Brazilians go to the polls in October to choose a president. This year’s elections are unlikely to be as frightening as in 2002, when the rise of Luiz Inácio Lula da Silva triggered a financial crisis that sent the real plunging, bond yields soaring and investors heading for the exits. Indeed, the outlook could hardly be more different this time around, even though the election’s outcome is far from certain.

Lula seemed invincible until a corruption scandal erupted last June. He has since lost ground in the polls and at least two opposition candidates appear to have a clear chance of victory. But investors remain bullish and keep pouring capital into Brazil.

“The electoral process is very different this year,” says Adauto Lima, head economist for WestLB in Brazil. “In 2002, there was concern that a radical candidate could be elected. Now there is little room for a radical outsider.”

While Lula has opted to postpone an official announcement of his candidacy for president, he is already in campaign mode. “The Brazilian economy will grow, income distribution will improve,” Lula promised recently. “Everything is in gear, everything is prepared and everything is set up for Brazil to have strong growth, strong income distribution and lots of jobs.”

Finance Minister Antonio Palocci agrees. “We are going to have strong growth in 2006.  Everything is in place: low inflation, an improved risk rating, balance of payments in a situation we’ve never seen before, real income growth, increased sales, more access to credit,” he said recently.

The director of the International Monetary Fund is also bullish on Brazil. “There won’t be any more lost decades, debt crises or emergency financial packages,” predicts Rodrigo de Rato, head of the IMF.

In spite of the general feeling of optimism, Lula’s reelection is not a done-deal; he will have to work hard to prove to the population that he deserves to keep his job.

“It is going to be a tight race, because of the political crisis. Fortunately the economy is no longer dependent on the political scenario,” comments Jorge Gerdau, head of steel giant Gerdau.

Serious Contenders
In the mean time, there are two serious opposition candidates – both from the centrist Social Democrat Party (PSDB). In the coming weeks, the PSDB will have to choose between São Paulo mayor José Serra, who lost to Lula in 2002, or São Paulo state governor Geraldo Alckmin, an effective administrator who lacks nationwide recognition.

Polls show that either candidate would give Lula and his leftist Workers’ Party a run for their money. The battle will only begin in earnest after the carnival holiday. “The PSDB is Lula’s biggest adversary and is just as likely to win at this point as Lula,” says Roberto Padovani, an analyst with Tendências, a consulting firm in São Paulo.

In addition to having run against Lula in Brazil’s last presidential race, Serra is well known throughout Brazil because of his role as Minister of Health under former president Fernando Henrique Cardoso. 

Alckmin, meanwhile, is a trained medical doctor with a friendly demeanor and high approval ratings as governor that – combined – could persuade the PSDB to choose him over Serra. Big names like Luiz Carlos Mendonça de Barros, the former head of Brazil’s BNDES development bank, have already signed on to the Alckmin team. Mendonça has rolled out a preliminary economic plan that he promises will reduce government spending and further open Brazil’s economy.

Paulo Vieira da Cunha, chief economist for HSBC Securities, thinks Alckmin has done an excellent job as governor. “He’s been a real leader on the fiscal side,” Vieira da Cunha says. In addition to substantially reducing the state of São Paulo’s debt burden, Alckmin has moved ahead with a series of important public works, including the São Paulo beltway and expansion of the subway line in São Paulo. He is also seen as tough on crime, which will doubtless continue to be a big campaign issue in the upcoming elections.

As for Lula, analysts agree he is likely to benefit from the past two years of economic growth, but they say he must deal with the fallout from a nasty political corruption scandal that gutted his administration last year.

“The Lula government has been tarnished by corruption and is seen as highly inefficient,” says Padovani. “His party needs to get organized and doesn’t have much time to do it.” Lula’s Workers’ Party, which has long touted itself as the only “clean” political party in Brazil, has been under investigation by Congress and the police for allegedly siphoning public funds from state-controlled pension funds and companies to pay lawmakers for support in Congress. The investigation also uncovered an off-the-books campaign finance scheme that prompted a crisis of conscience for the party.

Not surprisingly, Lula started loosening the government purse strings in the fourth quarter of 2005. In 2006, the government announced a 17% minimum wage increase – three times the annual rate of inflation. But even that bit of added spending isn’t causing investors to lose their nerve.

“Spending on social programs is likely to increase,” says Padovani, “but even if the primary surplus declined    to 4.25% of GDP it would still be sufficient to maintain investor confidence.” The primary surplus – before interest payments – was equivalent to 4.8% percent of GDP in 2005.

The bad news is that the government is unlikely to pass much-needed reforms this year given its weakened position and need to devote energy to defending itself against accusations of massive corruption. “The government doesn’t have a majority in Congress and is unlikely to get anything passed,” says Lima. “There’s no room for any reforms in 2006.”

Work Ahead
The federal government has yet to get its public/private partnership off the ground, which means that much needed investment in infrastructure has basically been sidelined. Other proposals, such as changes to higher education, an overhaul for the tax system, political reform and new guidelines for public pensions, have also been put off due to the political scandal. Even Lula’s poverty elimination programs have met with limited success and been plagued by irregularities.

There could also be more trouble ahead once the elections are over. With few exceptions, analysts caution that Brazil’s next administration, which takes office in January, will face a daunting series of challenges. Brazil needs to develop a coherent trade policy, rewrite its deficit-ridden social security system, cut the heavy tax burden and devise schemes that could help the economy grow at more robust rates.

Brazil needs higher growth rates if it wants to attract foreign direct investment (FDI). In 2005, FDI in the country declined 15% versus the previous year to $15.2 billion, while global FDI increased 29%.

José Carlos Grubisich, chief executive of chemicals company Braskem, recently complained to the media that Brazil gets zero attention on the world stage compared with China and India. “Brazil simply doesn’t have the accelerated growth that China or India have.” LF