Financial markets are beginning to panic because Luiz Inácio Lula da Silva, the veteran candidate of the Workers Party might win the October presidential elections. In fact, markets and the Brazilian people face some unhappy choices whether he or the government’s candidate José Serra wins.
The danger facing Brazil’s financial system is the growing size of the national debt. The debt as a proportion of GDP has risen inexorably, from 49% in 2000 to 55% in March 2002, according to the Central Bank. It could hit 57% by the end of the year. Brazil’s public sector debt now stands at $272 billion. Unlike Argentina, most of this debt is denominated in local currency and is held by residents. Instead of facing a risk of imminent default, Brazilians do face a real and rising risk of inflation.
Once public debt is at the level it has reached in Brazil, politicians rarely resist the temptation to debase the currency and cut the real value of the debt. The outgoing government of President Fernando Henrique Cardoso is making a superhuman effort to turn in a primary budget surplus, before interest charges, of 3.5% of GDP. But this is not enough to stabilize the debt’s growth. An incoming government is bound to consider reducing the real value of the debt by scrapping inflation- and dollar-linked bonds and allowing inflation to rip.
Most developed countries cannot do this because unlike Brazil, their central banks are independent. Brazil does have an outstanding central bank president in Armínio Fraga who has kept interest rates at an unbearably high level to keep inflation down. But inflation is creeping up anyway (and the real is weakening) which further expands the debt. Will the next president, whether he is Lula or Serra have the guts to stick to Cardoso’s virtuous but arduous monetary and fiscal policies? I doubt it