Is Lula Losing His Grip?

Declining confidence in Brazil's President could wreak havoc in the markets

Once bitten, twice shy. Investors who remember the meltdown of Brazilian securities in 2002 are watching closely to make sure they're not burned again. What are they afraid of? The Lula Effect, Part II.

The Lula Effect, Part I, was the panic that seized markets when the left-leaning Luiz Inácio Lula da Silva won the presidency in October, 2002. Investors got spooked by the notion that Lula would overspend straight into a debt default. That didn't happen: Lula proved committed to fiscal austerity. Brazilian bonds and stocks rallied powerfully.

But a new fear stalks the markets -- that Lula is losing his grip. Much-ballyhooed social programs have sunk in a mire of administrative muddling. Lula has come under fire for mishandling a corruption scandal involving a top aide to his chief of staff and the expulsion, later reversed, of a New York Times journalist over a widely discredited story that Lula's drinking was a matter of public concern.

More important, in the past month, two government-supported bills were defeated in Congress. By losing the second -- which would have allowed the presidents of the Senate and Lower House to stand for reelection -- the government may also have lost the support of its most valuable ally in the catch-all Brazilian Democratic Movement Party pmdb). "The government is in a state of permanent crisis," says Walder de Góes, a political consultant in Brasília.

The market reaction to all this? In early April, the Brazil C bond -- a widely held dollar-denominated issue -- was trading slightly under par. Then it had a mini-swoon, hitting 86 cents on the dollar before rebounding slightly. Meanwhile, the real slid 10% in the 30 days ending May 21, and the stock market is off 15.6% for the year.

The sell-off may get worse. Brazil's Supreme Court will rule any day on the legality of a social security reform enacted last year. If it rules against, as it has on a similar reform, it will wipe out the huge cost-saving gains of the plan, which would have taxed pension benefits. Congress -- including members of Lula's own party -- may also soon force the government to raise income-tax exemptions and grant a bigger increase than Lula wants in the national monthly minimum wage.


These judicial and legislative setbacks could cost the government $3.5 billion a year. "You can't exaggerate the importance [of these issues]," says Christian Stracke of CreditSights Inc., a New York capital markets research firm. "Defeat would be nothing short of a fiscal disaster." Stracke figures a supreme court defeat would wipe four or five points off the price of the C bond in a day. If yields jumped, the government could find itself in a pickle as it struggled to pay off dollar debt with a fast-weakening currency.

Of course, a favorable ruling would provide a boost in confidence. Lula is also working hard to regain control of the political agenda. "It's fundamental that the government's supporters in Congress follow the position of the majority," says José Genoino, president of Lula's Workers Party. "We are working hard to ensure unity." Some investors figure that when the smoke clears, Brazil will be solid. "Brazil has been a casualty of concerns over U.S. interest rates," says Mohamed El-Erian of PIMCO, the Newport Beach (Calif.) fund manager. El-Erian does not foresee a huge financial unraveling.

Whatever happens over the long run, it is already difficult for Brazil to borrow. At home, the government canceled bond auctions this month because interest rates demanded by lenders were 100 basis points higher than the central bank was willing to pay. The government probably has enough cash to meet payments at home and abroad until September; after that, it must regain access to international credit. But conditions are worsening. Six-month interest rates, which fell from 29% a year in February, 2003, to 15.5% at the start of May, have jumped to 17.5%.

What could reverse the slide? Brazil's economy, which contracted by 0.2% last year, is growing much faster, thanks to strong exports and falling rates. If a feel-good factor arrives in time for municipal elections in October, voters may endorse Lula's candidates rather than reject them, as looks likely now. That might boost confidence enough to eliminate the Lula Effect. But for now, the Effect is being felt in force.

By Jonathan Wheatley in São Paulo

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