Palocci under siege

Brazil's economy

Nov 17th 2005 SÃO PAULO
From The Economist print edition

An effective finance minister tries to fend off corruption claims and friendly fire

FOR much of the time since he became finance minister nearly three years ago, Antonio Palocci has been under siege. Many businessmen and economists, and even fellow-members of the government, have blasted his cautious policies, saying they undermine economic growth. Mr Palocci has shrugged off such attacks. He draws support from the financial markets, whose confidence has helped keep debt and inflation under control. Brazil's left-wing president, Luiz Inácio Lula da Silva, has backed him unconditionally.

Until now. With the economy slowing and a presidential election less than a year away, the barrage has intensified. Worse, Mr Palocci has been dragged into Brazil's kaleidoscopic party-financing scandal. It is claimed that he illegally funnelled money to the ruling Workers' Party (PT), both when mayor of Riberão Preto, a city in São Paulo state, and as Lula's campaign chief in the 2002 election. Mr Palocci reportedly offered to quit. This time Lula did not rush to his defence. On November 16th, the minister broke several days of silence to rebut the claims in testimony before the Senate. His vigorous self-defence may quell speculation that he is about to resign. But investigations will continue, and he is not yet in the clear.

The prospect of Mr Palocci's downfall was enough to cause the real and Brazil's bonds to wobble on November 14th. In a survey by Dresdner Kleinwort Wasserstein, an investment bank, 90% of investors said that Mr Palocci's main policies would survive him. They are probably right. But Brazil requires a stronger dose of fiscal reform. That may not happen if Mr Palocci is weakened or driven from office.

One of the minister's problems is that his success can look like failure. Stiff interest rates—the world's highest in real terms—have throttled inflation and boosted the currency. But they have slowed growth and threaten to dampen an export boom. In September, industrial output fell 2% compared with August, hit by high interest rates, waning consumer confidence and cheaper imports. The economy may have shrunk in the third quarter. Tendências, a consultancy, says that this may drag growth for this year as a whole below 3%—or less than half the average for developing countries.

Much of the blame is heaped on the central bank, which stands accused of cutting inflation too briskly—from 12.5% in 2002 to perhaps 5% this year—and of treating transient price spikes as serious threats to stability. Since two-thirds of the public debt is indexed to short-term interest rates, monetary easing would prompt “a very fast drop in public debt,” says Ricardo Carneiro, an economist at the University of Campinas. The real would weaken and investment might pick up. Even some orthodox economists agree that the central bank has been too slow to cut rates.

Instead of a quick monetary fix, Mr Palocci has advocated patient fiscal therapy. Its main ingredient is a primary budget surplus (ie, before interest payments) of at least 4¼% of GDP. That target is calculated to secure a gradual lightening of the burden of public debt. It was bettered in 2004, and should be this year too. There is a strong case for cutting public debt at a faster rate before the world economy's liquidity glut dries up.

The primary surpluses have come from big increases in tax revenues rather than cuts in current spending (which has risen sharply). The casualty has been central-government investment, now only 0.6% of GDP. Mr Palocci is backing a plan to entrench budget reform in the constitution. This would reduce earmarking and set a ceiling on central-government current spending, initially at 17½% of GDP and falling annually. That would make space for more public investment and lower taxes, and lead to lower debt and interest rates. If Lula and his rivals for the presidency endorse the idea, the most urgent fiscal problems could be solved before the next government takes office, says Fabio Giambiagi, one of the proposal's authors.

But with the election looming, many in the government want to spend more. In an interview this month in O Estado de São Paulo, a newspaper, Dilma Rousseff, Lula's chief of staff, called the budget-reform plan “rudimentary”—a snub apparently aimed at Mr Palocci. The primary surplus target is safe, Ms Rousseff said, but she was not keen to go beyond it.

In any event, growth should pick up before the election. The central bank has started cutting interest rates and is expected to do so again next week. Lower inflation is boosting consumers' purchasing power. Were it not for the corruption claims, sniping by Ms Rousseff would pose little threat to Mr Palocci.

Rogério Buratti, an aide when the minister was mayor of Riberão Preto, claims that Mr Palocci passed to his party a monthly payment of 50,000 reais ($21,000) from a rubbish contractor. The city's former finance chief, who has since died, allegedly arranged an illegal donation of up to $3m to the PT by Cuba's Communist government. According to accounts in Veja, a newsweekly, this was stashed in boxes of rum and flown from Brasília to a city near São Paulo. Prosecutors are expected to charge five former city officials with soliciting bribes but say there is no proof of wrongdoing by Mr Palocci. That improves his odds of survival. Brazil must hope that he recovers his prestige.

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