The Washington Post
Wednesday, November 6, 2002; Page E01

Lula's Market Challenge

Analysts Say Brazil's Next President Needs To Spark Big Rally

By Paul Blustein
Washington Post Staff Writer

Considering that he counts Fidel Castro among his old comrades and takes a dim view of U.S.-style capitalism, Luiz Inacio Lula da Silva is getting a remarkably
warm welcome in the halls of power abroad after his victory in Brazil's Oct. 27 presidential election.

Applause for "Lula," as he is universally known, is resounding both in official Washington and on Wall Street, thanks to his signals that he accepts the need to pursue
disciplined economic policies.

But meeting the demands of the globalized financial system looms as a monumental challenge for Brazil's new leader. International financial markets are still effectively
betting that Brazil will go the way of Argentina, which defaulted on its debt early this year and plunged into a profound economic slump. Such forecasts, when
markets make them, have a nasty tendency to turn into self-fulfilling prophecies.

That scenario hangs heavily over Latin America, given Brazil's status as the region's biggest nation. It also hangs over the Bush administration and the International
Monetary Fund, which three months ago staked their prestige on a record $30 billion IMF loan package for Brazil. And the critics of economic globalization may
gain ammunition if markets are perceived to have ravaged the country capriciously.

The problem is not just Lula's reputation as a left-wing labor leader; that's an issue U.S. and IMF officials, despite private misgivings, insist should be put to rest, as
do many market participants. Fueling their optimism is leaked word that Lula intends to name relatively conservative people to key economic posts and his public
assurances that he will honor the country's debts and stick to IMF limits on government spending and inflation.

At a recent seminar on Brazil at the Center for Strategic and International Studies, Jim Carragher, a State Department official responsible for Brazilian affairs, hailed
Lula's frequent assertion that "Brazil has changed and I have changed." Similarly soothing sentiments were voiced by Anthony Harrington, a former U.S. ambassador
to Brazil, who told the audience, "Lula recognizes the need for growth to accomplish his social agenda," and accordingly, "he will maintain the current financial

But the bar for Lula is being set very high on Wall Street and in other financial centers. Although Brazilian markets have rallied since mid-October -- the Brazilian
currency, the real, has risen about 11 percent against the U.S. dollar in the past two weeks -- prices of the government's bonds, and the foreign exchange value of
the real, remain at deeply depressed levels. The implicit message the markets are sending is that Brazil's economic problems are so daunting that no leader stands a
good chance of overcoming them, much less one who puts a high priority on solving the problems of hunger and homelessness.

So dire is the outlook, some analysts contend, that Lula might as well abandon his pledge that Brazil will fully honor its obligations. The next government will have no
choice, they say, but to induce its creditors to accept reduced payments. The only question, they say, is whether the process is an abrupt, Argentine-style default or a
"negotiated" restructuring that would presumably be less devastating but still wrenching.

"You could try to avert it, but when you don't face your realities -- well, the evidence for what happens then is very clear. It's called 'Argentina,' " said Walter
Molano, head of research at BCP Securities LLC.

Such predictions are based on some scary arithmetic showing that Brazil is on the verge of what economists call "exploding debt dynamics." The situation is not
unlike that of a consumer with a large credit card bill who falls deeper and deeper in the hole as rising monthly interest costs keep causing his total indebtedness to

The sell-off in Brazilian bonds has pushed up interest rates. Foreign investors, who this spring were buying Brazilian bonds bearing yields only about 7 percentage
points above the yield on U.S. Treasury securities, were demanding nearly 24 percentage points in extra yield a few weeks ago. (That "spread" has since narrowed
to about 17 percentage points.) Higher interest costs caused the government's debt burden to swell, as did the collapse in the real, because many government bonds
are linked to the exchange rate, with payments automatically rising as the Brazilian currency falls.

The sell-off can be attributed to a variety of factors, including Lula's rise in the polls, the policies of the current government and a panic among foreign banks and
investors . Whatever the reason, the upshot is that Brazil's net public debt, which was less than a third of gross domestic product in 1994 and rose to 49 percent of
GDP at the end of 2000, skyrocketed recently to 64 percent(about $240 billion) at the end of September.

To reverse the exploding dynamics, a Lula-led government not only has to avoid rattling markets further; it has to generate a huge rally -- a prospect that some
money managers are gambling on, but which many experts deem unlikely.

"You need interest rates to fall substantially, and the currency to appreciate substantially, to make it look realistic that the debt can be sustained," said Kristin Forbes,
an economist at the Massachusetts Institute of Technology who until recently was a top emerging-markets specialist at the U.S. Treasury. "But the markets are just
waiting for something to go wrong. Lula is going to have to be almost perfect to keep the markets going the way they have been the last few days, and realistically,
this is a new government, so they're going to make a lot of mistakes."

Even that $30 billion IMF loan program may not help much, backed though it is with a promise, which Lula has endorsed, for the Brazilian government to run a large
budget surplus -- the idea being to generate funds that can be used to pay down the debt.

"The market is already well aware of the existing IMF program, and the market clearly judges it to be inadequate -- not just marginally inadequate, but very
substantially inadequate," said Michael Mussa, the fund's former chief economist who is now a scholar at the Institute for International Economics, at a recent
congressional hearing.

All this accounts for the abundant speculation that Lula will resort sooner or later to measures the high priests of globalization traditionally abhor, such as imposing
capital controls -- that is, sharply restricting Brazilians from shipping money overseas -- and seeking a debt restructuring.

A vast chunk of the government's debt is held by Brazilian banks and other domestic financial institutions, and some analysts figure a Lula government will most likely
try to wriggle out of the trap it is in by forcing the banks to accept much lower interest payments. "Lula has a very low commitment to domestic banks," in part
because they supported his chief opponent, said Molano of BCP Securities. "He will pass most of the cost" of reducing the nation's debt burden onto them and slap
on capital controls to keep money from fleeing the country.

Such a move would hardly be painless, however, because it would risk wrecking the financial system. "For the Brazilian government to default or restructure is
politically disastrous, because it would mean wiping out the pensions and savings of the middle class," said Urban Larson, investment manager for Latin America at
Baring Asset Management. "I think Lula understands that, and I think he'll do whatever he can do avoid it."

So Lula has at least some incentive to try going all out in playing by the rules of globalization. He and his aides have hinted that they might be willing to run an even
more austere budget policy than is required under the IMF program, which sets a target for a surplus (excluding interest payments) of 3.75 percent of GDP. That
would entail scrapping campaign promises for more spending on social programs, though, and another reason to question the likelihood of this outcome is that to
ensure that Lula's tough steps weren't doomed to futility, a major increase in the size of Brazil's international loan package would be in order.

Would the IMF, or the Group of Seven major industrial countries, consider marshaling a substantially bigger bailout to keep Lula on the path of economic
orthodoxy? A Treasury spokesman declined comment. An IMF source, speaking on condition of anonymity, said: "There is a program that the present government
is following that the new government has promised to broadly follow. . . . We are looking forward to discussing the new government's program with them."

Translation: Economic policymakers are hoping that markets will continue to react enthusiastically to good news emanating from Brazil, eliminating the need for
drastic measures. At least events are moving in that direction. A month ago, foreign money managers said there is a 45 percent risk of a Brazilian default within a
year, according to a survey by J.P. Morgan Chase & Co.; a more recent survey puts the risk at 30 to 35 percent.

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