Elements of change: Brazil's Lula has lived up to hype: international financial community heralds labor to leader's first six months.

In early May, investors showed lots of interest in a Brazilian bond issue of US$750 million. Indeed, it turned out demand for the bonds was so great the government decided to increase the amount sold to US$1 billion.

A US$1 billion bond issue by a national government is not exactly sexy news in most places, but for Brazil the sale was significant. It signaled that investors were confident they would get their money back and marked a milestone of sorts for the young administration of President Luiz Inacio Lula da Silva, affectionately known as Lula.

CONFIDENCE IN LULA ABOUNDS

Since his inauguration in January, Lula--a longtime labor leader who had run for president several times before and failed--has nimbly moved toward the political and economic center and surrounded himself with skilled Cabinet appointees. His moderation has earned the praise of financial markets, according to Wharton faculty members and others who follow Latin America.

Lula's commitment to tight fiscal and monetary policies, coupled with a pledge to reform social security and the tax system, has been good for Brazil and its economy. Lula has managed to allay the market's fears while at the same time remaining steadfast in his commitment to improving the lives of the millions of Brazilians living in poverty.

"My feeling is he's the best thing happening in South America," said Gerald McDermott, a Wharton management professor and former consultant to the government of Argentina. McDermott added that Lula has been astute in building support from all parts of the political spectrum. "He shored up his base in his Cabinet through good appointments. He then moved to reverse expectations that his administration would pursue policies at odds with free-market principles. People wanted a revival in South American financial markets. He stuck with investors and said, 'We're going to make sure we run a tight ship, fiscally speaking.' Everybody has been very happy with that," he said.

"Initially, I was a little bit afraid that things could potentially go really badly" with Lula's election, said Wharton finance professor Armando Gomes. "But it turns out that things are going extremely well in Brazil."

Enrique Hidalgo Noriega, a Latin America expert at Eurasia Group, a U.S. consulting firm that conducts political-risk analysis, called the first four months of Lula's administration "tremendously successful, particularly because he has been able to instill confidence within and outside Brazil as to the possibility of reform."

CHALLENGING EXPECTATIONS

International investors held their collective breath when Lula was elected last fall, replacing Fernando Henrique Cardoso, who served eight years in office. They nervously wondered whether the candidate of the Workers' Party (PT) would push for the kind of anti-market programs that would boost government spending, stoke inflation and increase Brazil's already huge pile of public debt.

Eva Medina, professor of economics at the Autonomous University of Madrid, recalls there was a major "crisis of confidence" when Lula took office. "This was caused by the concern that a leftist government would break with the tradition of orthodox policy and [increase] the public deficit," she said. "The challenge [for Lula] was to re-establish confidence and make the leftist measures compatible with an orthodox policy, consisting of establishing economic stability for the long run."

So far, Lula has done just that, and Brazil has seen several positive signs in recent months. Brazil's currency, the real, has shown unusual vigor. On one day in late April, the currency closed at three reals to the dollar, its strongest showing since August 8. From its all-time low in 2002, the real gained 29% against the dollar as of May 5, according to the Financial Times.

But Lula is finding that off-the-cuff comments about the currency can roil markets. On May 2, he found it necessary to calm markets by stating his government would not intervene to weaken the currency. A day earlier, the real had declined 2% after Lula said the currency should "not strengthen too much." A weaker real would help Brazil's export growth by making goods cheaper to purchase.

Exports though, seem to have done nicely even with a strong real. For the first quarter of 2003, Brazil exported US$15.1 billion in goods and services, an increase of nearly 27% from the year-earlier period, while imports increased only 3.9%, to US$11.3 billion. Brazil's trade surplus is expected to reach US$16 billion this year, according to Dow Jones Newswires. In one particularly bright spot, Brazil is increasing its exports to China, a huge, fast-growing market. Volkswagen Brazil recently signed a five-year, US$500-million contract to supply Chinese factories with kits to assemble the Gol, a compact car.

Lula has also made progress in ensuring the autonomy of Brazil's central bank, so it can adopt policies without regard to political pressures. The Eurasia Group's Hidalgo said Lula passed this test of his fledgling administration "with flying colors" when Brazil's Congress in April amended Article 192 of the Constitution to give legislators more flexibility to change financial system regulations, including the authority to grant autonomy to the central bank.

In recent years, the head of the central bank had emerged as a strong figure, exercising increasing independence when it came to setting inflation-fighting policies. But that independence was not written into the Constitution and could have been reversed at any time, Hidalgo notes.

However, the controversy over central bank autonomy is not yet completely settled. Hidalgo points out that the amendment to Article 192 did not grant outright autonomy to the central bank; it only paved the way for complementary legislation on issues ranging from autonomy to limits on interest rates that still must be drafted and approved by legislators in so-called "itemized votes."

"These items are the really controversial issues that could threaten the unity of Lula's coalition," Hidalgo wrote in a recent report. "Even as they voted on reform, PT dissidents made it clear they will not support many aspects of an itemized vote." These votes probably will not take place until 2004.

Nonetheless, Hidalgo says the vote on the constitutional amendment signaled Lula has the ability to build the kind of consensus that will be needed for the two other big challenges confronting Brazil-a deficit-plagued pension system and a tax system that is too complex. It is these reforms that will determine, to a large extent, whether Lula's presidency is ultimately judged a success.

RIDICULOUS PENSION SYSTEM

In a dramatic gesture, Lula on April 30 entered the legislature to present a package of reform proposals. Among other things, the package called for the existing pension deficit to be reduced by imposing an 11 tax on inactive public-sector workers earning more than 1,058 reals (about US$365) a month, according to The Wall Street Journal.

Brazil's deficit-plagued public pension system is incredibly generous to retired government workers. According to Ana I. Eiras, a Latin America senior policy analyst at the Heritage Foundation in Washington, Brazil's pension system for public servants benefits only 1.4% of the country's population but generates a deficit that is the equivalent of 4.2% of the country's gross domestic product.

Women government workers can retire when they are 50, men when they are 53, and be paid full salary plus benefits. In addition, the surviving spouse of a deceased government employee can take the full benefits of the spouse who died and pass it on to the couple's children. Brazil's pension benefits, said Eiras, are "ridiculously expensive."

Lula is finding that social security reform will not be easy. Some members of his own party recently said they would forge alliances with other members of the governing coalition to fight the reforms. That illustrates the need for Lula to continue to exercise as much persuasive power as he can muster within the Workers' Party. Professor Maria Lucia de Padua Lima, of the Gettilio Vargas Foundation in Sao Paulo, said it has been vital for Lula to "keep his own party under control in order to make his political switch from the left to the center feasible."

Tax reform is also essential because the system is a mishmash of myriad taxes at both the state and federal levels that encourages tax evasion. 'There is a big burden on companies to operate legally in Brazil," said Wharton's Gomes. "That gives them stimulus to operate in the informal sector. Tax avoidance is a big problem. lithe government can simplify the tax system, it may get more companies and people to pay taxes."

McDermott added, "Resolving the income-distribution problem and the poverty problem demands strong tax reform. You need a progressive tax system, but at the same time it also has to be lean and mean. There are a lot of levels of taxation in Brazil. It creates a wild game of avoidance. So Lula will have to simplify it. That will take a lot of negotiations with the governors."

Inflation remains a concern and the government has moved to get a grip on it. "The objective of the government's monetary policy is to control the inflation that was generated as consequence of the depreciation of the currency [before Lula took office]," said Medina of the Autonomous University of Madrid. To do that, the central bank has raised interest rates to 26.5%.

The move appears to be working. According to the central bank, inflation eased somewhat in February and March. What's more, the central bank's weekly survey, released May 5, reported economists expect the IPCA Broad Consumer Price Index to rise 12.39% this year. That was down from last week's forecast of 12.47% for the year.

The government also recently reiterated its commitment to a tough fiscal policy. Finance Minister Antonio Palocci had announced in February Brazil would boost its budget surplus target to 4.25% of GDP from 3.75%, the figure that had been required by the International Monetary Fund when it made a US$30 billion loan to Brazil last August. Medina says raising the target "gives an image of greater confidence, showing that a default [on Brazil's US$255 billion in public debt] is not going to happen. In general, the government is trying to maintain economic orthodoxy for the long run."

STAYING TRUE TO ROOTS

Ironically, Lula's pledges concerning tax and pension reform mirror those of the Cardoso administration, which the Workers' Party had once repudiated. However, Lula has tried to distinguish himself from Cardoso by stressing his determination to push for social programs to help the poor, according to David Fleischer, professor of political science at the University of Brasilia. One example of this is Brazil's Zero Hunger program. In announcing approval of a US$505 million loan to Brazil in January, the World Bank cited the Zero Hunger project as an example of the Lula administration's commitment to the "continuation, improvement and expansion of ... effective social policies."

The Zero Hunger program, for which Lula has enlisted the support of popular entertainers and supermodels, is Lula's "pet project," according to the Eurasia Group's Hidalgo. "Hunger is a critical issue in Brazil. It is dear to Lula because it is something he suffered as a child," he said. Hidalgo also said the anti-hunger project makes it easier for Lula to push for reform of the pension system. "It's difficult for overpaid bureaucrats to go to the streets and say they're being denied their rights when the main issue in Brazil is hunger. That's a brilliant thing Lula has done."

Lula has said and done the right things so far. But his administration is, after all, only six months old and no honeymoon lasts forever.

LOTS OF BUMPS IN THE ROAD AHEAD

One controversial area where Lula has been treading carefully is agrarian reform. "The MST (Landless Peasant Movement) laid low during the 2002 campaign, but in early 2003 resumed farm invasions," Fleischer wrote in a paper in March. "Lula has vowed not to change the laws and invest more in upgrading existing settlements than greatly expanding expropriations. The minister of agrarian development is very close to the MST and has appointed many MST militants to positions within the agrarian reform institute."

In addition, Brazil's economy has been sluggish. Private economists expect an expansion of no more than 2% in 2003. Inflation, while easing, is still running at an annual rate of about 12%.

Eiras of the Heritage Foundation said it would be helpful to the economy if Brazil could streamline regulations that cripple small businesses.

"To me, the most important reforms are ones that allow small- and medium-size businesses to perform well because ... when they operate really well, they tend to be a large part of the engine of economic growth. Brazil has a long way to go in terms of simplifying regulations affecting small businesses," she said.

Eiras and de Padua agree Brazil must strengthen trade with foreign nations. "The only way for Brazil to increase its volume of trade would be to negotiate with economies like the U.S. that are also very large," Eiras said. He adds that the United States could help Brazil by becoming more engaged with South America through organizations like the Free Trade Area of the Americas.

"Organizations like the FTAA set the framework for countries to reform and eliminate a lot of barriers to growth. Brazilians are not going to be engaged in the process of lowering barriers through FTAA unless they see the U.S. doing the same thing," he said.

In the end, Lula's success or failure will hinge on his ability to strike the right balance between policies that please the political right and left. "Is Lula positioned to do that?" asks McDermott: "Yes, because he's worked hard. He's been running for this job for a long time."

This article is reprinted with permission from knowledge@wharton, an online resource affiliated with the University of Pennsylvania's Wharton School of Business.