Will Scandal Spare Lula But Kill Reform?

The corruption scandal engulfing the government of President Luiz Inácio Lula da Silva has more plot twists than a telenovela, the TV soap operas Brazilians are so addicted to. It all began in May when a post office official was caught on video pocketing a $1,250 bribe. Then came the explosive allegation that members of the ruling Workers' Party (PT) were paying legislators of other parties $12,500 a month for their votes. Since then fresh accusations have emerged almost daily -- from the PT official caught trying to board a plane with $100,000 in his underpants to the "event organizer" who allegedly procured call girls for politicians from the PT and other parties.

Among the most damaging accusations is that Lula's economic czar, Antonio Palocci, took kickbacks for the PT from waste-hauling companies while serving as mayor of a city in São Paulo state in the mid-1990s. Those allegations, aired on Aug. 19 and denied by Palocci, hammered Brazilian securities and the currency, although most of the losses were quickly reversed.

The damage to Lula's administration may be harder to repair. Opposition parties lack the evidence to launch impeachment proceedings against Lula, and they are mindful that doing so would imperil Brazil's hard-won financial stability. But Lula's chances of pushing through reforms needed to keep the economy growing, such as a simplification of the tax system and a revamp of the rigid labor code, are slim, as legislators start delving into the corruption mess.

Remarkably, South America's biggest economy has so far managed to avert a financial meltdown. Wall Street has shrugged off the political crisis, focusing instead on the fact that Brazil's economy is in better shape than it has been in decades. The country is running a budget surplus in excess of 4% of gross domestic product, excluding debt payments. And the current account is headed for a surplus of $14 billion, vs. an $11 billion deficit in 2002, helped by strong prices for commodity exports such as soybeans and iron ore.

His party's grim future

With interest rates in the U.S. and Europe at historic lows, emerging markets such as Brazil offer richer returns. So investors prefer to focus on the country's economic prospects, overlooking what they regard as mere political noise. "Brazil is on autopilot," says Jerome Booth, head of research at Ashmore Investment Management Ltd. in London. "Congress could do nothing for the next year, and Brazil would still be a good credit."

But the crisis could have implications that would eventually affect the markets. Lula may yet limp on to secure a second term in national elections scheduled for October, 2006. But the future looks grim for the PT, with several high-level officials forced to step down as a result of the scandal. Without a solid core of supporters in Congress, Lula's ability to govern would dwindle.

That's a concern since Brazil needs a strong leader to press ahead with difficult structural reforms to boost the economy's long-term growth potential. "A Lula victory in 2006 would deliver two years of crisis followed by four years of weak government," says José Luciano Dias of IBEP, a political consultancy in Brasília. For the 52 million voters who put their faith in Lula -- and even investors -- that would be harder to take than the worst telenovela.

By Jonathan Wheatley in São Paulo

Edited by Cristina Lindblad

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