Cablegate: U/S Larson Argues for Structural Reform, Improved

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


This cable is Sensitive But Unclassified, please protect

1. (SBU) Summary: U/S Larson congratulated Central Bank
President Henrique Meirelles and senior Finance Ministry
officials on the success of Brazil's macroeconomic
stabilization after the 2002 financial crisis. Larson noted
investor concerns about the electrical sector, the judicial
system and arbitrary actions by the governor of Parana that
had affected U.S. investment, and urged the GoB to build an
climate that could attract investment to meet pressing
infrastructure needs. Larson also urged the GoB to join the
Capetown Convention on Aircraft Financing.

2. (SBU) Meirelles highlighted the strength of Brazil's
current recovery, which has been export and capital-good-
spending led. The healthy external balance and fact that
price-pressure is under control makes this recovery much
more sustainable, according to Finance Ministry Executive
Director Appy. Export growth in particular has surprised
everyone. The GoB also is pursuing an ambitious agenda of
microeconomic reform, including a new law on Public-Private
Partnerships (PPPs), which should attract needed investment.
Appy and Meirelles acknowledged the damage inflicted on
Brazil's investment climate by Governor Requiao of Parana,
but pointed out that the judicial system lately has begun to
reassert itself and reversed some of Requiao's actions. The
GoB plans to address some persisting energy-sector investor
concerns as it drafts the regulatory framework implementing
the new energy model. End Summary.

3. (U) Background: During a July 20-21 visit to Brazil,
U/S Larson met in Sao Paulo with representatives of a cross-
section of U.S. businesses and in Brasilia with senior GoB
officials to discuss the full breadth of the bilateral
economic agenda. He met with Central Bank President
Henrique Meirelles, Central Bank Director for International
Affairs Alexandre Schwartsman, Finance Ministry Executive
Secretary Bernard Appy and International Secretary Luis

Pereira to discuss the economic situation and reform agenda.
Ref B reported on U/S Larson's meetings on IPR and trade
issues. Ref A reported on U/S Larson's conversations on
President Lula's hunger initiative.

Dinner with U.S. Business Community

4. (SBU) In Sao Paulo, U/S Larson attended a dinner with
10 senior representatives of U.S. companies operating in
Brazil. The banking, pharmaceutical, energy, agriculture,
construction, and consumer-products sectors were
represented. Larson solicited the business representatives'
views on the GOB's macroeconomic policy, the investment
climate, President Lula's domestic and international anti-
hunger initiatives, and the prospects for sustained growth
in Brazil. There was consensus that several key factors
significantly increase the cost of operating in Brazil and
deter foreign direct investment: the failure to enforce
contracts, due in part to the sluggish and unpredictable
judicial system; lack of a clear and transparent regulatory
environment, in particular in the energy and agricultural
biotechnology sectors; and high and complex taxes. The high
cost of capital for domestic investment was also identified
as a major drag on growth. The poor transportation
infrastructure was flagged by agribusiness participants as
an obstacle to further growth in Brazil's best-performing
export sector.

5. (SBU) The business representatives indicated support
for the Lula administration's macroeconomic policy, and
expressed confidence in Finance Minister Palocci and his
economic team. They were cautious, however, about the
prospects for sustained growth and expressed serious
reservations about the prospects for establishing a stable,
transparent regulatory regime. Energy-sector
representatives expressed frustration with the GOB's
proposed new energy model, in particular the provisions that
would provide preferential conditions for new investors in
the sector, prejudicing those firms that entered the market
during the first wave of parastatal privatizations in the
1990s. Most participants expressed doubt that the GOB's
initiative to establish public-private partnerships would
succeed in attracting much new FDI, in the absence of
regulatory certainty. While they lauded the economic team,
they expressed disappointment with the overall level of
competence and ideological bent of most of Lula's cabinet
and subcabinet appointees. They attributed the failure of
Lula's flagship Zero Hunger program and other social
programs to get off the ground to the administrative
inexperience of the senior officials in the social

Stabilization, Inflation and Potential Growth

6. (SBU) Larson congratulated Meirelles and Appy, in
separate meetings, on the GoB's very successful
stabilization after the financial crisis of 2002. Now that
interest rates had come down and growth seemed to be
returning, there is room to focus on what Brazilian
potential growth might be and what inflationary threats are
out there. Larson noted U.S. efforts to convince OPEC oil
ministers to increase production to help reduce the
inflationary threat to the world economy from oil prices.
Unfortunately, there is not much spare global capacity, he
said, and that which exists is concentrated in Saudi Arabia,
Kuwait and the UAE. OPEC, Larson said, appears to have
settled on a new price band of $28 to $36.

7. (SBU) The potential growth rate of the Brazilian
economy, Meirelles said, is unclear. He argued that the
astounding performance of Brazilian exports might be
instructive, albeit the analogy was imperfect. When we
embarked on our efforts to increase exports, many doubted it
could be done, noted Meirelles, citing infrastructure
bottlenecks and the relatively low level of investment by
Brazilian business in product development and distribution
mechanisms. Nevertheless, export growth has surprised
everyone. Meirelles argued everyone had underestimated the
positive effects of the establishment of a predictable
macroeconomic framework anchored to an inflation target and
fiscal primary surplus. Even the 1994 Real Plan, while
delivering low inflation, had been anchored to an
unsustainable exchange-rate peg. The consistent pursuit of
these goals since 1999, Meirelles said, along with the
reduction of exposure to exchange-rate linked debt, had
reduced volatility and uncertainty. This confidence in the
policy framework, in turn, spurred investment in product
development and distribution channels, contributing to the
current export boom.

8. (SBU) Meirelles noted that spending on capital goods
was one of the factors leading the current economic
recovery. Central Bank International Director Schwartsman
pointed out that this is the first time in recent memory
that capital-goods spending had been so robust so early in a
cyclical recovery. He attributed this in part to high
capacity utilization in industry, particularly those linked
to exports, which had forced investment in additional
capacity to meet growing demand. The economy had created
one million formal sector jobs in the first half of 2004,
according to Schwartsman. He expected investment to reach
20% of GDP by year-end, up from 18% of GDP in the first
quarter of 2003 and 19% in the first quarter of 2004. There
was less certainty about the behavior of productivity, but
Schwartsman believed it to be trending upwards, particularly
as Brazilian industry became more exposed to competition
from trade.

Reform Agenda and FDI

9. (SBU) Appy stated that the macroeconomic policy
framework was about right, and did not require major
adjustment. He argued that Brazil is in a situation in
which growth can be sustained, given the healthy external
balance and that price pressures are under control.
Consistent growth, however, required increases in investment
and in productivity, Appy stated. Given the GoB's fiscal
situation, Brazil needed as much private-sector investment
as it could obtain. The GoB agenda, therefore, included
prompt passage of a Public-Private Partnership (PPP) law
that would create a framework for private investment in
major infrastructure projects. Pereira enumerated several
other initiatives, including the new bankruptcy law,
incentives for innovation, judicial reform, creating
incentives for participation in formal labor markets,
deepening of credit markets, and reduction of red tape for
opening a business, all of which also are high on the GoB
reform agenda.

10. (SBU) Larson asked whether the GoB was concerned by the
fall-off in FDI. He noted cases of arbitrary actions by the
governor of Parana and concern over electricity-sector
regulation. Larson emphasized the importance of creating an
investment climate where businesses already in-country
become the best advocates for further FDI. This was
particularly important to meet government investment
priorities through initiatives such as PPP.

11. (SBU) Schwartsman noted that a certain amount of
reduction in FDI flows was to have been expected with the
conclusion of the privatization program. He estimated that
between a third and a half of FDI during the peak of
privatization was linked directly to foreign purchases of
parastatals or follow-on investments in those enterprises.
Meirelles noted that the change of management that
accompanied privatization had resulted in large productivity

12. (SBU) Both Meirelles and Appy acknowledged that the
governor of Parana had done serious damage to Brazil's
investment climate with his various steps to re-negotiate
existing contracts. Appy pointed out that Brazil's judicial
system was now beginning to reassert itself and that its
latest decisions had gone against the Parana state
government. Meirelles called for judicial reform in order
that the system deal more sure-handedly with cases such as
that of Parana's governor.

13. (SBU) Appy stated that the energy sector in particular
was troubled. In the aftermath of the 1998 devaluation,
energy companies, many of them newly-purchased in
privatizations, had been unable to service their dollar-
denominated liabilities. Along with poorly-written
contracts, judicial decision limiting price increases
exacerbated the sector's problems. Appy said the GoB is
attempting to address, through the new energy model's still-
evolving regulatory framework, the complaint of existing
investors in the energy sector that they were being
disadvantaged vis-a-vis new investment. Larson noted the
importance of investors' having confidence in the
independence and objectivity of the regulatory agency.

14. (SBU) Larson urged Appy and Pereira to consider joining
the Capetown Convention on Aircraft Financing. He also
emphasized the importance of competition through trade in
increasing potential growth.

15. (U) U/S Larson was unable to clear this message before
his departure from post.


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