A major contributor in this regard was the fact that the President elect used his first formal address to the press primarily to reaffirm his campaign economic policy commitments. This fueled the hope of an early start of a definition on what we think are the three central domestic drivers for sentiment in the transition period:

1. the unveiling of the economic team 2. the formation of a congressional working majority 3. progress with the early congressional agenda.

The period that followed however has seen some of this initial enthusiasm ease. The main driver behind this shift can be attributed to what could well be deemed a fourth domestic driver for sentiment, but which is so broad that is difficult to identify precisely. We are referring to the general market perception of how the new administration may manage the potential conflicts between former positions and supporters and their more recent counterparts over time. Examples in this connection can be given by the episodes regarding the PT’s position against the sale of Banco do Brasil excess stock this year and the reaction to São Paulo’s decision not to make an optional down payment on its debt with the Federal Government. While not of direct significance on their own, the episodes were read as indicative of the stance of the future administration with regards to privatization and renegotiating the debts of local governments.

This type of concern is likely to linger and could be responsible for bouts of asset price pressure in the future. Note however that the reverse is true as well. A reminder of this could come with the IMF mission due in Brazil next week, which may bring about statements deemed constructive regarding the new administration’s commitments for the future. In what follows however the focus is on the better defined three central drivers mentioned earlier.

Unveiling of the Economic Team -- The fact that the PT’s transition team is not to form the basis of the eventual ministerial cabinet has left markets still guessing at the possible names to head the new economic team. The transition team members, headed by the campaign’s government program coordinator António Palocci, indeed yielded a group largely representing the second level of PT local governments and allies in academia. A desire to preserve the eventual ministers from exposure while not yet in power, the option value of having slots open to negotiate with other parties and even a focus on getting key appointments “right” helps to explain why the cabinet will not be unveiled before December

Congressional working majority -- The formation of a working majority in congress took a significant step forward with the accord reached between the PMDB and PT. The parties agreed to favor the congressional tradition of majority parties holding the presidencies of each of the Congress’ chambers. In practice that implies that the PMDB would support a PT name for the House and the PT a PMDB name for the Senate. While a constructive development for governability, two caveats apply:

1. while many PMDB leaders have acknowledged the pact, a formal party endorsement of the arrangement has not yet been clearly made.
2. the question remains as to who the PMDB will propose for the Senate presidency as the party is divided between the wing that supported Lula (the front runner here seems to be Former President José Sarney) and the majority part which supported José Serra (no clear candidate yet). Depending on how this is resolved, the support of the PMDB may or may not be a unified one for the PT and for items in the congressional agenda. Ciro Gomes’ PPS party is expected to also formalize its support to the new administration early next week.

As such, the announcement is an overall positive first step but more remains ahead. The PSDB, meanwhile, formalized a “constructive opposition stance." This suggests that as expected the party should be well disposed to support some of the early reforms (many of which were authored by the party in the past) as long as these do not get too “transformed” in Congress.

In practice, this means that the characterization of three large blocs in the new Congress that are likely to result in a minimum working majority for the new government is getting support 1 . When adding the PMDB to the “Pro Lula” group, the new administration could reach the majorities needed for the passage of ordinary and complementary laws (e.g., MPs, FRL, Budget, etc.). On constitutional reforms (e.g. Article 192, social security) requiring 60% majorities, however, the help of other parties (notably the PSDB) would still need to be enlisted. What is apparent though is that the PFL’s opposition alone will not be able to bloc legislation. At present though the working majority remains a potential to be realized and only when the new Congress is inaugurated its value should be demonstrated.

1 “Pro-Lula”: PT, PCdB, PDT, PSB, PPS, PL/PSL, PV, PMN, “Neutral”: PMDB, PSDB, PTB, PSC, PST, PSDC,
“Opposition”: PFL, PPB, PRONA, PSD

Brazil: New Senate Composition
Party Members %
PMDB 19 23%
PFL 19 23%
PSDB 11 14%
PT 14 17%
PTB 3 4%
PDT 5 6%
PSB 4 5%
PPB 1 1%
PPS 1 1%
PL 3 4%
PSD 1 1%
Total 81 100%
Blocs w/o PMDB w/PMDB
"Pro-Lula" 33% 57%
"Neutral" 41% 17%
"Opposition" 26% 26%

Brazil: New Lower House Composition Party Members %
PT 91 18%
PFL 84 16%
PMDB 74 14%
PSDB 71 14%
PPB 49 10%
PTB 26 5%
PL 26 5%
PSB 22 4%
PDT 21 4%
PPS 15 3%
PC DO B 12 2%
Other 22 4%
Total 513 100%
Memo.: w/o PMDB w/PMDB
"Pro-Lula" 38% 52%
"Neutral" 34% 20%
"Opposition" 28% 28%

Early Congressional Agenda --
So that leaves us with the early congressional agenda. Here prospects look now a bit more mixed. The PSDB (which holds the presidency of the Lower House) and the PT transition team agreed last week on the voting agenda in the Lower House until the end of the session on December 15. The first order of business was the voting on 35 provisional measures (MPs) blocking consideration of other bills and 4 more due to the same in the first two weeks of this month. The agenda would then include voting on tax measures (extend the 27.5% maximum income tax bracket and CSLL’s 9% tax rate into 2003 and hike by 17.5% the minimum taxable income). At the same time the House should consider the reform of Constitutional Article 192 (financial sector) required for subsequently establishing the operational independence of the Central Bank. The house would then move to the discussion and voting of the 2003 budget in December. Without a set time, the House will also try to finalize voting on PLP9/00 (complementary pension for civil servants).

Thus far progress on the clearing of the MPs blocking the agenda has been positive. This week the House voted on 19 MPs by bypassing the procedural need to consider them in their original order. This allowed delaying the consideration of more controversial MPs to the second week of the month. The House leader Aecio Neves, indicated that the objective is to vote on the totality of remaining MPs next week and clearing the way for the agenda proper. Some of the pending MPs however deal with the regime applying to civil servant careers and the respective unions (traditional PT supporters) are already signaling their strong opposition. Central Bank workers in fact have already scheduled a work stoppage early next week. Here the difference will likely be marked by the extent to which the PT continues to enforce discipline within its ranks. Until this is demonstrated next week there is a risk that clearing the MPs could take longer than envisioned.

the most focal remaining items will the constitutional amendment to Article 192 and the Budget for 2003, as there is considerable support for the other measures in the agenda. With regards to the first it is important to understand that this reform should only enable the subsequent potential regulation of an operationally independent Central Bank. A sticking point in this regard has been the doing away of the section that caps real interest rates in Brazil at 12% as a constitutional matter. Considering that it is still not clear that the issue has yet been fully accepted by the PT and remembering the two rounds of approval that all such amendments need to satisfy (it has already been approved in the Senate), time may be just enough for approval. That would imply that the voting on the actual regulation regarding the operational independence of the Central Bank is likely to be relegated to later next year (after March probably).

Regarding the budget, there is a more substantial risk for delay. For one, since it’s the last item in the agenda, it would obviously be susceptible to the cumulative potential delays of any previous items. But also, there is the visible issue of the minimum and public servants wage increases to be implemented under the new budget. The current proposal is based on 5.5% and 4.0% wage increases, respectively. The PT transition team sent a constructive initial signal in indicating that the R$240 per month minimum wage that the party had been defending previously, up from the current R$200 per month, was no longer feasible. Seizing on the opportunity, the PFL officially came out in favor of the R$240 figure. Similarly, various members of congress have publicly advocated higher increases than 5.5%. As such, notwithstanding the new administration’s initial intentions, the stage looks set for a minimum wage that should exceed the R$211 level that is assumed in the current budget proposal.

The challenge is finding the revenues to satisfy the fiscal cost of a higher increase, as the budget law imposes consistency with the approved 2.8% of GDP Federal Government primary surplus (consistent with the public sector 3.75% of GDP surplus target for 2003). The cost does not relate so much to payrolls as it does to social security benefits, which are linked to the minimum wage. According the Ministry of Finance each 1% increase in the minimum wage adds approximately R$400 million in (mostly social security) additional expenditures over one year. The item that is giving some hope for a negotiated resolution is one of the few positives of the current pickup in inflation, namely higher nominal revenues in 2003. Based on the recent and projected evolution of the (IGP-DI) inflation index, which under the current proposal was assumed to rise only 6% next year, we think that the negotiations can settle for a minimum wage around R$220 per month. The actual increase in revenues would be higher than this increase but about 80% of revenues are earmarked so the “free” funds for the higher increase are limited. Another element that should act as a limit is the fact that the budget was based on 3% real growth next year and we would expect a downward revision to this figure.

The point is however that with the fine-tuning needed to make these negotiations consistent with a credible budget, and remembering the agenda that precedes this vote, there is a material risk that the approval of the budget may not occur by December 15. In such an event however, two avenues open: 1. Extend the current session by some days in December, or 2. Convene an extraordinary session of Congress in January of next year. Clearly the latter could bring about disappointment in the market but please note that such an outcome would lead to the rule of fiscal execution at 1/12 of this year’s budget for each month of next year in which a new budget has not been approved. This in fact would imply a fiscal tightening in practice.

As such, much regarding sentiment may follow from the pace of, and eventual concessions regarding, voting on the MPs still blocking the early congressional agenda next week. Don't forget however that while the timing of events on the other drivers is much less certain, developments related to those have the potential to impact valuations in the near term. This also extends to the “fourth driver” noted above, especially in the context of the Fund mission arrival next week.