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Cablegate: Gob's Financial-Market Honeymoon Finally Cooling?

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. Top front-page story in most national media Friday April 16
was JP Morgan's scaling-back of its recommendation for Brazil
bonds from overweight to market-weight, and the sharp market
reaction. News accounts generally headlined the JPM report's
unease over the direction of GoB fiscal policy, and its
judgment that the GoB is showing itself to be lax with regard
to outlays for public-sector workers and pensioners. The
report also listed concerns about the GoB's putative goal of
exempting infrastructure investment from future primary-budget
surplus calculations, as well as about increased potential for
negative exogenous events such as early U.S. interest-rate
hikes or a disturbance of China's commodity demand.

2. The JPM analysts see recent developments as threatening
Brazil's long-term debt/GDP trend. Their report characterized
January-February fiscal results as below expectations and,
without openly so stating, insinuated that this year's GoB
budget-surplus target is at risk. Its summary of the political
status quo was that "the government has lost an important
opportunity to launch a more positive reform agenda...".

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3. Reaction: by Thursday evening, Brazil's country risk was
up over 10% to 618, highest since last October (in January 2004
it briefly dipped below 400.) The benchmark C-bond was down
2.6% to 93% of face value. Commentators quickly pointed out
the extra difficulty this would mean for the GoB's plans to
raise a further USD 2.5 billion on international markets for
debt-service needs in 2004. The BOVESPA likewise dropped over
2.5%. The foreign-exchange rate showed greater steadiness.
The Real closed down by a mere percent, at 2.918 per USD, even
on a day when USD 5.1 billion in public-debt payment -- by far
the largest of this year -- fell due, and in the immediate wake
of the Central Bank's latest quarter-point cut of the SELIC
interest rate last Wednesday (as expected.)

4. Seemingly surprised as well as stung by these developments,
Planning Minister Mantega was quickly quoted as disparaging any
implication that the 4.25% budget-surplus target for 2004 might
not be met. Public-sector pay agreements, he stressed, are
being held in tight, fiscally responsible reins. Fortuitously,
Mantega was able to point to just-released first-quarter
revenue figures including a record collection for March as
providing more than enough margin to fund public-servant wage
agreements arrived at to date. Also by happy coincidence, the
GoB had just forwarded to Congress both its 2003-2007
Pluriannual Plan and its budget outline (LDO in Portuguese
acronym), in which the notion of counter-cyclical budget
spending has been officially dropped. (Mantega said counter-
cyclical novelties at Brazil's current juncture would risk
confusion.) Both the LDO and the PPA re-confirmed that the
budget-surplus target for 2005 remains 4.25%.

5. In the aftermath, various market voices have opined that
sellers' nerves were unduly taut and that the JP Morgan report
contained little news and was overblown. True, a day later
Citibank also lowered its Brazil-bond recommendation, and
Merrill Lynch issued a more general recommendation to move
assets from Brazilian stocks towards Mexican instruments.
Citibank's well-known analyst, however, attributed his shift
purely to external considerations, explicitly asserting that he
had no reservations about GoB policies. Meanwhile, other banks
(ABN Amro, West LB) reaffirmed their strong Brazilian "buy."

6. The JP Morgan report came in for relaxed roasting at the
April 16 blue-ribbon Businessmen's Seminar in Bahia, attended
inter alia by former president Cardoso as well as Finance
Minister Palocci. Comments ran along the lines that the report
must have been composed by a junior analyst who got out of bed
in a bad mood. In the process, Palocci went out of his way to
be quoted admitting that his policies have been a continuation
of FHC's, and that he is proudly ready to continue doing so for
ten years more. Friday April 16 market results walked back
much of Thursday's damage.

7. NOTE: The episode seems to be an amusing case of
"rational" markets' logic. In descending from "over-market" to
"market-weight" (i.e., 23% of the world emerging-market index,
reportedly) for its Brazil-bond recommendation, JPM was
literally just endorsing the general market assessment of
Brazil bonds' profitability, in place of its previous second-
guessing of the general market assessment. But its very
endorsement caused that assessment to adjust itself downwards.

8. This episode does have its frivolous aspect. Not least,
JPM raised its recommendation to "above-market" just six weeks
ago, on the premise that damage to the GoB from the Dirceu
scandal had been exaggerated. Yet the more sober view of
Brazil's longer-term prospects meshes with opinions we heard
from the chief economist of another top Brazil-based U.S. bank
in Sao Paulo last month. After a protracted honeymoon during
which, in our assessment, an eager market made more of Lula's
first-year reforms and policy than the latter's material
benefits objectively warranted, are we at an inflection point
in the market's rosy-tinted view of Brazilian Treasuries? The
big profits have already been made, and the benign external
environment may indeed be due for a change of weather. Many
would agree the GoB has failed to make the most of its first
year in terms of reforms, and there is less and less trust that
first-quarter GDP data will be reassuring when released in May.

9. Where we, and apparently most of the rest of the market
players, see the JP Morgan report as dead wrong is its notion
that the GoB is starting to fall off the fiscal-control wagon.
For us, Lula and his team have demonstrated by any reasonable
criteria that the opposite is true, even as pressure for fiscal
relaxation has swollen across Brazil's socio-political
spectrum. The various new GoB programs for housing, industrial
stimulus, land-reform, etc. that have admittedly been announced
of late, when examined, prove to be reasonably circumscribed in
fiscal practice. (Septel on "Brazil's 2004 Budget Blues".)
Lula's latest litmus test in this sphere will be the GoB
decision, due any day now, over this year's increase in the
minimum wage (Septel.)


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