UPDATE 1-Brazil ruling party says scandal won't hurt reforms

(New throughout with Workers'' Party briefing, previous Brasilia)

By Todd Benson

SAO PAULO, Brazil, Feb 19 (Reuters) - Brazil''s ruling Workers'' Party sought to distance itself from a corruption scandal on Thursday and said the government would emerge stronger when the truth was uncovered.

"The PT is very calm right now because the PT is a victim," Jose Genoino, president of the Workers'' Party (PT), told journalists in a briefing.

Last Friday a video surfaced showing Waldomiro Diniz, deputy secretary of parliamentary affairs for the presidential palace, collecting funds from an illegal bingo operation in return for political favors from the Workers'' Party in 2002. Diniz was fired a few hours later.

The events would not slow the reform agenda of President Luiz Inacio Lula da Silva''s government, Genoino said, when asked about the worries the scandal has provoked in the local and foreign investment community.

The so-called "Waldomiro affair" is the most serious scandal Lula''s government has faced since it came to power 14 months ago promising a new era in Brazilian politics.

The opposition has demanded a Congressional investigation into the matter. The government on Wednesday announced its own internal probe, but is resisting pressure from politicians and commentators to fire Jose Dirceu, Lula''s right-hand man, who gave Diniz his job in the presidential palace.

Some relief to the tensions came as legislators began to leave the capital, Brasilia, for their home districts for Carnival celebrations, which begin on Friday and last for about five days.

"The holidays will help calm down the excitement a lot," said political analyst Carlos Pio. "They will give people time to think and the government can benefit from this."

As part of the damage control campaign, Genoino held a two-hour meeting with foreign reporters in the financial capital, Sao Paulo.

A Congressional probe was not justified as the incident caught on tape took place before the government took office, he said. A police investigation and the internal inquiry announced by the government on Wednesday were sufficient, he said.

Diniz was not a Workers'' Party member, nor did any of the funds solicited end up in party campaign coffers, he said.

"He never exercised any role within the PT and never spoke in the name of the PT," Genoino said, saying that the party was the victim of a deliberate smear campaign.

"We condemn these attempts by the opposition to bring events from what happened in 2002 to 2004."

Financial markets still fretted on Thursday that the affair could harm the government and slow the passage of vital economic reforms. The local stock market and currency slipped and the prices of Brazil''s sovereign bonds fell.

Lula, a former shoeshine boy and militant leftist, has been feted by the business community for his conservative policies aimed at turning around Latin America''s biggest economy.

But, said Genoino: "The country isn''t paralyzed...the agenda for 2004 is not going to be slowed down."

Opposition sources said they were confident they had the support to launch a Congressional investigation and they had not expected to push it through before Carnival anyway.

"The government is having to act like a firefighter putting out the flames, and it is forgetting its political agenda," said Alvaro Bandeira, director at Agora Senior CTVM brokerage. ((Reporting by Guido Nejamkis and Todd Benson; Writing by Angus MacSwan; editing by Caroline Valetkevitch; Sao Paulo newsroom; Tel: 55 11 5644 7714))