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P 281325Z MAR 06
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 4938
INFO RUEHRG/AMCONSUL RECIFE 4519
RUEHSO/AMCONSUL SAO PAULO 6633
RUEHRI/AMCONSUL RIO DE JANEIRO 1765
RUEHMN/AMEMBASSY MONTEVIDEO 6137
RUEHAC/AMEMBASSY ASUNCION 5311
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RUEHCV/AMEMBASSY CARACAS 3166
RUEHPE/AMEMBASSY LIMA 2902
RUEHLP/AMEMBASSY LA PAZ 4450
RUEHSG/AMEMBASSY SANTIAGO 5403
RUEHQT/AMEMBASSY QUITO 1757
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RUEHC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RHEHNSC/NSC WASHDC

C O N F I D E N T I A L SECTION 01 OF 05 BRASILIA 000608 
 
SIPDIS 
 
SIPDIS 
 
NSC FOR CRONIN 
TREASURY FOR OASIA - DAS LEE, 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/SHUPKA 
STATE PASS USTR FOR SULLIVAN/LEZNY 
STATE PASS USAID FOR LAC 
 
E.O. 12958: DECL:03/28/16 
TAGS: ECON PINR PGOV ETRD PREL EFIN BR
SUBJECT: BRAZIL - AN EARLY LOOK AT ECONOMIC ISSUES IN THE 2006 
PRESIDENTIAL CAMPAIGN (C-AL6-00372) 
 
REF: A) STATE 39813 
 
      B) BRASILIA 0546 
      C) 05 BRASILIA 0521 
 
Classified by Economic Counselor Bruce Williamson, reasons 1.4 
(b) and (d). 
 
¶1. (C) Summary: In sharp contrast to Brazil's 2002 presidential 
election, in which Lula da Silva and the leftist Workers' Party 
(PT) emerged victorious, the 2006 presidential elections carry 
much less uncertainty about future economic policies.  Lula has 
established a surprisingly strong record of orthodox 
macroeconomic management and pursued, albeit with less success, 
necessary microeconomic reforms.  His principal opponent in the 
elections, Sao Paulo Governor Geraldo Alckmin, of the opposition 
Social Democratic Party (PSDB), also has a record of sound 
fiscal management at the state level.  While not an economist, 
Alckmin has called for a "capitalism shock" to boost economic 
growth and has begun to gather around him a team of advisors 
that includes players from the Fernando Henrique Cardoso 
administration.  Although neither Alckmin nor Lula (who has not 
yet formally declared his candidacy) has elaborated an electoral 
platform, from the point of view of macroeconomic policy both 
look like candidates of continuity.  But there are differences 
in their likely agendas for microeconomic reform, some of which 
will affect U.S. interests, such as trade liberalization.  How 
much of their agenda either candidate will implement will depend 
in large part on their mandate and the coalition politics of the 
next Congress, both of which remain big unknowns.  End Summary. 
 
¶2. (C) This cable is a partial response to ref A request 
(C-AL6-00372).  Septel will address political issues. 
 
PSDB's Alckmin not an Economist, but a Capitalist 
--------------------------------------------- ---- 
 
¶3. (C) Raul Velloso, a prominent fiscal expert linked to the 
opposition Social Democratic (PSDB) party, shared with Econoff 
his reflections on the economic policies that Sao Paulo Governor 
Geraldo Alckmin would likely pursue if elected, as well as his 
views of what a potential second Lula term would look like. 
Velloso confirmed press accounts that Alckmin has consulted him 
on economic issues and that he has become one of the Governor's 
regular tutors, helping Alckmin, who is a medical doctor by 
training, puzzle through complex economic issues.  Velloso 
stated that Alckmin has made a point of consulting widely with 
the leading economists in the PSDB, including many members of 
the administration of former President Cardoso.  Other analysts 
have noted Alckmin's closeness to the Sao Paulo business 
community, and in particular the Sao Paulo State Industry 
Federation (FIESP). 
 
¶4.  (C) Velloso labeled Alckmin a "traditional" politician, 
albeit a "serious, well-intentioned" one.  He loves to wade into 
crowds and knows how to connect with people, Velloso affirmed. 
As Governor, Alckmin established a strong record of fiscal 
discipline, effectively containing costs.  Alckmin, however, 
does not have an instinctive feel for the bigger-picture 
macroeconomic issues he would face on the presidential campaign 
trail.  By contrast, he easily perceives the political 
consequences of policies, quickly understanding what interest 
groups stand to gain or lose from a given economic policy 
stance, according to Velloso.  Alckmin, for example, easily 
identifies the political costs of maintaining high primary 
surpluses, Velloso noted, but like many politicians, he has 
difficulty understanding the linkages between fiscal and 
monetary policy and their implications for the contentious issue 
of high real interest rates in Brazil.  Alckmin nevertheless is 
 
BRASILIA 00000608  002 OF 005 
 
 
tenacious in seeking to understand important economic issues, 
Velloso said. 
 
Alckmin - Managerial Decision-Making Style 
------------------------------------------ 
 
¶5. (C) Velloso judged that Alckmin's personal traits and 
preferences make his approach to economic decision-making 
reminiscent of former President Fernando Henrique Cardoso, who 
relied on the majority opinion among his advisors.  Other 
observers, including the IMF resident representative, have 
echoed this assessment, noting that one of Alckmin's strengths 
is his ability to select good advisors.  Indeed, economic 
counsel is one commodity that the PSDB does not lack; the party 
counts among its members many of the prominent orthodox 
economists in the country.  According to the press, Alckmin in 
recent weeks has held discussions with notable PSDB economists 
Edmar Bacha, Arminio Fraga and Luiz Carlos Mendonca de Barros. 
Bacha, a well-known professor of economics at the Catholic 
University of Rio de Janeiro (PUC-RIO, a common point of 
reference for many PSDB economists), became part of the team 
that launched Cardoso's "Real plan" and later served as 
President of Brazil's Social and Economic Development Bank 
(BNDES).  Fraga is best known for his role as president of the 
Central Bank from 1999 to 2002. 
 
¶6. (U) According to press reports, Alckmin also frequently 
consults Yoshiaki Nakano on fiscal issues.  Nakano, a professor 
at the Sao Paulo branch of the Fundacao Getulio Vargas (FGV), is 
credited with cleaning up Sao Paulo state finances as an aide to 
Alckmin's political mentor, the late governor Mario Covas. 
Mendonca de Barros, another former BNDES president known to be 
close to the Sao Paulo business community, is singled out by 
another press report as having become one of Alckmin's economic 
advisors. 
 
Macroeconomic Continuity 
------------------------ 
 
¶7. (SBU) The direction of the economy under an Alckmin 
government may not differ that much compared to Lula.  In 
Brazil, the embrace of sound macroeconomic policies is no longer 
particular to one specific candidate or party, but instead has 
become institutionalized, JP Morgan President Charles Wortman 
declared to Econoff on March 20.  This, along with Brazil's 
solid macroeconomic fundamentals and continued strong 
international liquidity, was the reason financial markets barely 
blinked on March 16 when yet another witness accused Finance 
Minister Palocci of involvement in illicit activities. 
Financial market participants expect continuity of policy even 
were Palocci to depart, Wortman affirmed, because the healthy 
economy has been Lula's biggest accomplishment.  (Note:  On 
March 27, Finance Minister Palocci did indeed resign.  See 
septel for further analysis of the implications of Palocci's 
exit for the Lula government.)  IMF Resident Representative Max 
Alier likewise assessed that Lula would maintain the same 
overall policy stance for the remainder of his term and, if he 
were re-elected, during his second term. 
 
¶8. (SBU) While Alckmin has a clear track record of strong fiscal 
management, there is less basis upon which to evaluate his views 
on monetary policy.  The IMF's Alier expressed confidence to 
Emboff that while he lacked formal economic training, Alckmin 
would heed sound advice.  Among the economists that Alckmin has 
been consulting frequently, none is publicly advocating 
significant changes to the monetary policy framework.  All would 
maintain the Central Bank's inflation targeting regime, although 
Mendonca de Barros, arguing that Brazil is currently is in a 
 
BRASILIA 00000608  003 OF 005 
 
 
virtuous cycle of low-inflation growth, believes the Central 
Bank could be much more "flexible" in bringing interest rates 
down.  He has called for real interest rates to fall to 5 
percent by 2009. 
 
¶9. (SBU) CSFB Chief Economist Nilson Teixeira voiced some 
concerns to Econoff in a March 17 conversation that the Finance 
Ministry's steely fiscal discipline might fray around the edges 
during the remainder of Lula's administration (or in a second 
Lula administration) were Lula to name a political figure as 
finance minister.  (Currently, its unclear whether Palocci's 
replacement, Guido Mantega - previously Lula's Minister of 
Planning and President of the National Development Bank - fits 
that bill or not.)  Teixeira worried that in this scenario, and 
with senior technocrats such as Treasury Secretary Joaquim Levy 
set to leave the ministry, there would no longer be a voice of 
fiscal restraint within the Finance Ministry. 
 
Lula II - Less of a Mandate for Reform 
-------------------------------------- 
 
¶10. (SBU) Lula has accomplished more on microeconomic reform 
than anyone would have expected in 2002 but far less than his 
administration set out to do (ref C).  Lula made an early 
positive mark in 2003 by obtaining passage of social security 
reforms that stabilized the deficit in the public employees' 
pension system.  The GoB also undertook tax reform in 2003, 
making the PIS and COFINS taxes more VAT-like.  In 2004, the GoB 
achieved Congressional passage of a new bankruptcy code, a 
legislative framework for public-private partnerships in 
infrastructure investment, and a controversial overhaul of the 
regulatory framework for the energy sector.  An important set of 
judicial reforms also was enacted, which included measures that, 
over time, should improve the predictability of the judicial 
system. 
 
¶11. (SBU) In early 2005, the PT bumbled its way to losing 
elections for the speaker of the Chamber of Deputies.  Since 
then, very few administration priorities have made it through 
Congress.  The ongoing political scandal over vote buying, 
influence peddling and irregular campaign financing erupted soon 
after that, further reducing Lula's ability to move legislation 
through Congress.  Since May 2005, the only microeconomic 
legislation to pass has been a set of targeted tax benefits for 
exporters which garnered enough industry support to skate 
through Congress. 
 
¶12. (SBU) Reflecting wryly on Lula's surprising rebound in the 
opinion polls, Velloso said that the PSDB had allowed itself to 
believe that its choice of presidential candidate would 
determine the next president.  Lula, however, had successfully 
cleansed his image by shifting blame to the PT for the 
interlaced corruption, vote buying and influence-peddling 
scandals that engulfed his administration in the second half of 
¶2005.  That approach -- combined with Lula's personal charisma 
and carefully managed public appearances -- had allowed Lula to 
convince his core constituency that he was above the scandal. 
Velloso argued, however, that Lula's strategy, while opening up 
the possibility of reelection, nevertheless carried significant 
risks.  Principal among these, Velloso believed, was the 
weakening of the PT and a strong possibility that Lula would 
have less of a mandate in the second term.  In addition, Lula 
would have to rely even more on coalition partners, as some 
analysts here predict that the scandal-tainted PT could elect as 
few as 50 federal deputies (out of 513 total) in the upcoming 
October elections.  Velloso therefore predicted Lula would have 
at best limited success in pursuing the microeconomic reform 
agenda necessary to improve productivity and growth rates. 
 
BRASILIA 00000608  004 OF 005 
 
 
 
Alckmin vs. Lula on Micro Reforms 
--------------------------------- 
 
¶13. (C) Below are some of the principal microeconomic issues the 
candidates will have to deal with: 
 
Trade Liberalization -- While the GoB has engaged constructively 
in the WTO Doha round, the GoB has allowed negotiation of the 
Free Trade Area of the Americas (FTAA) to languish.  When 
unscripted, Lula has gone so far as to say that FTAA is not on 
his agenda.  Velloso assessed that an Alckmin administration 
would be much more likely to seek to reenergize the FTAA 
process.  In public comments, Alckmin has stated that he 
believes Brazil needs trade liberalization to boost 
competitiveness and specifically mentioned renewing FTAA 
negotiations as a priority.  On process issues, FIESP contacts 
have told us that Alckmin would reorganize the GOB's 
decision-making apparatus to take responsibility for trade 
negotiations out the hands of entrenched diplomats at the 
Foreign Ministry and lodge it with a newly-created interagency 
body (very much equivalent to USTR). 
 
Tax Reform -- the Lula administration changed the PIS/COFINS 
taxes in 2003 to make them more VAT-like.  While it had planned 
a badly needed overhaul of the state-level VAT system (ICMS), 
political considerations forced the GoB to abandon this effort. 
Unable to pursue broader based reforms, the Lula administration 
instead enacted several targeted tax measures, aimed variously 
at promoting exports, fostering innovation, developing real 
estate markets, creating new financial market products and 
facilitating capital equipment upgrades.  Velloso stated that 
Alckmin likely would pursue broad-based tax reform, which 
necessarily would include a reduction in mandatory transfers to 
state governments to allow the federal government to reduce 
taxes. 
 
Social Security -- The social security system deficit is growing 
despite previous efforts at reform.  A big part of the problem 
this time, according to Carlos Mussi of the UN Economic 
Commission for Latin America (ECLAC), is that the Lula 
administration granted substantial real increases in the minimum 
wage in 2004 and 2005.  As pensions are by law indexed to the 
minimum wage, social security accounts have suffered.  Given the 
potential political down-side of tinkering with social security 
during an election year, we anticipate that both candidates will 
largely remain silent on this issue during the campaign and only 
reveal their true agenda after the election. 
 
Interest Rates -- Brazil's high real interest rates are likely 
to be the most controversial economic issue of the campaign. 
Alckmin's stance, however -- that the government's borrowing 
requirement must be reduced through expenditure cuts in order to 
allow interest rates to fall -- differs little from what Lula 
would have to do if he is reelected.  (Very likely, a 
constitutional amendment would be required to do away with 
constitutional earmarks and allow the GoB to reduce 
non-discretionary spending.)  Neither candidate has, to date, 
mentioned the need to reform the directed credit system (for 
example, to agriculture at low interest rates), which 
effectively increases interest rates for all other borrowers. 
 
¶14. (C) Comment: The fact that an unabashedly pro-business 
candidate like Alckmin may have difficulty differentiating his 
economic agenda from that of the nominally leftist President is 
illustrative of how little uncertainty exists on the overall 
economic policies to be followed in Brazil after this election. 
This reflects in part the societal consensus in favor of sound 
 
BRASILIA 00000608  005 OF 005 
 
 
macroeconomic management that the still-present memory of 
hyperinflation past has helped to create.  It also shows the 
degree to which many reforms have become institutionalized, 
particularly those introduced by the fiscal responsibility law. 
How much of his microeconomic reform agenda either candidate 
will in fact be able to accomplish is an open question, which 
will depend to a significant degree on post-election coalition 
politics. To date, the principal economic policy difference 
between the two that stands substantially to impact USG 
interests is Alckmin's stated emphasis on re-energizing FTAA 
negotiations. 
 
LINEHAN