FACTBOX-Key political risks to watch in Brazil

BRASILIA, July 1 Thu Jul 1, 2010 6:07pm EDT

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BRASILIA, July 1 (Reuters) - Brazil's presidential election in October looks less risky to investors than any other in the last 25 years in the South American powerhouse as its economy bounces back from a brief recession, but there are still investment risks to watch this year.

PRESIDENTIAL ELECTION

President Luiz Inacio Lula da Silva's former chief of staff, Dilma Rousseff, is the ruling Workers' Party candidate to succeed him. Polls show she has now overtaken her main rival, Jose Serra, the former Sao Paulo state governor running for the centrist opposition PSDB party. [ID:nN29178728]

Most analysts see Rousseff as the favorite because she can count on support from the hugely popular Lula and will be helped by the rebounding economy. [ID:nN24264257]

Unlike previous races, there is no clear market favorite because neither of the main contenders is expected to break with the mostly market-friendly policies in place for the past decade: a free-floating currency, inflation control and fiscal discipline. Some investors prefer Serra for his party's centrist stance and his managerial experience.

In an effort to win over centrist voters and avoid unsettling investors, Rousseff has emphasized market-friendly proposals so far in the campaign.

Serra, who believes the government should be active in economic affairs, has yet to spell out many specific policy proposals. However, he recently called for lower interest rates and urged an overhaul of Brazil's costly pension system. [ID:nN10198404]

Rousseff, who was endorsed by the center-left Workers' Party in February, has praised the central bank and pledged continuity. She has said the bank should keep focusing on controlling inflation in coming years before it could consider economic and job growth when setting monetary policy.

Serra wants the central bank to look at the broader economy and not just inflation when setting interest rates. He says the central bank should have cut interest rates more aggressively during the 2008 global financial crisis.

There is also some doubt about how firmly the candidates would push for a second generation of structural reforms to ensure Brazil's international competitiveness if elected.

Both agree on the need to overhaul Brazil's complicated tax system to encourage investment but have not provided many details. Serra wants to reform the pension system by cutting benefits for some civil servants, while Rousseff favors a piecemeal reform that would raise more money to finance the growing pension deficit and alter some retirement rules.

Neither proposes nationalizing private companies. But Rousseff, and to a lesser extent Serra, favor a strong role for state firms in the economy, a position that gained ground after low-cost loans by state banks helped Brazil's economy recover from the global crisis. Larger state companies could weaken private sector participation in banking, oil and utilities.

Rousseff has said growth of state banks would not infringe on private banks, which she said were necessary to drive economic expansion and spur competition.

Government plans to revive state-owned telephone company Telebras (TELB4.SA) to expand broadband Internet access have sent its shares sharply higher, but further moves to strengthen Telebras could depress shares of private telecoms. Lula also wants to strengthen state-owned power company Eletrobras [ELET6.SA], though the intent may be to expand mostly abroad.

Serra is widely believed to be the tougher of the two main candidates on fiscal discipline and has said he would cap current expenditures, potentially paving the way for swifter interest rate and tax cuts. [ID:nN25443706] [ID:nN26210019]

Both Serra and Rousseff were officially nominated by their parties in in June. [ID:nN12147535 ] [ID:nN13136489]

A crisis over Serra's choice of running mate exposed divisions among his coalition. Serra tapped 39-year-old Indio da Costa, a lawyer from the small DEM party, scrapping a previous proposal to run with a senator from his own party after DEM leaders threatened to quit the coalition.

What to watch:

-- Serra and Rousseff will name their economic advisers in coming weeks. A left-wing choice could unnerve investors and send jitters through financial markets.

-- Details of Serra's economic proposals, particularly fiscal and monetary policy.

GOVERNMENT SPENDING

The government is expected to maintain a high level of spending before the election, putting pressure on the central bank to raise interest rates to curb inflation.

Public spending rose sharply in 2009, eroding the primary budget surplus to an eight-year low of 2 percent of gross domestic product. Finance Minister Guido Mantega has pledged to pursue a surplus of 3.3 percent of GDP in 2010 but inflation remains on track to exceed the center of the government's year-end target.

What to watch:

-- Weak monthly primary surplus figures would indicate worsening fiscal discipline and could push up interest rate futures. <0#DIJ:>

-- Lula and Mantega could put increasing pressure on central bank chief Henrique Meirelles to keep expected interest rate hikes to a minimum so as not to jeopardize the economic recovery in an election year.

OIL AND GAS

Congress is expected to approve by the end of the year government-proposed legislation that would increase state control over some of the world's biggest recent oil finds. The overhaul seeks to ensure proceeds from vast new fields flow to the state to help bankroll investments in areas like infrastructure, education and poverty-reduction programs.

The measures will likely reduce competition in the sector while boosting the role of state energy giant Petrobras (PETR4.SA)(PBR.N), offering fewer but still attractive opportunities for foreign investors. [ID:nN01485799]

Critics say the laws threaten the efficiency of Brazil's successful oil sector by stifling investment and increasing the dangers of political interference and corruption.

Brazil's Chamber of Deputies and the Senate have approved the key points of the legislative proposal. Analysts give the proposal about a 60 percent chance of approval this year.

Plans to create a production-sharing model for future oil projects to replace the current concession system have been approved by the Senate but returned to the lower house for conciliation after amendments were made.

What to watch:

-- Disagreement in the Senate over how to distribute oil revenue between the federal government and states could hold up parts of the proposal, along with election campaigning and the distraction of the World Cup. [ID:nN26161706]

POLICY STAGNATION

Nearly a dozen cabinet members resigned in April to campaign for public office in the Oct. 3 election. Most have been replaced by career civil servants who typically lack the political capital to push the government's agenda.

What to watch:

-- If Lula's successor fails to win a clear majority in Congress, reforms needed to improve Brazil's long-term competitiveness may face difficulty getting approval. These include reforms to an unwieldy tax system, costly pension benefits and rigid labor laws.

-- Strong pledges from Serra or Rousseff to cut spending and boost efficiency could help reduce inflation expectations.

CORRUPTION

Mud-slinging and corruption scandals tend to surface during Brazilian election campaigns. They could paralyze Congress and harm the camp of either of the leading candidates. Lula himself came close to facing impeachment proceedings in 2005 when his party was involved in an illegal campaign-financing scandal.

FOREIGN POLICY

If elected, Serra is likely to cool ties with some of Lula's left-wing allies in Latin America. That could affect energy investments in Bolivia and Venezuela, where Lula had prodded Petrobras to invest to foster regional integration.

Serra recently accused the Bolivian government of turning a blind eye to cross-border drug trafficking. Some analysts think Serra could also take a harder line in trade disputes with Argentina and the South American trade block Mercosur.

Rousseff, by contrast, has pledged to continue current foreign policy and could name the current deputy foreign minister, Antonio Patriota, as Brazil's top diplomat. (Additional reporting by Peter Murphy; editing by Kieran Murray and Anthony Boadle)

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