The Next Big Test: Brazil

By Tim Padgett

Brazilians sardonically call their monstrous public bureaucracy O Trem da Alegria--the Joy Train. It is ridden by millions of officials like Cesar Almeida, mayor of a working-class town near Rio de Janeiro. The Globo TV network revealed last month that he has manipulated the system so cleverly that he earns $22,000 a month--twice the salary of the country's President--while teachers earn as little as $70 a month. Brazil was able to finance that kind of waste when foreign capital was pouring in. But now, with the global financial crisis sucking hundreds of millions of dollars out of Brazil each day, the Joy Train, whose payrolls burn up a surreal 70% of all public revenue, threatens to pull the nation over a cliff.

Brazilians amended their constitution in 1997 to allow President Fernando Henrique Cardoso to seek a second term in last Sunday's election. Cardoso, 67, a left-wing academic turned free marketer, has stamped out hyperinflation and given many of his 165 million countrymen their first real faith in democracy, capitalism and Brazil's titanic potential. Another four years, they hoped, would complete the dream. But now they'll need Cardoso's leadership just to stop the country's sudden nightmare of recession, unemployment and staggering deficits.

Brazil must endure a painful cure, including possible tax increases and spending cuts. Its success or failure will decide not only the well-being of the world's ninth-largest economy--and the preservation of the strong, dollar-pegged currency, the real--but also possibly the fate of the global system of free trade and investment.

Financial leaders in Washington and on Wall Street regard Cardoso as their best hope to preserve the credibility of the capitalist discipline they've sold to emerging markets during the past decade, a discipline now crumbling from Moscow to Malaysia. "They're seeing Brazil's struggle as a crucial stand for the orthodox model," says Emily Alejos, vice president for emerging markets at BEA Associates investment firm in New York City. And because it is the linchpin of the dynamic South American market, Alejos adds, "letting Brazil succumb to the global contagion would mean Argentina, Chile and other Latin American countries following on its heels."

U.S. banks have nearly $28 billion in loans at risk in Brazil--four times the amount they lent to Russia and second only among emerging markets to their exposure in South Korea. More than 2,000 U.S. companies have investments in Brazil.

Little wonder that on the eve of this week's annual International Monetary Fund meeting in Washington, the IMF and U.S. Treasury Secretary Robert Rubin sent their strongest signals yet that they're poised to assemble a $30 billion package of bailout loans to Brazil. "We believe that the economic well-being of Brazil is critically important not only to our economy but to the entire hemisphere," said Rubin.

Aides to Cardoso privately expressed hope that the promise of a bailout would bolster investor confidence in Brazil. But the country's President knows much more is required. Two weeks before the election, Cardoso went on national television and explained that the country will have to learn "to live within its means." Which means, for starters, that Mayor Almeida can expect a pay cut.

--By Tim Padgett. With reporting by Sol Biderman/Sao Paulo and Adam Zagorin/Washington

With reporting by Sol Biderman/Sao Paulo and Adam Zagorin/Washington