Cablegate: Brazil's Prospects for a Return to Economic Growth

This record is a partial extract of the original cable. The full text of the original cable is not available.




E.O. 12958: N/A


1. SUMMARY. Brazil's government, economists and media all now
voice expectation of forthcoming relative economic relief.
Hardly anyone dissents from the forecast of 3/3.5% GDP growth
in 2004. Optimists suggest a parallel with 2000, when Brazil's
GDP grew 4.4% after the previous year's 0.7%, despite the
context of a cloudy world economy, as real interest rates fell
from 9 to 6 percent. The hopeful scenario today is for one or
two quarters of upswing to be driven by consumer-credit
expansion and long-deferred purchases of durable goods in
response to the GoB's monetary easing since July, with the
premise that this new consumption will induce fresh investment
that would become Brazil's primary economic driver for the
medium run, in turn spurring extra output, employment and
consumer buying-power by 2005. Some unexpectedly good recent
data for industrial output and capital-goods sales are
consistent with this picture.

2. Market confidence in the GoB and in domestic political
events seems quite sturdy. Calls for the Central Bank to relax
monetary policy still faster have come from some surprising new
quarters. But the GoB is plainly set on breaking Brazil's
habit of bubble-and-inflationary-bust. It wants multi-year
sustainable growth (which coincides with Lula's re-election
interests), and won't be rushed. Investors view the status of
Lula's pension and tax bills, however watered-down, as still
adequate. Greater doubt exists as to the GoB's future
microeconomic/regulatory reforms, upon which by general
agreement vital investment will hinge. And Brazil's debt/GDP
vulnerability remains on everyone's mind. The main worry is of
a too-early U.S. monetary tightening. END SUMMARY.

Consensus on Growth
3. This cable reflects recent discussions in forty-plus
meetings with GoB, market, and think-tank specialists in
Brasilia, Rio and Sao Paulo during Treasury and EXIM visits.
Interlocutors were drawn from a half-dozen foreign or
domestic private banks, the Ministries of Planning, Finance
and Trade, Treasury, multiple offices of the Central Bank,
the Banco do Brasil, BNDES, Getulio Vargas Foundation,
National Confederation of Industry, a major manufacturer, a
top credit-rating agency, congress's tax committee, and

4. Without exception, sources agreed that Brazil's economy
should grow 3% to 3.5% in 2004. All saw the ongoing drop in
interest rates (with the benchmark SELIC down since June
from 26.5% to an expected 18% on November 19) producing a
marked, steady expansion of credit. Bradesco chief
economist Osmar Pinho expected easing credit terms, coupled
with traditional end-of-year bonuses and negotiated salary
increases taking effect in January, to spark a near-term
consumption mini-boom. Pinho thought a modest 20% increase
in credit from its current depressed level sufficient to
achieve the 2004 growth figure. Longer-term, he expected
new investment to assume the role of central economic
driver, pointing to Brazil's need for electrical generation
capacity and ongoing telecom investment projects.

5. NOTE: Brazil's credit stock totaled Reals 390 billion
in September -- almost exactly 25% of GDP. Hence, credit
expansion of the order specified by Pinho would merely
involve bringing the ratio back up to 30%. That would still
be appreciably below the 32% of early 2002, when Brazil's
economy was already hard-hit by the contractionary effects
of Argentina's collapse, Brazil's own energy crisis, and
9/11. END NOTE.

6. CSFB's chief economist Rodrigo Azevedo likewise believed
the monetary stimulus from falling interest rates and
growing credit would carry the economy through the first two
quarters of 2004 at a 3% rate. After that, investment would
be needed to extend growth. Azevedo's counterpart at Banco
Pactual, Guilherme Bacha, volunteered the view that the CB
ought to be lowering interest rates still more aggressively,
to better pump early consumption. Bacha (who reportedly was
offered the post of CB Chairman after Lula's election but
turned it down in the belief that the GoB would accord him
too little authority to ensure fiscal restraint),
acknowledged with a grin that monetary loosening was the
last recipe he would have prescribed in the PT government's
first months, but explained that the GoB has so conclusively
established its credibility that bolder cuts now would be

7. In a related vein, Central Bank (CB) Governor for
Monetary Policy Bevilacqua noted to us that Brazil has a
historical record of swift, strong reaction to the early
stages of monetary easing. Even with real interest rates
(10-11%) still high by most standards, Brazilians have begun
to make new buying decisions based on the CB's interest-rate
cuts since June, averred Bevilacqua. He was careful to
state that the CB does not necessarily see the current 10%
as the economy's "equilibrium" real-interest rate. At the
same time, he offered no hint of how fast or far the SELIC
might fall in 2004. Rather, he stressed the GoB's unaltered
resolution to preempt any possible reversion to what he
termed Brazil's past "go and stop" pattern: too-carefree
monetary easing fuelling good growth for a year or two, only
to be followed by inflation's return and GDP slowdown.

8. Ministry of Finance Economic Policy Secretary Lisboa
echoed Bevilacqua's thesis that the Brazilian economy reacts
unusually quickly to interest-rate decreases. Separately,
however, the IMF ResRep made plain to us his own disbelief
that a sustained wave of consumption is on Brazil's near
horizon. Other specialists note the likelihood that
Brazil's much-increased current tax burden and real-income
constraints will inhibit renewed spending far more than
during Brazil's past historical episodes of monetary easing.

9. Nonetheless, some unexpectedly good recent statistics do
accord with the GoB's optimism. Industrial production this
September grew nationally by 4.2%, and in Sao Paolo by 5.7%,
compared to September 2002. National vehicle sales in
October were up by double-digit percentages for the second
month in a row, admittedly helped by a recent GoB tax
incentive. Encouragingly for near-term investment
implications, capital-goods sales and imports were also both
up strongly, month-on-month. Retail sales rose slightly in
October, for the first time in fourteen months. In what the
GoB claims as further evidence of overall recovery, October
tax revenues rose twenty percent over September's. And Sao
Paulo's industrial-sector employment surprised all observers
by growing 0.5% (7,700 new jobs) in October, the best
October result since 1994.

10. All private-sector contacts lavished uniform praise on
the Lula government's macroeconomic policies for restoring
credibility and bringing Brazil Risk (the spread above U.S.
treasuries that Brazil must pay to borrow on international
markets) down from over 24% in October 2002 to its current
level of under 5.5%. A few acknowledged that part of this
effect was simply because expectations for macroeconomic
policy in a Lula government had started so low.

Main Hazard -- External Interest Rates

11. CSFB's Azevedo and others warned that Brazil's
financial stabilization has benefited from an unusually
benign international environment, with developed-country
interest rates at very low levels. The flip side of the
coin is that Brazil's debt-service burden (debt/GDP ratio
still at 57%) leaves it prey to potential tightening of U.S.
monetary policy. That could re-ignite last year's vicious
cycle of currency depreciation, causing foreign exchange to
exit or avoid Brazil anew and upsetting the GOB's carefully
balanced fiscal apple cart. This risk may loom larger in
light of the third-quarter U.S. growth figures.

12. Banco Pactual's Bacha was particularly emphatic that
the main threat to Brazil's economic prospects in 2004-2005
would be a too-early initiation of U.S. Fed interest-rate
hikes. Yes, Bacha admitted, such hikes would presumably be
correlated with strong U.S. growth, which should fuel
Brazilian exports. But, he said adamantly, the financial
downside for Brazil would far outweigh any export-demand
benefit. Asked at what stage U.S. interest-rate movement
might become critical for Brazil, Bacha declined to
quantify, opining just that world-market atmosphere at the
time would be decisive.

13. In this context, minds are focused on the GoB's
reduction of the dollar-indexed component of public debt.
With the ongoing non-rollover of up to 12 billion dollars'
worth of dollar-linked Brazilian domestic debt, that
component may fall below 23% by year's end. Continuing this
progress through next year is essential to keeping the
dollar-linked debt from exerting undue pressure on fiscal
accounts when the inevitable developed-world monetary
tightening begins. As to overall debt-to-GDP ratio, GoB
officials admitted that it will be marginally greater at the
end of 2003 than a year earlier, but maintained that from
2004 it will steadily fall.

Reform Uncertainties

14. The double-consensus of public and private sectors is
that investment must carry growth in the longer term, and
that that investment will hinge on macroeconomic and
microeconomic/regulatory reforms. The question then is how
quickly Lula's structural reforms advance and begin to bear

15. Given the delays, watering-down and remaining
uncertainties of Lula's macroeconomic reforms -- i.e., the
tax and pension bills -- we repeatedly asked if the market
might at some point deem those reforms inadequate and react
accordingly. The consistent answer was negative. Analysts
explicitly said their companies are comfortable enough with
the two bills' status. They agreed that their legislative
progress has been underwhelming, and that the fiscal effect
of each has been diluted to unimpressive dimensions. Few
saw the pension-reform bill as doing much more than
"stopping the fiscal bleeding." Alvaro Freire of Unibanco
warned that all such politically sensitive reforms would be
an iterative process, requiring years and multiple re-
visits. But the simple fact that the PT had tackled pension
and tax reform seriously remained positive and paramount.

16. One GoB reform to be unconditionally applauded was the
new bankruptcy law, recently passed and sent to the Senate
by the lower Chamber. Unibanco's Freire, among others,
expected the bankruptcy law to have a fairly rapid effect in
reducing banking spreads, although opinion was split on the
size of that impact. On the subject of Brazil's regulatory
and microeconomic framework for future investment (Ref B),
we heard a perhaps surprising lack of comment. This applied
most conspicuously to the future energy model and the reform
of regulatory agencies' roles.

Not Too Much of a Good Thing

17. Several interlocutors noted that sustained growth above 4%
would pose its own risks. Ministry of Finance International
Secretary Canuto asserted that there is sufficient slack

capacity in the economy to accommodate growth on the order of
3% to 3.5%. Beyond that level, bottlenecks and inflation would
rear their heads. AmCham Economic Committee head Paulo
Albuquerque raised a similar caveat. GOB officials spoke of
their aim to alleviate some of these constraints by attracting
private investment in infrastructure through new Public Private
Partnerships (PPP) projects.

18. On the external-account side, renewed Brazilian growth
could be expected to involve a return to current-account
deficits, as imports rise from their currently depressed levels
and with Brazil's exporters perhaps selling a greater share of
output to a reviving domestic market. The standard estimate
for these deficits, from both private economists and GoB
specialists, was five-to-six billion dollars for 2004, and six-
to-eight billion for 2005. Many observers noted the need for
extra foreign investment to bridge these gaps.


19. To judge from these meetings, local prognoses for
Brazil's economy are more homogeneously positive now than at
any time in the last two years. We have our reservations.
First, even granted that consumption has begun to pick up
pre-Xmas, it seems debatable that Brazil's population has
the income or savings for sustained buying after six
successive years of annual real-wage decline. Second, the
GoB's record to date in Congress has not been such as to
inspire confidence in early achievement of the follow-on
"microeconomic" reforms which by general account are a pre-
condition for vital future investment (Septel). Third, the
GoB itself, as Finance Minister Palocci is making newly
clear, sees 2004 as being perhaps its most austere yet for
discretionary budget expenditures -- no pump-priming likely
from that quarter. Fourth, even 3.5% growth in 2004 would
hardly begin to make up the ground lost in national income
and employment in 2001-2003, with that period's annual
growth rates of 1.8%, 1.5% and perhaps 0.6%, respectively.

20. Even in the smoothest scenario, the timeframe for new
jobs and income to reach the sectors of Brazil's population
that need them most still looks far-off indeed. It may look
particularly so to PT party candidates and others planning
to contest the October 2004 municipal elections.


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