Paulo Vieira da Cunha: Investors' perception of Brazil country risk is at historically low levels as measured, for example, by JP Morgan's EMBI Index. This is due in part to technical and global reasons in the market. For example, the recent debt management operations of the Brazilian Treasury which have reduced the stock of external debt; the further opening of local capital markets to foreign investors; the continued high level of liquidity in global capital markets with a positive assessment of prospects for the global economy and the US in particular.

It is also due to the specific positive moment in the macroeconomics of Brazil. The fiscal and external vulnerabilities have been reduced significantly. Inflation is low and the outlook is stable with an important buildup of policy credibility at the central bank. In these conditions, the elections are seen as a potential source of volatility without a significant impact on fundamentals. Investors remain confident and see the electoral outcome as neutral to the market. Macro policy would be essentially the same regardless of who wins and it would be market-positive.

While I agree with the general thrust of this argument, I believe that 2007 could be a difficult year, post elections. The issue is the required fiscal adjustment both in the fiscal accounts themselves (e.g. the constitutional requirement to reenact the CPMF and the DRU) and in the social security system, made worse by the excesses of 2006. The new president would have to implement urgent measures to buttress the fiscal foundation without which the entire macro edifice crumbles. It is a mistake to think that Brazil is done with its fiscal adjustment. What has been done is insufficient and of poor quality, having produced a major expansion in fiscal expansion, in real terms and as a share of GDP. This has to be redressed.

Vieira da Cunha No. The global economy is in a different phase of the cycle, much more receptive to risk. The domestic economy has been transformed. Currently, the federal government (Central Bank and Treasury) is a net creditor in foreign exchange. At the time of the 2002 crisis, more than half of the public domestic debt was indexed to the US dollar. Today, a devaluation would lead to a capital gain; back in 2002, fears of an uncontrolled devaluation threatened to make monetary policy ineffective. In the fourth quarter of 2002 Brazil suffered a "sudden stop" in foreign capital flows and the Treasury could not fund itself in local markets for debt with maturity extending beyond 2002. This year, the Treasury has pre-funded in external markets all of its current obligations, and more. In the domestic market, it has reduced the share of debt in floating rate instruments (reducing the potentially negative feedback loop from interest and/or exchange rate volatility on the public debt) and placed more debt with fixed rate and/or inflation-index with very long maturity (reducing the rollover risk).

Vieira da Cunha: Foreign investors have done very well under Lula and understandably have a bias for the status quo - though, obviously, it is hard to generalize from anecdotal evidence. I am not aware of any recent survey evidence about this question. Foreign investors as a group may be more worried about the corruption scandal in Congress and the administration than the average Brazilian voter, as indicated by the recent polls. To that extent they may have a bias against the PT though it is not clear that it would extend to Lula himself. In his time, investors supported Fernando Henrique Cardoso. Certainly they favored the PSDB over the PT and my sense is that is still true today in so far as they "separate" Lula from the PT.

The PSDB candidates are viewed with equanimity if not support. Between Alckmin and Serra the preference seems to be for Alckmin but, personally, I would not rely on this kind of hearsay opinion at this stage of the campaign. The important aspect is that investors believe that the electoral outcome will not threaten the basic macro framework. I think they are right; though the outcome will matter for the quality of the next administration, the avoidance of a fiscal crunch in 2007, and the growth prospects of the economy.

Vieira da Cunha: My sense is that the Central Bank has managed monetary policy well. It guides inflation expectations from a position of credible strength and, arguably, expectations are the critical variable in an inflation-targeting regime. This suggests a measured and continuous process of easing: 75bp per meeting until the rate reaches 14.5%, as long as expectations remain anchored at the center of the target (4.5%). At that point the authority may pause before taking the rate further down. The "equilibrium range" would depend on the measure of country risk and the stability of expectations at the time; but it is conceivable that the rate would be down to 14% by year-end.

The argument for greater speed with the rate cuts would hinge on an unexpected deceleration in the pace of growth of domestic aggregate demand. Given what we know today, it seems unlikely. Note, however, that output growth in 2006 is likely to be slower than the pace of expansion in domestic aggregate demand (i.e. domestic absorption). The reason is, primarily, the expected smaller contribution of net exports to growth. (In fact, with a trade surplus forecast of $39 billion the contribution of net exports to growth would be negative in 2006.) It is possible that absorption grows at about 4-5%pa in 2006 while GDP grows at a rate of 3%-3.5%. Since the Central Bank is primarily concerned with demand (and its impact on the output gap) the "slow" growth in GDP would not, in itself, be an argument for greater speed with the rate cuts.

Vieira da Cunha: Yes and increasingly with greater efficacy. The tripod introduced in mid-1999 - a floating exchange rate regime supported by credible inflation targeting anchored on a fiscal surplus sufficient to stabilize debt dynamics - has demonstrably worked well in Brazil, already through several crises and changing market conditions. The current concern is with the slipping fiscal anchor. The issue is not only the size of the primary surplus though this too is a problem given the speed at which it is being eroded. The main problem is the poor quality of the fiscal adjustment, that made the tax burden grow by 10pp of GDP in less than a decade with continuously expanding real public expenditures practically none for investments. Obviously, the trend is unsustainable and yet we will see more of it in 2006!

Vieira da Cunha: The moves were well timed and executed, welcomed and rewarded by the market. Arguably, the Brazil spread would not have diminished as much or S&P advanced the credit rating without them. Reducing the burden of external (and dullar-linked) debt is a way to increase investor confidence and reduce the potential impact of unexpected external volatility. It is encouraging to see the Treasury seize the positive opportunity to pursue these goals. Even so, the measures are second best. The first-best approach would have been to use the foreign exchange "cushion" to pursue trade liberalization; to reduce tariffs and stimulate imports, increasing the productivity of the economy while avoiding potentially negative second-round effects from the appreciation of the currency that could happen if capital inflows increase suddenly.

Vieira da Cunha: The problem with the US dollar is that it should depreciate but nobody (other than exporters in the US) wants to see it depreciate, least of all China. This means that the main instrument to correct the US imbalance should be fiscal policy supported by a coordinated expansion in the other G-7 economies. It is, admittedly, an unlikely outcome. Nevertheless, it is stretching things to say that the US economy is in such a bad shape that it will erupt into a crisis, the housing "bubble" notwithstanding. As the largest economy in the world it has room and time to adjust. My sense is that the global economy will slow down in a moderately smooth way without major disruptions to capital markets. The scenario is benign for Brazil, especially in 2006; and, in the event, Brazil is much better prepared to face global turbulences. The impact of a global slowdown would be negative, to be sure. But given a strong balance of payments position and reduced external liabilities what could otherwise be a crisis would likely be a recession.

Vieira da Cunha: It is a disadvantage to be based outside of Brazil and the São Paulo-Rio axis, to be specific. Nevertheless, given the much greater transparency of public institutions, the Central Bank and the Ministry of Finance in particular, of the availability of timely and accessible data, and of web-based information, one can make due. There is the advantage of being closer to the non-Brazil investor community and benefiting from its perception about global and Brazil specific events and circumstances. Personally, I benefit most from the continuous dialogue, criticism and assistance from colleagues and friends in Brazil. The quality of market research and commentary in Brazil is very high and on a par with what is done for the major capital markets in the US and Europe. To do without this knowledge and feedback would be, indeed, a serious handicap.