Cablegate: Brazil's Steely Monetary Policy

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

UNCLAS SECTION 01 OF 03 BRASILIA 000682

SIPDIS

SENSITIVE

NSC FOR BREIER, RENIGAR
TREASURY FOR OASIA - DAS LEE AND FPARODI
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON

E.O. 12958: N/A
TAGS: ECON EFIN ETRD PGOV EIND BR
SUBJECT: BRAZIL'S STEELY MONETARY POLICY

REF: A) 04 BRASILIA 3115
B) 04 BRASILIA 3100
C) BRASILIA 417
D) SAO PAULO 193

This cable is Sensitive but Unclassified, please protect
accordingly.

1. (SBU) The GoB published a decree March 4 reducing to
zero the import tariff on fifteen different categories of
steel. The measure is temporary and does not represent a
general liberalization, but rather is aimed at containing
inflationary pressures driven by price increases in steel
and other major industrial inputs. Dealing with these
inflationary pressures has proven difficult for the GoB,
despite the Central Bank's elevation of interest rates to
18.75%, in a cycle of monetary tightening beginning in
September 2004. Despite the monetary tightening, and a
concurrent 10% appreciation of the Real, inflationary
expectations have hardly budged. This may be in part
because current inflationary pressures, concentrated on
the supply side, differ from previous episodes. The small
percentage of credit in the economy, much of which is
directed to certain sectors or loaned at fixed rates by
the development bank, limits the influence of Central Bank
interest rate changes on the course of the overall
economy. The episode highlights the need for financial
market reform and broader, permanent import liberalization
to increase competition in the economy. End Summary.

Inflationary (and Political) Bias
---------------------------------

2. (SBU) In December 8, 2004 conversation (ref A),
Central Bank President Meirelles complained to the
Ambassador about the inflationary bias in the Brazilian
economy, and specifically about steel prices. Meirelles
argued that this bias was a legacy of Brazil's hyper-
inflationary past, when businesses tried to earn money by
raising prices faster than wages could adjust. In
January, President Lula echoed Meirelles' argument (made
in private to the Ambassador), when he publicly criticized
industry for increasing prices, blaming them for keeping
inflationary expectations alive and forcing the Central
Bank to raise interest rates higher than it would
otherwise need. It was during that attack that Lula first
publicly threatened to liberalize imports to restrain
price increases. (Note: Brazil, while a major steel
exporter, has imported between USD 456 million and USD 550
million worth of steel products annually over the last few
years. End note.)

What has Inflation Been Doing?
------------------------------

3. (SBU) After spiking in 2002 due to the effects of
currency devaluation, recently Brazilian inflation has
been under control. The consumer price index (IPCA)
peaked in 2002 at 12.5%, falling to 9.3% in 2003 and 7.6%
in 2004. While not high in historical terms, this
inflation has reacted stubbornly to Central Bank interest
rate hikes meant to bring inflationary expectations in
line with the 5.1% target for 2005. The Central Bank has
raised its benchmark interest rate on overnight borrowing
(the SELIC) by 2.75 percentage points, from 16% in
September 2004 to the current 18.75%. Private sector
inflationary expectations for 2005 (measured by Central
Bank surveys of financial institutions that run their own
forecasting models), however, have hovered in a band of
about 5.7% to 5.95% during the period of adjustment. The
Central Bank, for its part, has declined to revise upward
its target, perhaps fearing -- as the local IMF ResRep
recently confided to Emboffs -- that it needs to get
inflation as low as possible this year as 2006 is an
election year.
Is This Inflation Different?
----------------------------
4. (U) The interest rate hikes in particular have been
profoundly unpopular, and rekindled debate about the
effectiveness of Brazil's inflation targeting regime and
monetary policy tools (i.e. targeting inflation using the
SELIC benchmark interest rate). Even some supporters of
the inflation targeting regime and the GoB's orthodox
policy line have begun to debate what lies behind the
current inflationary stickiness and whether the SELIC is
the right tool for achieving the target. For example,
former Central Bank President Gustavo Franco has argued
that recent inflationary pressure has been characterized
by small supply shocks (such as the steel price increases
that sparked Lula's and Meirelles' ire), the costs of
dealing with exchange rate volatility and the high cost of
credit itself.

Limits of Current Monetary Policy Tools
---------------------------------------

5. (U) In addition to the nature of the current
inflationary pressures, several structural elements in the
financial system tend to limit the effectiveness of
Central Bank interest rate changes on overall economic
activity. First, credit as a percent of the economy is
low, at 26.3% of GDP in January 2005. This is down over
ten percentage points over the last decade, albeit on a
recent upward trend. Many businesses, particularly those
that do not have access to lower interest rate foreign
currency loans, tend to self-finance investment out of
retained earnings.

6. (U) The amount of credit directly influenced by the
SELIC is further reduced by the existence of "directed
credit," which, according to Central Bank data, makes up
about 36% of all credit. Over half of all directed credit
is long term financing granted by the National Development
Bank (BNDES) at a GoB-set rate (the TJLP, currently
9.75%), which does not reflect changes in market interest
rates. The remainder of directed credit consists of
agricultural credits (30%) and housing credits. These
latter two categories of credit have below-market floating
interest rates that track the overall direction of market
interest rates. These directed credits are among the
villains that account for Brazil's infamously high lending
spreads.

7. (U) Other, likely less significant factors limiting
the effectiveness of monetary policy are the effects of
recent microeconomic reforms designed to enhance access to
credit, including the 2003 creation of payroll-deduction
loans. While payroll-deduction loans work to increase the
aggregate amount of credit -- which, all things being
equal, would tend to make interest rate targeting more
effective -- like BNDES lending, these particular loans
have commanded far lower interest rates than normal
personal loans. A similar measure that would use social
security pension benefits to secure loan repayments is
under implementation. Franco further pointed out that
Brazilian consumers, in particular, have become so inured
to scandalous interest rates that a change of only a
couple points has very limited impact on consumption
decisions. Taken together, these factors reduce the
impact that the price of overnight credit, embodied in the
SELIC, has on much of the economy.

Need More Competition
---------------------
8. (U) One factor that the public debate has not focused
on is the existence of cartels in many sectors of the
economy, making prices stickier (ref D). While the GoB is
cognizant of the existence of such, and domestic air
carriers (traditionally one of the economy's high tariff
sectors) have recently launched a price war, the
government's plans to improve competition policy and anti-
monopoly efforts are longer term (septel). Thus the
decision to liberalize steel imports, in an attempt to
boost competition and reduce prices in a more relevant
timeframe. Industry reaction has been mixed, with car
manufacturers and other steel consumers welcoming the
opportunity to negotiate with foreign suppliers as
leverage in price negotiations with domestic steel
suppliers, while the steel industry predictably has
dissented.

Comment
-------

9. (SBU) Despite the debate over the effectiveness of
the SELIC and, secondarily, the inflation-targeting regime
itself, the GoB does not intend to abandon either.
Moreover, attitudes in the financial markets may be
catching up those in the Central Bank. The IMF Resident
Representative observed to Econoffs March 8 that over the
last month financial market participants have begun
revising their views that the Central Bank would be forced
to abandon the 5.1% inflation target for the year as
unrealistic. That said, the episode highlights the
importance of further microeconomic reform of the
financial system, particularly to eliminate directed
credits and to make BNDES interest rates more closely
reflect monetary policy objectives. While some financial
system reforms, such as measures enhancing access to
credit, may work against the effectiveness of the SELIC in
the short term, over the medium and longer term they
should help create a more rational financial system, and
one that ultimately will respond more readily to smaller
interest rate changes by the Central Bank. Import
liberalization, however welcome, will not contribute much
towards that goal until it becomes broader-based and is
made permanent.

DANILOVICH

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