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Brazil - Economic Briefing July 2002

Lula Prompts Confidence Crisis and Raises Debt Concerns

The left-wing Labour Party candidate Luiz Inácio da Silva (‘Lula’) continues to maintain a wide lead over the second place government candidate José Serra. Increased concerns about the possibility that a Lula victory could threaten economic policy continuity and government’s willingness to continue servicing its increasing debt obligations, have significantly increased risk perceptions.

Elections loom over financial markets and economy

The Central Bank’s inability to place a R$ 2 billion bond issue prompted a large scale sell-off in fixed income markets on 11 June, as investors became increasingly unwilling to hold debt that matures after the 6 October nationwide elections. Mounting concerns about the possible victory in presidential elections of the left-wing Labour Party presidential candidate, Luiz Inácio da Silva (‘Lula’), could threaten economic policy continuity and government’s willingness to continue servicing increasingly high debt payments, have significantly increased risk perceptions. Investors remain concerned that a Lula administration, rather than moving to the political centre, would reverse economic reforms of the past eight years by introducing protectionism and even reversing privatizations. The benchmark Brazilian sovereign debt J.P. Morgan EMBI+ spread rose from 976 basis points to comparable US Treasury (UST) securities at the end of May to 1,527 at the end of June. The spread widened further in the first week of June to 1,715 basis points to the UST – the highest level since the 1999 currency devaluation and even above the spreads of country’s in default. According to the most recent opinion polls, Lula continues to enjoy a comfortable lead over the government’s candidate José Serra, who with 20.5% of the vote remains well behind the 38.0% endorsement that Lula currently enjoys.

Currency under pressure as political risk looms heavy

The desire of investors to rid themselves of Brazilian risk was reflected in a marked deterioration of the currency, which weakened from 2.52 reais to the US$ at the end of May to 2.84 on 28 June – an 11.3% drop in value. The June depreciation in the currency was the strongest decline in value observed since the devaluation in January 1999. The currency stabilised somewhat in the first week of July to close just 0.1% weaker than at the end of January. The Central Bank’s announcement that it intends to sell US$ 1.5 billion in reserves to stem the deterioration throughout July, served to bolster the real. Starting 8 July, monetary authorities plan to intervene in exchange rate markets by selling US$ 50 million daily. This month’s Consensus sees the real recovering lost ground throughout the year.

Currency weakening looms over inflationary expectations

The mid-June consumer price index (IBGE-IPCA 15), which covers monthly price increases up to the 15th of every month, increased 0.3% over May, down from the 0.4% increase in the preceding month. The June figure lowered the annual inflation rate from 7.7% in May to 7.6% in June. The recent deterioration in the exchange rate has raised concerns since further weakening could pass through to domestic prices and curtail monetary authorities’ ability to bring down interest rates to bolster growth. With this objective in mind, the Central Bank has also decided to raise the inflation target for next year to 4.0% from 3.25% established earlier and to widen the +/-2% margin to +/- 2.5%. According to Consensus data, inflation this year will continue to drop.

Persistence of market pressure could forestall further monetary easing

In its 19 June meeting, the Central Bank decided to leave the benchmark SELIC rate unchanged at 18.5% for the third consecutive month. Monetary officials stated that the solid economic fundamentals and favourable inflation prospects would enable easing in the coming months but that the short-term volatility in financial markets and the exchange rate warranted a more cautious policy stance. Participants have not adjusted their interest rate forecasts this month, expecting the Central Bank to lower rates once the current volatility has subsided and bringing down the benchmark interest rate to 17.0% by the end of the year.



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