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Cablegate: Brazil's Current Account Deficit Not Worrisome

VZCZCXRO7880
RR RUEHRG
DE RUEHSO #0476/01 2521557
ZNR UUUUU ZZH
R 081557Z SEP 08
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 8506
INFO RUEHBR/AMEMBASSY BRASILIA 9641
RUEHRG/AMCONSUL RECIFE 4184
RUEHRI/AMCONSUL RIO DE JANEIRO 8838
RUEHBU/AMEMBASSY BUENOS AIRES 3240
RUEHAC/AMEMBASSY ASUNCION 3487
RUEHMN/AMEMBASSY MONTEVIDEO 2765
RUEHSG/AMEMBASSY SANTIAGO 2487
RUEHLP/AMEMBASSY LA PAZ 3900
RUCPDOC/USDOC WASHDC 3164
RUEATRS/DEPT OF TREASURY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 03 SAO PAULO 000476

STATE PASS USTR FOR KDUCKWORTH
STATE PASS EXIMBANK
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE
DEPT OF TREASURY FOR JHOEK, BONEILL

SIPDIS
SENSITIVE

E.O. 12958: N/A
TAGS: ECON EFIN EINV ETRD BR
SUBJECT: BRAZIL'S CURRENT ACCOUNT DEFICIT NOT WORRISOME

SENSITIVE BUT UNCLASSIFIED--PLEASE PROTECT ACCORDINGLY

REF: Sao Paulo 0268

1. (SBU) Summary: Brazil is set to run its first current account
deficit since 2002; however, unlike previous years, the more stable
composition of the balance of payments should protect the Brazilian
economy from crises. The floating exchange rate, smaller share of
foreign currency denominated debt, status as an investment grade
sovereign, and record-shattering foreign direct investment inflows
all put Brazil in a better position to manage its current account
deficit. The primary drivers behind the deficit are twofold.
Brazil's external financing profile has moved from debt to equity,
and profit and dividend remittances have replaced interest payment
outflows. The declining trade surplus due to the growth in
capital-intensive imports is also contributing to the current
account deficit, as companies boost investment spending. Although
the Brazilian currency has appreciated by 25 percent against the
U.S. Dollar over the last three years, many interlocutors disagree
on its impact on Brazil's trade balance. Despite the GOB's efforts
to boost exports, the decline in the trade surplus is likely to
continue. Different from the historical crises associated with
current account deficits, Brazil's current account deficit is now
more of a signal that foreign investors recognize Brazil's
potential. End Summary.

Historically Bad, But Not This Time
-----------------------------------

2. (SBU) Brazil will close out 2008 with a current account deficit
of approximately 1.9 percent of GDP; the first deficit in five
years. Current account deficits in Brazil were common and have
historically been an ingredient for disaster. Since 1947 when the
Brazilian Central Bank first began measuring the current account,
Brazil has registered a surplus only 12 times, with five of those
occurrences in the last five years.

3. (SBU) According to Itau Bank, the composition of the current
account is very different than in the 1990s when Brazil ran current
account deficits of more than four percent of GDP. Brazil no longer
has a pegged exchange rate; the floating rate will help to
automatically correct any current account imbalance before it
becomes unsustainable. Brazil also has a large stockpile of foreign
reserves and is a net external creditor, which means that Brazil's
external accounts now actually benefit when the Brazilian currency
depreciates.

4. (SBU) Brazil's capital/financial account inflows are very
different today than in the past. Foreign direct investment (USD 34
billion in 2007) and portfolio inflows have substituted debt as an
important financing source, resulting in increased outflows of
profit and dividend remittances, negatively impacting the current
account. According to Unibanco economist Darwin Dibb, soaring
outflows of profits and dividends have already inflicted more damage
to the current account than the shrinking trade balance. Through
2003, profit and dividend remittances were approximately USD five
billion. Since then, the two have grown exponentially to close to
USD 30 billion. Both signal the more stable move in Brazil's
external financing from debt to equity. Both are sustainable in the
event of an economic downturn because dividends and profits retract
while interest payments are fixed.

5. (SBU) The new financing profile also represents a change in
perception about Brazil. Increased foreign direct investment and
portfolio inflows suggest that the world seems willing to finance
Brazil's transition towards a credible economy with solid
macroeconomic stability. The fact that Brazil is now investment
grade reduces the likelihood of sudden outflows. According to
Merrill Lynch, a current account deficit of up to three percent of
GDP is consistent with a country that receives foreign savings to
fund investment, given the higher domestic return on capital.

6. (SBU) Brazil had habitually financed its domestic spending via
foreign denominated debt, which implied outflows of interest
payments to foreign creditors; however, in the last few years Brazil
has reduced its net external debt as share of GDP. Itau Bank

SAO PAULO 00000476 002 OF 003


reported that interest payment outflows as of May were one fourth
the size of those paid only three years ago.

7. (SBU) The consistent decline of Brazil's trade balance since May
2007 is another reason for the resurgence of Brazil's current
account deficit. Through August, Brazil's trade surplus was down 38
percent from last year to USD 16.9 billion. (Note: The trade
surplus peaked at USD 47.8 billion in May 2007. End Note.) The
sharp rise in imports is the chief culprit for the declining trade
surplus. While the value of exports was up 29 percent through
August, imports were up a whopping 54 percent. The Center of
External Trade Studies Foundation (Funcex) reported that export
volumes grew by only 1.2 percent over the last year, reflecting the
deceleration of external demand. Booming domestic demand in Brazil,
however, pushed import volumes up 23 percent during the same period.
Brazil's recent imports have been highly capital-intensive,
primarily due to the sharp rise in investment spending now occurring
in Brazil. Despite the 25 percent appreciation of the Brazilian
currency in the last three years (it peaked at nearly 35 percent in
July), interlocutors have disagreed about how much of an impact the
exchange rate has had on the trade balance.

Reversing the Spread
--------------------

8. (SBU) Faced with the declining trade balance, the GOB has become
increasingly aware of encouraging export growth and has taken
several measures to boost exports. Indeed, the Brazilian Sugarcane
Industry Association's (UNICA) chief U.S. representative Joel
Velasco told Econoff that the GOB is starting to catch up to global
changes. Velasco said that Brazil's pro-agreement behavior during
the latest round of Doha talks demonstrated the shift from the
inwardly focused approach of exporting only domestic surplus to the
recognition that exports play an important role. In May, the
Ministry of Development, Industry, and Foreign Trade announced a new
industrial policy designed to spur small and medium sized companies
to export (reftel). The GOB also increased the export target for
this year to USD 190 billion in July, compared to USD 160 billion in
exports in 2007.

Expect More of the Same
-----------------------

9. (SBU) Economic interlocutors are expecting the trade balance and
profit and dividend remittances to continue to put downward pressure
on the current account. Unibanco forecasted the trade surplus for
2008 to be approximately USD 23 billion, down 43 percent from 2007.
Economist Mauricio Oreng from Itau Bank believes that Brazil would
continue to run a current account deficit and that it would approach
three percent of GDP by 2012.

10. (SBU) Despite the downward pressure on the Brazilian currency
because of the recent decline in commodities, the trade surplus is
unlikely to reverse the trend over the short-term. Merrill Lynch
told Econoff that Brazil has benefited relatively little from the
commodity price boom (a modest 1.2 percent of GDP by their
calculations) because the Brazilian economy remains relatively
closed and with a diverse trade in goods and services. Trade
represents approximately 25 percent of Brazil's GDP and Brazilian
commodity exports make up only five percent of GDP, according to
Merrill Lynch.

Comment
-------

11. (SBU) The narrowing trade surplus, and by extension, the
widening current account deficit, are a reflection that the
Brazilian economy is outperforming other emerging economies. A
combination of strong imports, flattening terms of trade, and a
softening global demand should prompt a continued decline in
Brazil's trade balance over the coming years. Likewise, the recent
upgrade to investment grade should power further foreign direct
investment and portfolio inflows to finance the current account.
The current account deficit is now more flexible and would
automatically adjust during an economic downturn as businesses
become less profitable, causing dividend payments and purchases of

SAO PAULO 00000476 003 OF 003


capital goods imports to diminish. Going forward, Brazil needs to
pursue measures to further stabilize the economy and raise
productivity, capitalizing on the inflows of foreign savings to
foster greater competitiveness. End Comment.

12. (U) This cable was cleared by the US Treasury Financial Attache
in Sao Paulo and by Embassy Brasilia.

WHITE

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