FACTBOX-Key political risks to watch in Brazil

BRASILIA Mon Aug 2, 2010 11:26am EDT

BRASILIA Aug 2 (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. She is tied in some polls, and in others is ahead of her main rival, Jose Serra, the former Sao Paulo state governor running for the centrist opposition PSDB party.

Most analysts say Rousseff has better chances to win as 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 business leaders prefer Serra for his support of national industry and his managerial experience. But concern is growing in financial markets over his heavy-handed approach to economic policy [ID:nN29257620].

In an effort to win over centrist voters and avoid unsettling investors, Rousseff has emphasized market-friendly proposals so far in the campaign. She is also being advised by market-friendly former finance minister Antonio Palocci.

Serra, who believes the government should be active in economic affairs, has yet to spell out many specific policy proposals. However, he has called for lower interest rates and said the currency was overvalued and that the central bank needed to follow the government's economic policy. [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.

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.

Uncertainty over government plans to use state-owned telephone company Telebras (TELB4.SA) to expand broadband Internet access has sent its shares lower after an initial rally. The plans could also affect share performance of private telecoms depending on their participation in deals.

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 [ID:nN25443706] [ID:nN26210019], though he has failed to match the detailed primary surplus targets Rousseff has given.

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:

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

-- New names surfacing during the campaign as potential cabinet members.

GOVERNMENT SPENDING

The government is maintaining a high level of spending before the election, potentially fueling inflation and forcing the incoming president to adopt austerity measures.

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 in the 12 months to June it was only 2.07 percent.

What to watch:

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

-- Mantega and Lula could step up pressure on central bank chief Henrique Meirelles to keep the next interest rate hike to a minimum so as not to jeopardize the economic recovery in an election year.

OIL AND GAS

Brazil's Senate has postponed voting on key oil-related legislation until after the election. That raises the risk that the government-proposed overhaul be shelved in the case of a victory for Serra, whose party has criticized the bills.

The proposal aims to increase state control over some of the world's biggest recent oil finds and ensure their proceeds flow to the state to help bankroll investments in areas like infrastructure, education and poverty-reduction programs.

If approved, the measures will likely reduce competition in the sector while boosting the role of state energy giant Petrobras, offering fewer but still attractive opportunities for foreign investors. [ID:nN01485799]

Of the four bills, only one enabling a massive capitalization plan for Petrobras (PETR4.SA)(PETR3.SA)(PBR.N) has passed into law.

But investor uncertainty over a possible Serra win could force Petrobras to delay the capitalization plan.

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.

What to watch:

-- Disagreement in the Senate over how to distribute oil revenue between the federal government and states could close an already small window of opportunity in November or December to approve the bill before Lula leaves office. [ID:nN26161706]

CONGRESSIONAL SUPPORT

If Serra were to win the October election, the Lula administration could lose its majority in Congress as "swing" legislators migrate to the president-elect's camp. This could create a hung parliament with little chance of approving major bills before Lula leaves office on January 1.

Similarly, 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.

CORRUPTION

Mud-slinging and corruption scandals tend to surface during Brazilian election campaigns and have the potential to paralyze Congress and harm 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. He has also criticized Venezuela for allegedly harboring Colombian rebels. Some analysts think Serra could 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. (Editing by Kieran Murray)

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