Brazil: The Leftist Who's Spooking the Markets

It's just what Latin America doesn't need--an Argentine-style crisis of panicked markets and debt default that damages the region's economy and scares investors away. Yet that's the scenario analysts are beginning to worry could unfold in Brazil, a bigger economy where foreign banks and companies are more financially exposed than in Argentina.

At the center of the storm is Luiz Inácio "Lula" da Silva, leader of the left-wing Workers' Party. Lula, as he is known, is making his fourth run for President in the upcoming October election. Official campaigning starts in early July, and this time, Lula has his best chance ever at winning. He is more than 20 points ahead of his closest rival, free-market centrist José Serra, the candidate of President Fernando Henrique Cardoso's Brazilian Social Democratic Party, in public opinion polls.

Lula's ascendance is helping to rattle Brazil's markets. Indeed, investors are worried that Serra, whose campaign is off to a weak start, won't be able to close the gap with Lula, a 56-year-old former union leader who heroically resisted earlier military regimes but who declared in an earlier campaign that a burdened Brazil should not bother to pay its foreign debt. That memory, although distant, is spooking investors. The Brazilian currency, the real, has plunged 14% this year and on June 12 hit its second-lowest level against the dollar ever. That prompted the government to tap a $9.4 billion International Monetary Fund credit line to bolster the real, strengthening it slightly.

At the same time, some investors fear Brazil may be unable to avoid a default on its $260 billion in public debt--especially early next year, when the new government has to roll over a sizable chunk of it. At 54% of gross domestic product, the debt is nowhere that of Japan or other highly leveraged countries, and only $93 billion is owed to foreigners. Still, analysts are worried that 90% of the domestic debt is indexed to local interest rates, the dollar, or inflation--making it harder to pay if markets stay jittery.

It's not a formula for stability. "Following the default of Argentina, investors tend to sell first and ask questions later. That's what you are seeing in Brazil," says Jonathan Binder, senior investment officer at Standard Asset Management in Miami. A Lula win would lead to "economic chaos," he adds.

The leftist candidate, a former metalworker, strongly rejects such a forecast. He pledges to honor Brazil's debt agreements and maintain the fiscal discipline that has marked Cardoso's eight years in power--a time in which he tamed triple-digit inflation, brought free-spending municipal and state governments under control, and privatized $70 billion in federal assets. Even so, investors remain skittish because the Workers' Party platform, approved last December, lays out a radical vision. The platform calls for "a break with the current economic model" and steps to "suspend or reevaluate the privatization program."

Voters, including those in the business community, are waiting to see if the party includes details of such policies in its election manifesto, due to be published on June 30. "Investors realize that the party is more radical than the party leadership, and they wonder who, if he gets elected, Lula is going to pay attention to," says Christopher Garman, a political and economic analyst at São Paulo consulting firm Tendências.

As campaigning intensifies, business is expected to back Serra strongly, since his victory would mean a continuation of Cardoso economic policies. The 60-year-old Serra won positive reviews for his stint as Health Minister in Cardoso's government, but he lacks charisma on the campaign trail. If he can't boost his appeal to voters fast, Brazil's financial markets--and the economy--may be in for a wild ride.

By Andrew Downie in Rio de Janeiro

Edited by Rose Brady

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