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Cablegate: Will Brazil Join the Sovereign Wealth Fund Club?

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DE RUEHSO #0053/01 0380904
ZNR UUUUU ZZH
R 070904Z FEB 08
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 7872
INFO RUEHBR/AMEMBASSY BRASILIA 9024
RUEHRG/AMCONSUL RECIFE 3986
RUEHRI/AMCONSUL RIO DE JANEIRO 8567
RUEHBU/AMEMBASSY BUENOS AIRES 3050
RUEHAC/AMEMBASSY ASUNCION 3298
RUEHMN/AMEMBASSY MONTEVIDEO 2604
RUEHSG/AMEMBASSY SANTIAGO 2301
RUEHLP/AMEMBASSY LA PAZ 3708
RUCPDOC/USDOC WASHDC 3022
RUEATRS/DEPT OF TREASURY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC
RUEHC/DEPT OF LABOR WASHDC

UNCLAS SECTION 01 OF 03 SAO PAULO 000053

SIPDIS

SENSITIVE
SIPDIS

STATE PASS USTR FOR KDUCKWORTH
STATE PASS EXIMBANK
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE
DEPT OF TREASURY FOR JHOEK
USDOC FOR 4332/ITA/MAC/WH/OLAC
USDOC ALSO FOR 3134/USFCS/OIO
DOL FOR ILAB PEREZ-PKOPEZ AND WHOLEY

E.O. 12958: N/A
TAGS: ECON EFIN EINV BR
SUBJECT: WILL BRAZIL JOIN THE SOVEREIGN WEALTH FUND CLUB?

REF A: BRASILIA 0036
B: SAO PAULO 1005
C: SAO PAULO 0012
D: SAO PAULO 0768

SENSITIVE BUT UNCLASSIFIED - PLEASE PROTECT ACCCORDINGLY

1. (SBU) SUMMARY: In the closing months of 2007, Brazil's Finance
Minister Guido Mantega proposed establishing a Sovereign Wealth Fund
(SWF) as a vehicle to intervene in foreign exchange markets to curb
the appreciation of Brazil's currency. Brazil's controversial plan
differs substantially from other nations' funds and sparked a public
battle between the Ministry of Finance and the Brazilian Central
Bank over the government's commitment to maintain Brazil's floating
exchange rate regime. Brazil's Central Bank is unlikely to hand
over access to Brazil's sizeable foreign reserves and relinquish
control over monetary policy. Furthermore, Brazil is a poor
candidate for a SWF because the GOB is not flush with excess
revenues from the commodity price boom and does not have a
burgeoning fiscal surplus to fund a SWF. Sao Paulo-based financial
analysts believe Minister Mantega's plan would amplify any economic
crisis following an external shock instead of minimizing the risk.
Most are skeptical that the GOB would create a SWF given the timing
and global economic turmoil. END SUMMARY.

Lack of Coordination and Planning
---------------------------------

2. (U) Brazil's Finance Minister Guido Mantega first proposed last
October the idea of establishing a Sovereign Wealth Fund (SWF) that
would draw on Brazil's foreign reserves of USD 180 billion to fund
infrastructure projects in Brazil. That idea sparked a public
dispute between Minister Mantega and the Brazilian Central Bank
President Henrique Meirelles, who argued that the fund would not be
created until foreign reserves could cover Brazil's gross external
debt of USD 200 billion. In December, Mantega announced an
unorthodox scheme for a SWF in 2008 that would be a tool for the GOB
to directly intervene in foreign exchange markets to counter the
appreciation of the Brazilian currency. Since 1988, Brazil's
Central Bank has exclusively controlled monetary policy (the Central
Bank falls under the Ministry of Finance and is therefore not
technically independent), and this development would be a
significant departure from the GOB's recent economic policies.
Although the details are limited, according to Mantega's publicly
announced scheme, the SWF would, in theory, be used to invest in
offshore assets of Brazilian companies including securities issued
by the National Development Bank (BNDES) to boost public
infrastructure investment. [Note: Brazil is currently
under-executing its public infrastructure budget due to a lack of
clear investment guidelines and mechanisms to pursue such activities
as public private partnerships,as well as, the GOB's inability to
identify good projects and make them viable. End Note.]

3. (SBU) In part, these uncertainties reflect a lack of discussion
within and among Brazil's ministries and highlight the fact that a
unified view among Brazil's key ministries does not exist. A senior
adviser to the COPOM (Political Monetary Committee of the Central
Bank of Brazil equivalent to the U.S. Board of Governors of the
Federal Reserve Bank) told the Treasury Attache that a SWF "is an
idea" but that the Ministry of Finance had not prepared a single
internal policy paper on this issue (ref A). A senior member of the
Central Bank's Department of Economics told Treasury officials that
it knows nothing about Mantega's proposal other than what has been
reported in the press. Likewise, the Ministry of Foreign Affairs
told Treasury officials in December that it has no specific
knowledge about a SWF and believes creating such a fund is
ill-advised. In a recent meeting with Mission officials, former
Finance Minister and GOB insider Antonio Palocci agreed that a SWF
is ill-advised, and said that the plan is on hold in light of recent
domestic and international economic turbulence.

There's No Money

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----------------

4. (SBU) One immediate problem in establishing a SWF is that the
GOB has not identified the source of funding. Although Brazil's
foreign reserve assets are excessive by most measures of reserve
adequacy, Central Bank President Meirelles has stated previously to
the Treasury Attache that Brazil's large foreign reserve assets have
been the single most important factor in preserving Brazil's
stability amidst recent global financial market volatility. Given
that view, it seems highly unlikely that Brazil's central bank would
be willing to use reserves for this purpose.

5. (SBU) Brazil's fiscal framework also leaves no room in which to
finance a SWF. Ten billion dollars, the initial injection in the
Mantega scheme, represent approximately five percent of Brazil's
non-interest expenditures. To finance this expenditure from the
budget, the Ministry of Finance would be forced to raise revenues,
reduce expenditures, or lower its primary surplus target. Given the
USD 22 billion hole created by the failure to pass the CPMF
(financial transactions tax) in December, Brazil's 2008 fiscal
framework is already facing new pressures (ref B and C). Minister
Mantega has publicly ruled out any adjustment in Brazil's 2008
primary surplus target which if changed could potentially undermine
Brazil's march towards receiving an investment grade sovereign
credit rating (ref D). Furthermore, expenditure reductions would be
politically difficult in 2008 as municipal elections will be taking
place throughout the country, setting the tone for national
elections in 2010.

Private Sector Opposition
-------------------------

6. (SBU) Brazil's private sector also has been largely opposed to
Mantega's idea to create a SWF because Brazil does not fit the
typical model country. Mauricio Oreng, from Itau Bank, explained to
Econ Specialist that Brazil is not in the same position as nations
which, due to their large foreign exchange reserves and fiscal and
current account surpluses, have been able to establish SWFs to
invest money that would otherwise remain unproductive in short-term
instruments. Brazil's foreign debt exceeds its foreign exchange
reserves and its current account surplus is approximately 0.7
percent of GDP, not nearly enough to sustain Brazil's economy in the
event of a future crisis, he said. Furthermore, Oreng said Brazil
is expected to post a current account deficit this year. Oreng
opined that Mantega had likely not discussed the proposal with the
Central Bank prior to his announcement, but said that the idea had
thankfully fallen off the radar screen for now.

7. (SBU) ABN Amro noted Mantega's plan for a SWF might incite
further appreciation of the Brazilian real by encouraging local
companies to issue more securities via the new investment vehicle,
in turn increasing the flow of dollars. As a result, in their view,
the GOB would therefore undermine its chief goal of limiting the
Brazilian currency's appreciation. Tomas Malaga, a senior economist
at Itau Bank also noted that Mantega's plan to use the SWF to
finance BNDES investments would intensify the impact of external
shocks on the Brazilian economy by increasing exposure to Brazilian
assets instead of diversifying away from them. He also highlighted
a potential financing mismatch because the GOB would conceivably
finance BNDES lending abroad through Brazilian banks at higher
interest rates than the likely return on investments. Virgilio
Castro Cunha, an economist at Merrill Lynch, concurred with Malaga's
analysis and opined to Econoff that BNDES had encouraged Mantega's
proposal as a way to increase BNDES budget allocations in a less
transparent manner.

8. (U) Unlike countries that employ SWFs to control excessive
government revenues from state-run enterprises, the GOB would need
to issue debt to fund the SWF as Brazil's private sector is the
primary driver of Brazilian exports. According to an ABN Amro
analysis of SWFs, typically countries that established SWFs export a
single commodity (oil, gas, minerals, etc.) that brings in

SAO PAULO 00000053 003 OF 003


government revenue in the form of royalties, dividends, or taxes.
For these countries, higher prices translate directly into improved
fiscal performance. ABN Amro's case study showed that SWFs help
mitigate the cyclical nature of these revenues as a savings tool for
prudent fiscal management. Brazil doesn't have a single commodity
that dominates exports nor excessive government revenues directly
associated to export performance because Brazil has a diversified
export base.

Central Bank Opposition Likely
------------------------------

9. (SBU) The Brazilian Central Bank's decision-making body, the
National Monetary Council (CMN), is likely to question the idea of a
SWF and using reserves to create a wealth fund will require formal
approval by the CMN. [Note: The Council includes the Central Bank,
Finance Ministry, and Planning Ministry. End Note.] Furthermore, a
senior Ministry of Finance official told the Treasury Attache on
December 13 that the Finance Ministry was aware that the Central
Bank was not enthusiastic about an SWF and might resist if the
Ministry of Finance tried to push. Although Minister Mantega could
likely persuade Planning Minister Paulo Bernardo to support his
plan, Central Bank President Meirelles seems certain to oppose any
efforts to spend its reserves. Any perception of political pressure
on Meirelles and his board members in this effort would undermine
the perceived independence and hard-earned credibility of Brazil's
Central Bank. Finance Minister Mantega is thus likely to face strong
internal opposition and negative market reaction if he moves too
aggressively to create a SWF.

Comment
-------

10. (SBU) Support for the GOB's proposal for a Sovereign Wealth
Fund is limited. Financial analysts from Sao Paulo's private sector
clearly oppose the GOB's unorthodox idea and cite valid concerns
about its possible implementation. The GOB also faces an uphill
battle to get funding and approval from the Central Bank, suggesting
that the GOB may be unable to develop and launch an official
proposal over the near-term. For now at least, the GOB is focused
on defending the Brazilian economy against the recent global
economic turmoil and appears to have shelved the proposal. END
COMMENT.

WHITE

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