An uncertain role on centre stage

A lot is riding on Brazil’s success. It has always been the dominant economy in south America but until Argentina collapsed it did not have to play a leadership role in sustaining investor sentiment about the region. Today Brazil must rise to its economic challenges or be held responsible not only for its own stagnation but for sinking south America as an economically significant continent.

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Luiz Inacio Lula da Silva

The magnitude of the problems facing Brazil is clear from JPMorgan's list of country spreads in its EMBI+ bond index. Its spread is 838 basis points over treasuries, roughly the same as two countries only just coming out of default: Pakistan and Ukraine. It is 186bp wide of Turkey, 263bp wide of Russia and 565bp wide of Mexico or South Africa. It is 650bp wider than Poland, a country that has completely turned the tables on it, repaying $2.5 billion in bilateral obligations dating back to 1970s, when Brazil helped out Poland with export credits.
Clearly the financial markets have relatively little faith in Brazil's long-term prospects, despite their love affair with its present economic team.
To some extent the issue is geographical. Poland has benefited greatly from bordering on the EU and from its aspirations to join that union, and Mexico, with Nafta, has successfully leveraged its north American status. But other countries outside the big customs unions have succeeded where Brazil has failed.
Stanley Fischer, former managing director of the IMF and now vice-chairman at Citigroup, says: "There are some converging emerging-market countries, which have low spreads because their policies are good and they are likely to enter EMU; there are others with low spreads because policies are strong like South Africa, which is not heading to membership in any particular bloc, or Korea. And there are some countries that have good policies but are still struggling to get their spreads down to a reasonable, pre-growth level. Brazil is a leading example of the last group."

It's hard to pinpoint exactly what it is that makes the markets so nervous about Brazil. There is certainly some contagion from Argentina: investors are now nervous about heavily indebted countries. But other possible channels of contagion don't really apply: emerging-market debt in general hasn't been affected, Argentina's devaluation isn't going to make it more competitive internationally until it has some kind of banking system back in place for trade credits and the like, and there's no chance at all that Brazilian politicians in the upcoming election will look to Argentina as an example of how to break with the Washington consensus successfully.
The October elections are a worry, however. Investors' concerns are basically threefold. Their first and largest worry is that leftist populist Luiz Inacio Lula da Silva, universally known as Lula, will win the election outright and become president. After he lost in 1990, 1994, and 1998, the general consensus is that his working-class supporters are numerous enough to force him into a second-round run-off, but insufficient to give him the presidency. Brazil's growing middle class, the argument goes, is bigger now than it has ever been and will vote for anybody over Lula.
The second worry is that even if Lula doesn't win the presidency outright, Brazilian elections are always extremely volatile and unpredictable, and the polls will certainly look bad at some point. That, in turn, is going to cause consternation in the markets so there is good reason to avoid investing in Brazil until the election-related noise is over.
The final worry is that Fernando Henrique Cardoso's replacement - even if it isn't Lula - won't have the same degree of commitment to openness and reform that has been seen under the present administration. The situation in Brazil, where the presidency, finance ministry and central bank presidency are all held by highly respected economic reformers, is almost unique in Latin American history. Chances are that none of the three - Cardoso, Pedro Malan and Arminio Fraga - is going to remain in office long into 2003 and it will take time for their replacements, whoever they are, to get anything near the degree of international respect commanded by today's team.
Not a two-horse race
Besides, Brazilian elections are complicated and can't really be simplified to a race between Lula and some unspecified coalition candidate running on a platform of continuing Cardoso's policies. The leading contender at the moment for the job of being Lula's opponent in the second round is Roseana Sarney, the daughter of former president José Sarney. Her father's economic policies were far from orthodox and although she has surrounded herself with highly respected economic advisers, she might find some conflicts with vested interests on the business side within Brazil, which doesn't always want more openness.







Soy exports have doubled without subsidies but US protectionism hinders further growth

Similarly, Sarney's main opponent on the centre-right is José Serra, an old foe of Pedro Malan. There is a good chance that he could resort to protectionism and deliberate weakening of the currency in an attempt to drag Brazil out of its endemic current-account deficits.
There are any number of other candidates who still have more than enough time to emerge from the pack and win the election, including former president Itamar Franco, who forced Brazil's 1999 devaluation when he announced plans to default on the debt of Minas Gerais state. Another is Anthony Garothino, the popular (and slightly populist) left-of-centre governor of Rio de Janeiro state. After all in 1990 an obscure candidate from an obscure state who wasn't on anybody's radar screen five months before the election - Fernando Collor de Mello - ended up becoming president. In Brazil, anything can happen.
Whoever wins the election, the country's single biggest obstacle will remain its enormous current account deficit. Median forecasts for Brazil's current-account deficit run at about $20 billion in both 2002 and 2003. With privatizations drying up and expansionary tendencies among European companies being quashed, foreign direct investment is likely to be about $16 billion in both years - roughly half its level two years ago.
One of the main reasons for such a huge external financing requirement is that Brazil has a very low level of domestic savings, so most of its investment has to come from abroad. "In some Latin American countries there is a chronic savings problem," says Citigroup's Fischer. "I don't know how you [solve] it. Some countries turned to funded partly or wholly privatized pension schemes as a way of encouraging saving and helping build up the capital markets. In principle that could increase national saving. There has not been enough experience with such schemes to know how successful they will be."
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