Worried about Lula: investors fret over upcoming Brazilian election. (Spotlight).

On June 30, when Ronaldo redeemed himself and his country by scoring two goals and winning the World Cup, Brazilians celebrated for days and nights on end, filling the streets with dancing and the skies with firecrackers.

Unfortunately, the party is now over and the contest is no longer about sports but politics. In October, Brazil will hold a presidential election whose outcome will play a large role in determining which direction the struggling Brazilian economy will take. Indeed, with neighboring Argentina already in a state of financial collapse, some are wondering now if the panic will spread to Brazil, Latin America's largest economy and biggest country, with a population of 175 million.

While most people agree that Brazil's problems are less severe than Argentina's, there are nonetheless troubling developments in this huge sprawling country, better known to some for its Rio Carnaval than its plunging currency. Its stock and bond markets have taken a dive, inflation is expected to be between 4% and 6% next year rather than the 3% predicted earlier, annual interest rates have risen above 20%, the trade surplus is low, the pension system needs drastic reform, and--perhaps most worrisome of all--risk spreads on the country's approximately US$250 billion public debt have surged. Since Fernando Henrique Cardoso, the current president, took office in 1995, public debt, according to a recent article in the Economist, has risen from 30% to 55% of gross domestic product (GDP), highlighting concern over the possibility of a default.

The instability resulting from this mix of economic news has been exacerbated by the upcoming election. The business community in particular is worried that the current frontrunner--Luiz Inacio Lula da Silva, candidate of the leftist Worker's Party--might win, despite having lost in three earlier tries. Lula, as he is known, was defeated in 1994 and 1998 by Cardoso, who cannot run again but has put up his own centrist candidate, Jose Serra, former health and planning minister.

According to press coverage of his campaign, Lula has in the past taken anti-business, pro-union stances, advocating such things as a "renegotiation" of Brazil's debt and increased spending on social programs. However, he reportedly now toes a more centrist line, promising to keep inflation under control and pledging that he would not default on Brazil's debt. Despite these assurances, some wonder whether Lula can deliver on any promises at all, given that his own party is split into various factions with their own reform agendas.

"It's because the left wing party is way ahead in the polls that people perceive the economic outlook to be uncertain," said Wharton finance professor Armando Gomes. "Nobody really knows what Lula's party will do if it is elected. It doesn't have a reputation for sound economic policy so people are scared."

On the other hand, Gomes added, "one reason I think the left wing is strong is because people are tired of all the scandals in government. There were too many of them during the last three years involving ministers, senators and others. People want to try something different."

Now FOR THE GOOD NEWS

Yet despite the pre-election anxiety that has gripped Brazil, the consensus among many observers is that the country's underlying economy is basically sound and the danger of a default on its public debt is small.

"The economy is much better now than it was three years ago when it went through a massive devaluation of the currency," said Ezra Safra, who works at M. Safra and Co., an asset management firm in Sao Paolo. The real "has recently improved a bit and some of investors' uncertainty seems to have gone away. When you start looking at the numbers, it's almost impossible for Brazil to default. The Treasury has 50 billion reals in cash; there is a domestic surplus of 26 billion reals, and Brazil has confidence in its domestic banking system."

Indeed, Safra and others note that most of Brazil's debt is in reals and is held by domestic institutions. Only about a quarter of it is dollar-linked and owned by foreigners. That isn't the case with Argentina, where most of the debt is in dollars, and the default last December resulted from a collapse of its currency, the peso, which is pegged to the dollar. Brazil has a floating exchange rate. The central bank can provide liquidity in reals, thereby offering a degree of flexibility. In addition, Brazil still has access to a US$10 billion loan from the International Monetary Fund (IMF).

Roberto Civita, CEO of Abril S.A., reportedly the largest publishing, printing and electronic media company in Latin America, put it this way: "It's as if you grew up in Rio and one morning you discover there is such a thing as Pao de Acucar (also known as Sugarloaf, a 1,500-foot mountain offering spectacular views of Rio). That is exactly what is happening in the Northern Hemisphere with regard to Brazil's financial situation. Nothing has changed. But (the United States) has discovered we have Sugarloaf, which is the debt. We had the debt before. Why did everyone suddenly get excited? Because Lula might win the election and then people think everything will go to hell, that he won't respect internationalization, that he won't pay the bills, that everyone will panic and sell their Brazilian paper."

Civita said Brazil's institutions are old and tried enough to weather current uncertainties. As well, Lula's party "has come, as it inevitably must, closer and closer to the center. It happens the same way in Europe: You have lots of parties and when the left or the right wins, they come to the middle. There is no other way in today's world if you want to belong to the community of nations. You have to pay your debts, to balance your budget, to play the game to attract investments," said Civita.

These are today's standard operating procedures for good world citizens, he said, except in the United States. 'The Americans do everything they tell the rest of the world not to do. They say free trade and they raise trade barriers. They say balance your budget and they cut taxes and increase spending."

It's a view that others share. Rogerio Tsukamoto, head of PRYT International, a strategy consulting firm in Sao Paolo, said that when foreign investors decide to invest in developing countries, they "see Latin America as one place rather than as separate, distinct countries. So they set aside an amount of money to invest in 'Latin America.' Then, whenever a problem occurs in a developing country, whether it is Russia or a part of Asia or a part of Latin America, these investors look at their overall portfolio in developing countries and decide to cash out of Latin America, specifically Brazil."

Tsukamoto said that in times of crisis, investors are quick to pull out of Brazil, rather than other Latin American countries, because it is a large, liquid market. "In addition, Brazil was a market where investors had made a profit so they could cash Out and get a good return. Consequently, during the late 1 990s, what happened whenever a problem appeared somewhere in a developing country, the first place that was hit was Brazil," he said.

Despite this situation, Tsukamoto maintains that Brazil, unlike Argentina, has sound economic fundamentals. Argentina, he said, has suffered for "the past 70 years from leaders who kept spending and spending, and powerful states within the country that paid no attention when the central government finally tried to curb the excesses and impose some restraints. Basically the people in Argentina don't trust their government anymore. There has been too much corruption and too much inept economic policy."

The Brazilians, by contrast, have more confidence in Brazil's future. "Even Lula has come out and promised to defend the primary surplus of Brazil and the fiscal equilibrium," said Tsukamoto.

Foreign debt, he added, is not a problem. "Investors who really know Brazil are not worried about that."

A PUSH TO EXPORT

While others point to the size and diversity of Brazil's economy as a major strength--certainly in contrast to Argentina's economy--they also cite the need for Brazil to bolster its exports as a way to bring in more foreign investment. "Brazil has to export more, not just to increase the trade surplus but more importantly to make it a more global player," said Safra. "What has happened is that both exports and imports have shrunk."

Recent trade figures show that Brazil expects to export about US$55 billion this year and import about US$50 billion. Its major exports include such items as coffee, sugar, orange juice, airplanes, cars, steel, pulp and paper products, and textiles. "Brazil has been considered somewhat of a closed economy compared to some other Latin American and Asian countries," said Gomes. "Because Brazil has such a huge domestic market, a lot of companies just sell within the country. But I think it's starting to open up."

Tsukamoto agrees. "Brazil is changing its export platform," he said. "But what happens is this. Suppose we keep growing our electronic equipment industry. for example, and we export a bigger number of cellular phones. But because we don't produce microchips in this country we have to import those. So the more we export the more we have to import. Consequently the government has to discuss some development strategies to attract industries to Brazil such as microelectronics, because that's where the value-added is."

"Service is also an important sector to generate export revenues. We are developing more software in Brazil. Just like Bangalore in India is known as a center for excellence in software development, there are some companies doing that now in Brazil," he said.

In addition to increasing exports, Civita suggests focusing on tourism. "This is God's country in terms of tourism and no one has ever done the job properly of bringing in tourists and money. No major investment is required. It's the best short-term thing you can do. That and keep the economy stable and inflation under control."

Safra would also like to see tax reform. "The current system is very complicated and it puts a lot of pressure on industry and on those who are trying to produce domestic goods or even to export. And you also need to fix Brazil's pension system."

Wharton business professor Olivia Mitchell recently completed a paper on pension reform in which she notes that pension systems "throughout the Americas are increasingly imposing ever-higher burdens on government budgets already facing a cash-flow crisis. In Brazil, paying public pension benefits commands such a large fraction of some states' revenue that very little financing remains to cover education, roadwork, public health, and other demands on the fiscal budget."

According to Mitchell, "Brazilians, as well as many others, often ask their 'pension' plan to do more than just provide retirement income. The plans are also required to offer survivors' insurance, disability benefit coverage, and even health insurance. Sometimes they are required to offer participant loans."

Asking a pension plan to do "too many things," she adds, "can sow confusion regarding the multiple nature of the risks insured. ... This lack of transparency muddies the waters for accounting purposes and it makes it extremely difficult to do clean forecasting of the pension plan's future obligations to retiring workers."

In any attempt at reform, Mitchell says, "the question of curtailing 'acquired rights' under the old system must be resolved. ... This is a problem, since many public pension systems were never conceived of as funded programs from their inception, and finding solutions for this underfunding will be an expensive and long proposition."

NEW TRADING PARTNER

One recent and positive development was the bilateral trade pact signed this summer between Brazil and Mexico, which is expected to facilitate the sale to each other of an increased number of agricultural and industrial products. The pact is considered a response to what some see as increasing protectionism on the part of the United States, just when developing countries around the world are trying to gain access to more international markets. "We need as many bilateral trade pacts as possible," said Safra.

Meanwhile, it would appear that much of the Brazilian business community will be anxiously awaiting October 6, when the first round of the elections will take place. (Should no candidate win a majority, a runoff is scheduled for October 27.) Tsukamoto for one is predicting that either Serra or another strong candidate, Ciro Gomes, will win the election. "The number of people who vote against Lula is always high, but they only appear later on during the campaign," he said. "So the polls that are showing Lula substantially ahead now are misleading. In the end, he will not get the 51% of the valid votes that he needs to be elected."

Whatever the outcome, Brazilians will still play soccer, dance at Carnaval and generally carry on much as before. For the near future, said Gomes, "It's the uncertainty of what Lula might do that is causing problems for Brazil. But once he is elected, if he is, people will just deal with it."

This article is reprinted with permission from Knowledge@Wharton.