In addition, a congressional agenda for the transition phase of November-December will be negotiated among the main parties, representing the preliminary step of next year’s congressional agenda.

A Lula government poses inherent uncertainties, given that Lula and his party PT have migrated to a moderate economic platform only during this year. Therefore, a Lula government will have to build its credibility of a responsible economic policy (represented by credible and consistent fiscal and monetary policies), by consistently giving the right signals, while maintaining the necessary governance.
economic policy and the congressional majority that the Lula government will pursue. We also indicate our expectation. In summary, we expect relatively benign signals, although without any major positive surprise, which suggests caution.
Table 1: Key Drivers to Monitor in the Transition Phase
Driver Our Expectation
1. Appointment of the
economic team
• New economic team (president of the central bank, finance minister, planning minister and the development minister) is reasonably positive, but some names will disappoint. Timing for the appointment will also disappoint (December only), generating some anxiety. Armínio Fraga is replaced.
2. Building of the
government coalition
in the congress
(position of PSDB and
PMDB)
• PSDB and PMDB provide conditional support (not participating in the government), however with a constructive position.
3. Congressional
Agenda of the
transition phase
• Includes the projects for the independent central bank, part of the social security reform, beginning of the tax reform. Final 2003 budget is fiscally responsible, meeting IMF targets. 4. Lula’s control of his
left-wing coalition,
specially regarding
radical groups
• Relatively positive signals are given from radical groups, providing a favorable initial cohesion of Lula’s coalition.
5. First Revision of the
IMF agreement in
November
• Lula agrees with IMF revised targets, even if the primary fiscal targets have to be raised.

Potential Positive Developments
1. The appointment of the economic team surprises on the upside, including the maintenance of Armínio Fraga in the Central Bank, even if it were only for the initial months of the Lula government. 2. Consistently positive balance of payments results improve market sentiment, while consensus forecasts continue to be revised upward, leading the current account results to be close to balanced in 2003. As a result, the currency appreciates, reducing inflationary pressures. 3. A positive reform agenda is established and gains a strong momentum in 2003. PT, which has historically represented the main opposition to a reform agenda, is now larger. The party decides to embrace an aggressive positive reform agenda for the market. Over 50% of PSDB, PMDB and PFL support the new reform agenda, since the new agenda largely coincides with their agenda during the Cardoso phase.

Potential Negative Developments
1. Inflation accelerates during the remainder of 2002 and early-2003, generating market concerns regarding the need for further monetary tightening and the rising social demand for wage indexation. The currency remains weak at least during the first months of 2003. 2. Lula’s popularity starts to deteriorate, as a result of higher inflation, no room for a rate cut in the near term, leading to an increasing criticism form the press and the public opinion. Radical members of Lula’s coalition become more vocal and critical. 3. The congressional agenda gives signals of stalling, due to Lula’s declining popularity, his weakening political credibility with the congress and a deteriorating cohesion of his coalition. The support from PSDB and PMDB in the congress is low. 4. The PT faces an internal crisis, with the radical group openly challenging Lula, eventually leaving the party to join another emerging radical left-wing party (such as PSTU). As a result, Lula’s coalition in the congress becomes smaller.
5. The Lula government shows recurring execution problems and inconsistencies, largely due to the appointment of an excessively diversified cabinet, aimed at pleasing all his wide spectrum of support base. Even the economic team is not united enough, showing signs of internal conflicts. Market sentiment deteriorates, becoming increasingly concerned that the president’s support to an austere fiscal and monetary policies could decline.

Lula’s transition team will likely be comprised of nearly 55 members, including people from the PT, people from outside the party that worked in preparing his government program (economists, other academic people, specialists in the main government areas, etc.), and representatives of the business community that support him, such as Eugênio Staub (owner of Gradiente), who has been quoted by the press as a possible development minister.

The four main coordinators of Lula’s campaign, José Dirceu (president of the PT), Antônio Palocci (coordinator of Lula’s government program), Luiz Dulci (general secretary of the PT), and Luiz Gushiken (former president of the PT) will likely belong to the transition team. They will probably be the main advisors of Lula during the process of negotiating and building the new cabinet.

Political Leaders of PT’s Transition Team

José Dirceu • PT’s President and Lula’s most important advisor • Students’ leader in the past. While exiled in the 70’s, he lived in Mexico, Cuba and illegally in the state of Paraná until his amnesty in 1979. • Federal Deputy (SP).
• Responsible for removing radical members from the PT management, he is viewed as having a hard-line style in the party.

Luiz Dulci • General Secretary of PT and Professor at FGV (Fundação Getúlio Vargas).
• One of the main intellectuals, fluent in many languages. Antônio Palocci • Mayor of Ribeirão Preto (an important country-side city in the state of São Paulo).
• Coordinator of Lula’s government program. • The main liaison between Lula and the business community. Luiz Gushiken • Very Close to Lula • Former President of the workers’ union of the banking sector. • President of the PT and federal deputy for 12 years.

The new cabinet may comprise members of the transition team as well as people from outside. Thus, the appointment of the transition team may not be a clear signal of the final cabinet names. The intention of Lula and his closest advisors seems to be to gradually build the cabinet during November and December, when PT will have to negotiate with parties from his supporting base during the campaign (PT, PL, PSB, PDT, PPS, and PCdoB) as well as other parties that could potentially become part of his coalition, namely PMDB and PSDB. It is unclear whether those two parties will provide only a conditional support in the congress, that is, without participating in the Lula government, or whether they would be open to negotiate a direct participation in the new cabinet, in which case they would explicitly become part of the government coalition.

Building the Government Coalition in the Congress -- Where is the Opposition to Lula’s Positive Reform Agenda?

Uncertainty remains regarding what kind of reform agenda Lula and PT would pursue in the congress. Simplistically, we see basically two scenarios. In the first scenario, Lula and PT would pursue a “positive” reform agenda, that is, an agenda that predominantly includes most of the necessary reforms that the market understands as necessary to solve Brazil’s fiscal and infra-structure problems. That agenda would include a broad social security reform, a broad tax reform, the regulatory reform of main infra-structure sectors (including privatization), the regulatory reform that entices the development of the domestic institutional market, the labor reform, the revision of Brazil’s federal system, and the political reform.

The second scenario is a “disappointing” reform agenda, which would combine only a small part of the positive agenda with some “left-wing” proposals that could generate negative fiscal and inflationary impacts, including real increase of the minimum wage, a partial indexation of private-sector wages, a step back in the regulatory framework of some infra-structure sectors by adopting models that are broadly understood as ineffective, among others.

We tend to believe that Lula and PT will be leaning towards a positive agenda. But we remain in a show-me position until indications are clearer. Assuming that Lula will embrace a relatively positive reform agenda, the most intriguing conclusion regarding the victory of Lula in the presidential race and of PT in the congressional election is that the party that historically had adopted the most fierce and consistent opposition to structural reforms could now be leading that process in the congress. So, where is the consistent opposition to Lula’s positive reform agenda? We do not find it. Even PFL, which seems to become the main opposition party, has a track record of strong support to structural reforms during the eight years of the Cardoso administration.

Therefore, we tend to conclude that the opposition to Lula’s positive reform agenda (mainly PFL) tends to be much more constructive than the opposition faced by Cardoso in the past years. What is even more intriguing is the conclusion that the Lula government may enjoy a more constructive congressional support to a positive reform agenda than if Serra had won, in which case all left-wing parties, including PT, would likely continue to represent a fierce opposition. And they would be a larger opposition than in the past, thus representing a more challenging obstacle than in the Cardoso phase.

Perhaps the strongest risk of opposition to a positive reform agenda during a Lula government would be located exactly inside the government’s formal coalition, represented by the radical members of PT, as well as some radical coalition parties such as PC do B (Brazil’s Communist Party). An internal crisis within his coalition would be embarrassing for Lula, leading to a deteriorated popularity and a weaker political credibility to negotiate with the congress.

The Government Coalition --
This week, parties will begin to discuss their intended position regarding the Lula government. PMDB and PFL will hold a national meeting next Thurday to discuss the issue. The initial expectation is that the formal government coalition will be comprised of the parties that formed PT’s campaign coalition, that is, PT, PL, PSB, PDT PPS and PC do B. PMDB and PSDB will likely position themselves as “independent” parties, that is, providing a conditional support on a case-by-case basis, without directly participating in the government. Two other small parties, PPB and PTB, would also be included in this category. Finally, we expect PFL to become a formal opposition.

Current New Difference
Nº Seats % Nº Seats %
Gov. Coalition 134 26% 187 36% 53
PT 58 91 33
PL 22 26 4
PSB 16 22 6
PDT 16 21 5
PPS 12 15 3
PCdo B 10 12 2
Conditional Support 281 55% 242 47% -61 PMDB 87 74 -13
PSDB 94 71 -23
PPB 53 49 -4
PTB 33 26 -7
Others 14 22 -14
Opposition 98 19% 84 16% -14
PFL 98 84 -14
Total 513 100% 513 100% -22

Senate
Current New Difference
Nº Seats % Nº Seats %
Gov. Coalition 19 23% 28 35% 9
PT 8 14 6
PDT 5 5 0
PSB 3 4 1
PL 1 3 2
PPS 2 1 -1
PSD 0 1 1
Conditional Support 45 56% 34 42% -11 PMDB 24 19 -5
PSDB 14 11 -3
PPB 2 1 -1
PTB 5 3 -2
Opposition 17 21% 19 23% 2
PFL 17 19 2
Total 81 100% 81 100% 0

The key point to monitor is whether PT will be able to negotiate a formal participation of PMDB or PSDB in the government, which would represent a major upside for Lula. The explicit support of either of those parties would provide the government with a robust majority of roughly 50% in the lower house and in the senate. However, that scenario is unlikely. Nevertheless, another point to monitor is what portion of the “independent” PSDB and PMDB can become a more consistent support group.

Election of the Presidents of the Two Houses -- A key instrument available for the government to negotiate the support of PSDB and/or PMDB in the congress will be the appointment of the new presidents of the two houses. Based on some internal rules and on the tradition of the congress, the largest party, or party block, enjoys the right to appoint the new president of the respective house. In the case in which a relevant party does not reach an agreement with other large ones, a direct election dispute may occur. That was the rare case in early-2001, when PSDB, led by Aécio Neves, challenged PFL, which was the largest party, triggering a direct election process between him and PFL’s Inocêncio Oliveira. Neves won, which generated a crisis for the Cardoso government. Since that outcome, PFL has never provided the same support to Cardoso again.

In the lower house, PT became the largest party, thus having the right to appoint the new president of that house. PT could transfer that right to another party, in exchange of a more consistent support, especially in the cases of PMDB and PSDB. Our initial sense is that PT would pursue an agreement with PMDB, allowing the party to appoint the president of the house. An obvious candidate in our view would be Michel Temer, PMDB’s president.

In the senate, PMDB and PFL have an equal number of 19 senators. However, since José Alencar (PL) is Lula’s vice president, his alternate is Aelton José de Freitas from PMDB (Minas Gerais), which would then become the largest party, having the right to appoint the president of the senate. If an agreement is established at the lower house as we discussed, PMDB would transfer its right to appoint the new president to the government’s coalition. It that case, there seems to be two strong candiates: Eduardo Suplicy (PT) and Jefferson Peres (PDT). Both are highly respected in the senate.

An alternative scenario would be one in which the PMDB appoints José Sarney as the new president of the senate (PT owes a lot to him, given that he supported Lula since the first round), while the president of the lower house would be appointed by PT or PSDB (in case the party agrees to support Lula).

In conclusion, the most important indication about the majority that the Lula government will enjoy in the congress will be given by the election of the new presidents of the two houses. The final results will translate what kind of political agreement is established among parties.

Congressional Agenda in the Transition Phase -- This week, President Cardoso, president-elect Lula and the leaders of the main parties will define the congressional agenda for the transition phase of November-December. Most likely, the agenda will compromise three main projects: (1) the approval of the revised 2003 budget, incorporating the consensus version of Cardoso and Lula, (2) PL9, which is part of the reform of the social security system for public servants, and (3) progress in the voting of the necessary legal framework to establishing an independent central bank. Below, we detail those projects and discuss other issues related to the congressional agenda, including the need to pass 34 provisional measures to unblock the agenda of both houses.

34 Provisional Measures Blocking the Agenda -- Before any new project is voted, the congress will have to pass 34 provisional measures that are already blocking the congressional agenda, since the timeframe to vote them has already expired (45 days after they are originally issued by the president). One of those provisional measures represents the first step of a broader tax reform, in that it eliminates the cascading effect of the PIS-PASEP federal taxes. According to the project, the base for the collection of those taxes will no longer be total corporate revenues, but rather the value-added revenue only. To avoid a revenue shortfall, the PIS bracket is raised to 1.65% from 0.65% currently. This provisional measure will be approved.

2003 Federal Budget -- The 2003 federal budget should be approved by the end of 2002. The President of the Budget Commission in the Congress, Deputy José Carlos Aleluia (PFL-BA), should resume the works on the budget, including the analysis of proposed amendments, as well as the necessary revision of macro-economic assumptions, which are fairly outdated

Currently, the Budget establishes a 2.80% primary fiscal surplus for the federal government or R$ 39.5 billion, which is in line with the consolidated public sector primary surplus target of 3.75%, as currently established by the Fiance Minister Pedro Malan.

However, economic assumptions will have to be revised to a more conservative scenario. Currently, the 2003 assumptions include a real GDP growth of 4% in 2003, compared to consensus market forecast of 1.25%, and our official forecast of 1.10%.

The main economic assumptions currently in the budget; 2003 2004 2005 Real GDP Growth (%) 4.0% 4.0% 4.5% Inflation IGP-DI (% annual. - 12 months) 4.0% 3.0% 3.0% Foreign Exchange Ratio (R$/US$) 2.42 2.45 2.48 Nominal Selic Interest Rate at year-end (% p.a.)
12.84% 11.25% 10.21%
“Skeletons” – Privatization (R$ bln) 9.21 11.45 12.21 Source: Ministry of Finance

Federal Government Budget
2001 Actual 2002 F 2003 F
R$ bln % R$ bln % R$ bln %
I. Revenues, Excluding
Pension Funds
209.6 17.7 240.1 18.5 249.6 17.6
1. Administrative Revenues 184.4 15.6 211.7 16.3 220.9 15.6 2. Non-Administrative
Revenues
25.2 2.1 28.4 2.2 28.7 2
II. Constitutional Allocations 43.2 3.6 49.8 3.8 49.7 3.5 III. Net Revenues (I-II) 166.4 14.1 190.3 14.7 199.9 14.1 IV. Expenses, except Pension Funds 131.1 11.1 143.4 11 148.6 10.5

V. Pension Funds -12.8 -1.1 -17 -1.3 -19.6 -1.4 1.INSS contributions 63.0 5.3 70.9 5.5 78.3 5.5 2.INSS Benefits payments -75.8 -6.4 -87.9 -6.8 -97.9 -6.9 VI. Statistical Errors -0.4 0 0.8 0.1 0 0 VII. Primary Fiscal Result
(III-IV+V+VI)
22.1 1.9 30.7 2.5 31.7 2.2
VIII. Nominal Interest
Expenses
47.3 4 54.6 4.2 67.5 4.8
IX. Federal Government
Nominal Results (VII-VIII)
-25.2 -2.1 -23.9 -1.7 -35.8 -2.6
X. Primary Result of State
Owned Companies
7.6 0.6 7.5 0.6 7.8 0.6
XI. Federal Primary Result 29.7 2.5 38.2 3.1 39.5 2.8

The discussion and the voting of the 2003 federal budget during the transition phase will be the first concrete test of the Lula government and PT regarding their commitment with an austere fiscal policy. The most controversial issues will likely be related to the adjustments of the minimum wage and public servants’ wages. Some PT leaders and economic advisors have been stating that they would find room in the budget to finance a stronger wage adjustment by further cutting discretionary spending. In our view, that is virtually impossible, representing only campaign rhetoric. In practice, roughly 90% of the primary federal spending are earmarked spending, including wage costs, thus being inflexible.
Therefore, in practice, only 10% of the central government spending is discretionary.

The minimum wage is currently R$200. The 2003 budget establishes a 5.5% nominal rise (in line with the previous inflation forecast) to R$211. However, the PT coordinator at the Budget Commission, deputy Jorge Bittar, stated that he intends to raise it to R$240 in 2003. According to the Finance Minister Pedro Malan, each R$1 increase in the minimum wage generates an increase of R$200 million in the federal government spending, of which 75% is related to social security obligations. Therefore, an increase of R$40 in the minimum wage would generate an additional spending of R$8 billion, which seems unlikely to be offset by additional cuts in discretionary spending.

Legal Framework for an Independent Central Bank -- The regulation for an independent central bank requires two steps. Firstly, the passage of a constitutional amendment eliminating restrictions imposed by article 192, which currently requires that the legal framework for an independent central bank can only pass together with the establishment of a comprehensive new regulation for the entire financial system. The government intends to advance in the voting of that amendment by the end of the year. The amendment has already passed in the senate, and needs to be voted by the chamber of deputies in two rounds, with the approval of 3/5 of the house in each session. Secondly, the passage of a specific project for an independent central bank. Until recently, PT leaders were against the elimination of some restrictions currently defined in article 192, including the absurd interest-rate ceiling limit of 12%. The party intended to define most of the regulation for an independent central bank in the constitution, instead of in a specific law, which would be the appropriate instrument. It seems that the PT now will accept the idea of removing all the inappropriate restrictions in article 192 and the passage of the specific project.

If there is enough support from Lula and the PT, the congress would be able to pass by December the constitutional amendment and begin to vote the specific project, which could ultimately pass in the congress by March-April of 2003.

PL 9 – Reform of the Social Security System of Public Servants -- This project is part of a necessary broader reform of the social security system of public servants. The project establishes a ceiling benefit limit at the same level of the INSS system (for private-sector workers), or nearly R$2,100 ($570) currently, establishing that for benefits above that level, public servants would have to pursue private pension plans in the market. The project is currently at the plenary of the lower house, where the basic text is already voted, but three amendments are yet to be voted. After being passed at the lower house, the project will be submitted to the senate. Realistically, the project can pass in the congress by year-end.

Other Tax Issues -- There are two other key projects to be approved by year end in order to avoid fiscal revenues shortfall for next year of nearly R$3 billion. 1. Income Tax on Individuals: According to the legislation, the higher bracket of 27.5% on individuals that receives more than R$ 2.115 would return to 25% in 2003. The government intends to keep the bracket at 27.5% in 2003, which will require the passage of an ordinary law. The reduction of the bracket to 25% would generate a revenue shortfall of R$1.7 billion. 2. Social Contribution on Net Profit: According to the current legislation, the CSLL (social contribution on net profit) would return to 8% in 2003 from 9% currently. However, the government has already issued a provisional measure keeping the bracket at 9% in 2003, thus avoiding a fiscal revenue shortfall of R$1.1 billion.

We expect both projects to pass relatively easily, since there will likely be enough consensus on the need for those adjustments.

The IMF agreement of US$30 billion, approved on September 6, requires a primary surplus of US$50.3 bln in the 12-month period ending in December 2002, R$13.8 bln in the 1Q03, R$31.4 bln in the 1H03 and US$41.9 billion in the first 9 months of 2003. Up to August 02, the primary surplus amounted to R$ 37.3 billion (4.48% GDP). The Real depreciation of 28% since the beginning of September and the three-point Selic rate hike to 21% in October have negatively impacted the Debt/GDP ratio. As a result, the IMF could require a higher primary fiscal surplus for 2003. The first revision of the agreement is scheduled for November 2002. That revision will directly involve Lula, thus representing an important signal for the market about his commitment to the IMF agreement.