
to the Vice President, Jose Alencar of the Liberal Party 
(PL).  The strength of Brazilian democratic institutions and 
the country's successful use of these mechanisms in the 
Collor case suggest the transition to a new president would 
occur without major difficulties. 
 
¶7. (C) Even in these difficult circumstances, there are 
reasons to believe that Vice President Alencar, although an 
outspoken and frequent critic of Brazil's current high 
interest rates, would not break sharply from Lula's orthodox 
economic policies upon taking office.  First, as is argued 
above, a majority of Brazilians support sound economic 
policies and demand such from their leadership.  Given his 
lack of experience in economic policy, Alencar would 
presumably turn to wiser heads for counsel -- with the likely 
candidates being responsible veterans of the Cardoso economic 
team or perhaps even former military government FinMin Delfim 
Netto (who is currently propounding a plan limiting 
government spending). Credit Suisse/First Boston (CSFB) chief 
economist Nilson Teixeira put the probability of Alencar 
pursuing orthodox policies at 70% in a recent conversation 
with Econoff.  Other observers, including the IMF resident 
representative, have echoed this assessment (without 
assigning probabilities).  Second, as was the case after 
Lula's election in 2002, Alencar would receive considerable 
pressure from the markets to support orthodox policies and 
would need to act quickly upon assuming the presidency to 
reassure investors.  Most of the Brazilian public and the 
Congress, likely would view Alencar as a caretaker until the 
next elections, limiting even further his scope of action to 
pursue a heterodox policy mix. 
 
¶8. (C) Given the caretaker nature of a putative Alencar 
presidency, we do not believe he would have the clout 
necessary to push the microeconomic reform agenda through 
Congress.  This would be no worse than under scenario one 
above, though, as the markets would have already discounted 
the chances of major reform before the 2006 elections.  Given 
congressional disarray in this scenario, however, we do not 
expect the Congress effectively to advance significant policy 
changes.  Instead, we look for Congress to erode fiscal 
discipline opportunistically where it can in support of 
individual members' re-election campaign efforts. 
Unfortunately, Alencar would be in an even weaker position 
than Lula to resist spending pressures originating in 
Congress.  Still, such erosion should not fatally undermine 
overall fiscal discipline given the healthy growth of tax 
revenues, the Executive Branch's discretion to sequester 
excessive expenditures, and Fiscal Responsibility Law (LRF) 
restrictions on the budget process. 
 
Scenario Three -- Lula Survives, but Opens Floodgates 
--------------------------------------------- -------- 
 
¶9. (C) This scenario, which we do not believe is likely to 
occur, posits that Lula, feeling threatened, decides to open 
the fiscal floodgates and abandon high interest rates in an 
attempt to shore up his congressional support base to survive 
politically or perhaps to stave off an impeachment effort. 
This would require the dismissal of the champions of these 
policies, Finance Minister Palocci and Central Bank President 
Meirelles, an event that markets would greet with sharp 
downturns.  (As Meirelles told D/NSA Shirzad in November 
2004, "if you see Palocci and me leaving the GoB -- watch 
out".)  Brazil currently is less vulnerable to external 
shocks than it was in the lead-up to the 2002 crisis of 
confidence sparked by the likelihood of Lula's election. 
Nevertheless, a protracted loss of faith by the financial 
markets likely would be characterized by a similar set of 
events to those that unfolded in 2002: sharp depreciation of 
the Real, capital flight, GoB difficulty in rolling over 
domestic debt (except at increased interest rates), spiking 
inflation, etc.  Such a financial crisis would doubtless play 
a big part in the 2006 election campaigns, with parties such 
as the PSDB campaigning for a return to orthodox economic 
policies. 
 
¶10. (C) Brazil has institutional safeguards limiting a 
president's ability to open the spending floodgates in 
scenarios such as this.  Foremost is the LRF, which requires 
that specific revenue sources be identified to fund new 
spending commitments.  These requirements can be manipulated 
to a degree (e.g. by unrealistically inflating predicted 
revenue flows in the budget), but since this requires 
congressional complicity, there are limits to what extent the 
safeguards can be undermined.  The LRF also prescribes 
criminal penalties for those who violate it, a fact that acts 
as a brake on the economic policy bureaucracy, which 
naturally tends to resist spending pressures. 
Scenario Four ) PT Splinters; A Thousand Flowers Bloom 
--------------------------------------------- --------- 
¶11. (C) Our last scenario, the probability of which is at 
this time difficult to assess, contemplates a discredited 
Lula causing the PT to disintegrate ) with the radical 
elements of the party joining forces with past PT refugees 
and other fringe elements to form a new leftist party. 
Figures like Senator Heloisa Helena (expelled from the PT in 
2003 for voting contrary to the party line) and Carlos Lessa 
(President of the National Development Bank until dismissed 
by Lula in 2004) would likely rally to this new political 
entity.  Freed from the shackles of Palocci-imposed economic 
orthodoxy, this amalgam might well embrace traditional 
leftist economic stances ) such as imposing a moratorium on 
foreign debt payments, increased corporate taxes, and 
combatative relations with the IFIs.   Should the 
disintegration of the PT generate market upheaval ) with the 
accompanying adverse affects on exchange, interest, and 
inflation rates ) public debate on these heterodox 
"solutions" could well begin in earnest.  This is not to say 
that any successor government to the Lula administration 
would adopt such measures.  As noted earlier, currently there 
is an extraordinary degree of societal consensus on orthodox 
economic policies.  With the moderate Campo Majoritaria wing 
of the PT reining in the party,s radicals, the left side of 
the political spectrum in Brazil embraces more or less the 
same macro-economic line as the center and the right. 
However, should the PT splinter and radicals regain their 
voice, while the consensus would not disappear, it would 
certainly fray. 
 
¶12.   (C) Although there is some risk that a Lula downfall 
could ultimately lead the left to unite around a less 
pragmatic figure than Lula, there is little reason to suspect 
that this reamalgamated left would be any more successful 
come election time than Lula was prior to his move to the 
political center.  This could change should the scandal 
become so deep as to undermine public confidence in the 
institutions of Brazilian democracy themselves, leading to an 
institutional crisis that creates space for some of the 
untainted politicians on the left.  So far, however, while it 
is clear that Brazilians are fed up with the corruption of 
their political class, there is little evidence that they are 
calling for a sharp break with the current institutional 
framework and its economic policies. 
 
LINEHAN