Cablegate: Brazil's Economic High Point Reinforces Lula's Hand

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

REF: A) Brasilia 2221

B) Brasilia 463
C) Sao Paulo 1328

1. (U) Summary: Brazil is living one of its best economic
moments in recent memory. GDP growth has averaged above 6%
on an annualized basis for the last three quarters. The
external accounts remain healthy as exports continue to
boom; Brazil should run a 1.5% of GDP current account
surplus this year, its second in a row. Unemployment, while
still high, has begun to fall while real incomes are
beginning to rise after several years of decline.
Inflationary pressures are building, however, leading the
Central Bank to raise interest rates (by a quarter point) to
16.25% on September 15. The inflationary trajectory already
has shifted; expected inflation in 2004 is for 7.37%, within
the plus/minus 2.5 points band around the 5.5% target. Due
to these dynamics, the Central Bank on September 23
announced the revision of its 2005 inflation target from
4.5% to 5.1%.

2. (U) Strong revenue growth means the GoB is in the
unfamiliar situation of having the option of tightening
fiscal policy to take some of the burden off of monetary
policy, without sacrificing expenditure. The GoB announced
on September 22 that it would increase the primary fiscal
surplus target from 4.25% to 4.5% of GDP. It hopes that
formalizing the new target will help limit interest rate
increases while allowing the GoB to continue to reduce the
debt-GDP-ratio. Already the debt-to-GDP ratio has fallen
from 58.6% in December 2003 and may close out the year at
about 55%, which would mark the first year-on-year decline
in the debt-to-GDP ratio in a decade.

3. (SBU) Brazil took advantage of the positive situation
to tap international markets with an over-subscribed Euro
750 million eight-year bond, at a spread of 477 basis points
above the benchmark German Treasury note. Standard and
Poor's recognized the progress by upgrading Brazil's credit
rating to BB-, the same level it had before the 2002 crisis.
Current low, albeit growing, investment levels mean the
economy should cool off in the near term from current growth
rates. But, the good economic news should strengthen
President Lula's hand as he implements rigorously orthodox
economic and fiscal policies and pursues structural reforms
critical to boosting weak savings and investment to the
levels necessary for faster economic growth. The economic
news may also help candidates from Lula's Workers' Party
(PT) in the October 3 nationwide municipal elections. End

The Good News

4. (U) The good economic news has been rolling in
recently, with the Brazilian economy posting its fourth
consecutive quarter of growth and the third at an annualized
rate of over 6% (ref A). Analysts have been busily revising
upwards their growth projections for the year: according to
Central Bank survey data, the market now expects growth of
4.36% this year, and some respected analysts are predicting
growth as high as 4.7%. It is not clear whether the economy
has begun to cool off since the end of the second quarter.
One closely-watched leading indicator, sales of packaging
products, dropped over 4% in August, albeit after a July
increase of over 5%. Some analysts suggest this data point
meant the economy has reached an inflection point and begun
to trend towards the expected 2005 growth rate of 3.5%. But
other indicators from the same time frame, such as steel
production, show little sign of such a cooling.

5. (U) Employment growth, which had lagged a bit, has now
begun to pick up markedly. While unemployment is still high
and remains a political issue, new GoB data show record
formal employment creation in January to August (677,900 net
new jobs). The recovery is broadening across sectors, with
consumption spending picking up. External accounts remain
very favorable, with export growth leading to a predicted
trade surplus of $30 billion and an overall current account
surplus for the year of 1.2% of GDP. The weakest part of
the external accounts had been Foreign Direct Investment
(FDI), but after a recent uptick the Central Bank has
revised its prediction of total FDI for the year from $13
billion to $17 billion.

But, Inflationary Pressure Rears its Ugly Head
--------------------------------------------- -

6. (U) Inflationary expectations, however, also have been
mounting. Wholesale price pressures fed by high capacity
utilization, particularly in the intermediate goods
industries such as steel, have been feeding through to
consumer prices. Workers are beginning to increase wage
demands (such as the currently-striking bank employees) to
make up for years of sliding real incomes (ref C).
Companies are often acceding to union pressure and granting
wage increases above inflation. Energy prices also have
contributed to the mounting inflationary pressures.
Accumulated inflation in the year through August clocked in
at 5.14%. The market consensus as of September 17 was for
consumer price inflation of 7.37% this year, substantially
above the official 5.5% target, but still within the band of
plus or minus 2.5 percentage points.

Balancing Monetary and Fiscal Policies

7. (U) Given these increasing inflationary pressures, the
Central Bank on September 15 hiked the basic SELIC interest
rate by a quarter percent to 16.25%. Unlike some of the
previous rate decisions this year, the Central Bank
telegraphed its intentions well, using the minutes of the
August monetary policy meeting to lay the groundwork with
the market for an increase. Public debate has shifted to
how quickly and to what degree the Central Bank needs to
increase interest rates to tamp down emerging inflation.
The minutes of the September 14-15 Central Bank monetary
policy meeting make clear that the Bank sees the September
15 hike as the first in a "process of moderate adjustment"
of monetary policy, implying further interest rate
increases. Increased inflationary expectations have
actually reduced forward-looking real interest rates by
about a percentage point since April, when the Central Bank
last cut the nominal interest rate to 16%. This process of
nominal adjustment would reverse some or all of that slide
in real interest rates.

8. (U) Strong revenue growth this year has given the GoB a
realistic fiscal policy option to help head off increased
interest rates. On September 22 the GoB announced it had
increased its primary surplus target for 2004 from 4.25% of
GDP to 4.5% of GDP. Analysts argue that this should help
ease the burden on monetary policy in managing inflationary
expectations, allowing the Central Bank to limit the
necessary interest rate increases. Notwithstanding feelings
by some in President Lula's inner circle (notably Chief of
Staff Jose Dirceu) that the GoB needed to dedicate part of
its windfall to social and investment programs, Lula took to
the airwaves September 23 to justify the decision, arguing
it was better to pay down debt with the extra revenue than
simply spend it. The debt-to-GDP ratio at end-year may be
as low as 55%, according to some analyses, down 4.6 points
on the year.
9. (SBU) One analyst with the Institute for Applied
Economic Research (IPEA) told Econoff that the GoB really
had no choice but to exceed the original 4.25% target, since
revenues are running so far ahead of predictions while
expenditures are ultimately capped by the 2004 budget law.
(For example, last year's revisions to COFINS, a social tax
paid on revenues, have brought in additional percentage
point of GDP in revenues, according to the IMF ResRep;
revenues also have been buoyed by the strong GDP growth.
Note: The official prediction now is a total federal
government revenue increase of 1.1% of GDP.) The IPEA
economist opined that while the GoB might have considered
trying to spend more, it would have had to obtain
Congressional approval for a supplemental budgetary
authorization. This, however, would put the GoB in the
uncomfortable position of acknowledging that the Congress's
growth and revenue predictions, which the Executive
criticized in January as inflated during a sometimes
acrimonious debate over cautionary spending freezes, were in
fact closer to the mark than the GoB's (Ref B).

10. (U) Looking forward to next year, the Central Bank
acknowledged in the minutes of its September 14-15 monetary
policy meeting, published on September 23, that the
trajectory of inflation has made unrealistic, without a
sharper monetary response, the achievement of the 2005
inflation target of 4.5%. It decided to accommodate
partially that inflationary inertia and announced a new 2005
inflation target of 5.1%. Subsequent to the Central Bank
decision, the September IPCA-15 (a version of Brazil's
consumer price index calculated on the 15th of each month,
one of Brazil's rich heritage of inflation indices) clocked
in at 0.49%, lower than had been anticipated.

International Markets

11. (U) The GoB took advantage of a favorable
international market to launch on September 8 a Euro 750
million 8-year fixed-rate bond at a spread of 477 basis
points over the benchmark German treasury note. The issue
was oversubscribed, which allowed the GoB to increase the
amount from Euro 500 million. The GoB then reopened the
placement and issued a further Euro 250 million on September
22, for a total placement of Euro 1 billion. With this
bond, the GoB has completed its borrowing program for the
year on international markets, though some speculate the GoB
will seek yet another Eurobond placement prior to year's end
to increase international reserves and/or get a head start
on 2005 borrowing. At both the September 8 and September 22
auctions, spreads were down markedly from the GoB's June and
July issues, which were launched strategically after May and
early June financial market turbulence to pave the way for
private Brazilian borrowers to re-access international
markets. Standard and Poor's (S&P) recognized the progress
by upgrading Brazil's credit rating to BB-, the same level
it had before the 2002 crisis. The move by S&P came eight
days after Moody's had raised its Brazil rating to B1.


12. (SBU) The GoB had only the most fleeting of instants to
sit back and enjoy the positive macroeconomic moment before
shifting focus to combat new threats. While inflation is
not out of hand and remains the lesser concern, investment,
expected to hit 19% of GDP by end-year, will not bring on-
stream enough capacity quickly enough to sustain growth at
the current rates. Sustaining growth even at more moderate
rates (3.5% to 4.5% range) will require implementation of
more of the GoB structural reform agenda, including the
Public-Private Partnership (PPP) legislation, bankruptcy law
and reform of the judiciary. These still are pending
congressional approval, with the PPP law (slated for a
Senate vote after the upcoming October municipal elections)
the closest to passage. Investors also would like to see a
lower tax burden and more predictable (and less
bureaucratic) regulatory environment, items on which it will
be difficult for the GoB to make substantial progress in the
short term. Still, the recession-weary public is beginning
to breathe a collective sigh of relief. And, as the old
adage goes, "nothing succeeds like success." Both factors
should give Lula and his macroeconomic guru, FinMin Palocci,
greater space to pursue their orthodox fiscal and monetary
policies and the structural reform agenda.


© Scoop Media

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