Is Lula's Honeymoon Winding Down?

He was Latin America's biggest surprise. After winning a landslide victory in 2002 on a campaign to revamp the economy and battle for the poor, Brazil's left-leaning President Luiz Inácio Lula da Silva thrilled worried investors when he continued his predecessor's plan of strict financial austerity. Instead of catching the jitters as predicted, the country's bond and stock markets enjoyed stellar returns last year and are still going strong.

But now pressure is mounting on Lula to make a lurch toward populism -- a sure way to jettison Brazil's stability and growth prospects. After riding a wave of popular support through his first year, Lula is facing withering criticism from within his own Workers' Party and governing coalition as well as from ordinary voters. Many feel betrayed by Lula's rejection of the socialist policies the Workers' Party has always fought for. In a late March opinion poll, only 28% of Brazilians voiced support for the government, down from 41% in December. Lula's personal approval rating has slipped from 66% to 51%. Meanwhile, leaders of Vice-President José Alencar's Liberal Party have called for Lula's Finance Minister, Antonio Palocci, and Central Bank President Henrique Meirelles to be sacked -- an astonishing act of disloyalty.

Both the Right and the Left are turning up the heat because of unhappiness with the economy, which has grown an average of just 2% a year since the mid-'90s. Fed up with rising unemployment, Brazilians turned to Lula and his promise of a "spectacle of growth." Yet the economy contracted by 0.2% in Lula's first year. Unemployment is stuck at 12%; in São Paulo, the industrial heartland, it reached nearly 20% in February -- a record.

Calls are growing for the Central Bank to rev the economy by cutting interest rates. Business and labor lobbies are also demanding more intervention in the real economy. The government recently announced some $3 billion in financial help -- mostly low-interest loans -- for sectors such as pharmaceuticals. "We are seeing signs of a drift away from orthodox policies," warns Marcelo Carvalho, chief economist at Itaú Corretora, a unit of Brazil's No. 2 private-sector bank.

Pork-Barrel Demands

Political dynamics are further complicating Lula's position. A campaign-finance scandal implicating an aide to his chief of staff, José Dirceu, erupted in February. That has seriously damaged the Workers' Party's squeaky-clean image. To fend off a congressional inquiry, Lula has been forced into an ever-closer alliance with the pork-barrel politicians of the Brazilian Democratic Movement Party (PMDB), a catch-all party that traditionally trades its support for federal money for local projects. "The PMDB is likely to charge more and more for its support, and that will have a fiscal cost," says Vladimir Caramaschi, economist at Fator Doria Atherino, a São Paulo brokerage. Adding to the pressure, in October, Brazilians will vote for more than 5,300 mayors and municipal councils -- widely seen as a mid-term referendum on the President.

The good news for Lula is that growth should pick up this year, to about 3%. Voters may welcome the turnaround. But Brazil needs growth of 5% or 6% a year to cut unemployment. And that requires more painful reform of the tax system, bureaucracy, and labor markets. Lula, however, may already be feeling reform fatigue -- and the heat won't ease anytime soon.

By Jonathan Wheatley in São Paulo

Edited by Rose Brady

    Before it's here, it's on the Bloomberg Terminal.