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Cablegate: Brazil's Business Environment

VZCZCXRO7627
PP RUEHRG
DE RUEHSO #0692/01 1731515
ZNR UUUUU ZZH
P 221515Z JUN 06
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC PRIORITY 5299
INFO RUEHBR/AMEMBASSY BRASILIA 6396
RHEHNSC/NSC WASHDC
RUCPDOC/USDOC WASHDC 2497
RUEHRC/USDA FAS WASHDC 0619
RUEHMN/AMEMBASSY MONTEVIDEO 2042
RUEHBU/AMEMBASSY BUENOS AIRES 2315
RUEHSG/AMEMBASSY SANTIAGO 1771
RUEHLP/AMEMBASSY LA PAZ 2869
RUEHPE/AMEMBASSY LIMA 1024
RUEHCV/AMEMBASSY CARACAS 0345
RUEHBO/AMEMBASSY BOGOTA 1407
RUEHRG/AMCONSUL RECIFE 2997
RUEHRI/AMCONSUL RIO DE JANEIRO 7206
RUEHAC/AMEMBASSY ASUNCION 2639
RUEATRS/DEPT OF TREASURY WASHDC
RUEHC/DEPT OF LABOR WASHDC
RHMFISS/CDR USSOUTHCOM MIAMI FL

UNCLAS SECTION 01 OF 06 SAO PAULO 000692

SIPDIS

SENSITIVE
SIPDIS

DEPT FOR WHA/BSC, WHA/EPSC, EB/IFD
STATE PASS TO USTR FOR MSULLIVAN
STATE PASS EXIMBANK
STATE PASS OPIC FOR MORONESE, RIVERA, MERVENNE
NSC FOR FEARS
USDOC FOR 4332/ITA/MAC/OLAC
USDOC FOR 3134/USFCS/OIO
TREASURY FOR OASIA, DAS LEE AND DDOUGLASS
DOL FOR ILAB MMITTELHAUSER
SOUTHCOM ALSO FOR POLAD

E.O. 12958: N/A
TAGS: ECON EINV KIPR PGOV ETRD BR
SUBJECT: BRAZIL'S BUSINESS ENVIRONMENT

REF: A) SAO PAULO 685; B) BRASILIA 1178; C) BRASILIA 1188

SENSITIVE BUT UNCLASSIFIED - PLEASE PROTECT ACCORDINGLY

1. (U) SUMMARY: Viewed through the lenses applied by many business
groupings, Brazil's "competitiveness" has been falling relative to
its major emerging market peers, such as India and China. Numerous
surveys of business leaders and some studies, including by the OECD,
show Brazil falling in various competitiveness rankings. While
there is no settled definition of what constitutes a country's
"competitiveness" -- indeed, it is a concept which some economists
believe to be flawed -- these surveys/studies do highlight a common
set of problems with Brazil's business environment and investment
climate. These include: a high tax burden, onerous tax compliance
requirements, excessive bureaucracy, insufficient infrastructure,
middling economic growth prospects, corruption, convoluted labor
legislation, high real interest rates and a lack of investment in
education and innovation. The reforms called for by these studies
and surveys are legion, but tax reform stands out as a particular
need. END SUMMARY.

IS BRAZIL A MAJOR EMERGING MARKET?
----------------------------------

2. (SBU) The term BRIC (Brazil, India, Russia, and China) was first
coined by investment bank Goldman Sachs in a 2003 paper asserting
that these rapidly developing economies may eclipse most developed
markets by 2050. Since then, BRIC has entered into popular usage to
refer to these four countries and their status as the leading large
developing economies. Although Brazil since 2003 has made
measurable progress in many areas, particularly debt management and
efforts to improve the functioning of financial markets, its GDP
growth has looked paltry in comparison to India, China and Russia.
Growth in the four years of the Lula administration is expected to
average 2.86 percent. Although better than the 2.34 percent
achieved under former president Fernando Henrique Cardoso (FHC) from
1995 to 2002, it stands in sharp contrast to recent Chinese averages
of close to 10 percent and India's of around 6 percent. World Bank
figures show Russia's yearly growth since 2000 at around 7 percent.
An early 2006 article in the "Economist" magazine on the importance
of emerging markets showed three countries, represented as animals,
circling the globe: a dragon for China, an elephant for India, and
a bear for Russia. Brazil was notably absent. Regarding Brazil's
absence, newspaper columnist and former Finance Ministry official
Roberto Macedo commented, "Perhaps the artist just couldn't think up
an animal to represent Brazil. But a monkey would be appropriate.
Either way, it's time for Brazil to choose its own mascot before
it's too late and we end up with a donkey, a sloth, or even a
beached whale."

COMPETITIVENESS SURVEYS
-----------------------

3. (U) HUMPTY DUMPTY: Brazil slipped 8 places to 65th in the World
Economic Forum's (WEF) 2005 - 2006 Global Competitiveness Survey,
which represents business leaders' opinions on competitiveness in
117 countries. Brazil's fall from 57th to 65th was among the
largest slide of any country. Breakout data showed more surprising
figures. Brazil was 79th in macroeconomic environment, ranked just
below Nigeria. It was 81st in macroeconomic stability and 83rd with
regard to inflation. It was second to last in terms of interest
rates. And Brazil was dead last in the efficiency of its tax
system. On the positive side, the study showed a low terrorist

SAO PAULO 00000692 002 OF 006


threat index for Brazil, but its "cost of crime" index was among the
worst in the world. In terms of education, Brazil is in 97th place
in the quality of its public schooling. In terms of potential for
growth, Brazil was 65th in the opinions of these business leaders,
beaten out by Ghana and Kazakhstan. The WEF report emphasized that
it is not enough for Brazil to merely maintain its solid
macroeconomic management. "If a country wants to be competitive, it
needs to be vigilant and attack on various [reform] fronts. The
government needs to respond quickly to important problems like
education, infrastructure, and labor," said Augusto Lopez-Claros,
Chief WEF Economist.

4. (U) PERCEPTION OF CORRUPTION UP: According to the WEF, the
ongoing corruption scandals, allegedly involving influence peddling
and vote-buying in Congress by members of the Lula Administration,
sullied the image of the public sector with a one-two punch:
undermining private sector confidence and distracting legislators
from the important task of preparing the Brazilian economy for
competition in the global marketplace. The WEF ranking indicates
that the largest slide occurred in business leaders' perceptions of
the quality of public institutions. In this category, Brazil slid
20 places to 70th. According to the study, government inefficiency
is one of the major obstacles to business in Brazil. With regards
to the use of public funds, Brazil occupied one of the lowest slots,
111th. It ranked 62nd in terms of government corruption and 69th in
terms of favoritism in government decisions. Professor Carlos
Arruda, Director of Development at the Dom Cabral Foundation and
coordinator for the WEF study in Brazil, made the following
observation: "Last year, whn we announced the results, we expected
that Brazl would gain in the rankings on the strength of it sound
macroeconomic policies. But we fell in te rankings due t the
private sector's loss of cnfidence in public institutions. For
2006, it'surgent that we find a solution to Brazil's institutional
crisis." Arruda confirmed that countries eperiencing institutional
crises have historicall felt negative impacts on the macro and
microecoomic fronts. Business leaders had better perceptins of
the level of corruption in China and India, which placed 49th and
50th places respectively. Russia came in 75th.

AN INTEMPERATE INVESTMENT LIMATE
---------------------------------

5. () FROSTIER THAN DENMARK: According to the Busines Climate
Ranking released in March by the Economist Intelligence Unit (EIU),
Denmark will maintainthe best business climate between 2006 and
2010 (it was also first from 2001 through 2005). Brazil, however,
slipped three places to 45th among 60 countries. The EIU's global
business rankings model is applied to the world's 60 largest
countries, which account for more than 95 percent of global output,
trade, and FDI. It measures the quality and attractiveness,
adjusted for country size, of the business environment and its key
components. The model considers 70 factors across 10 categories
important to business life, including political and institutional
environment, macroeconomic stability, approach to entrepreneurs,
foreign investment, funding, and infrastructure.

6. (U) CHILLY FORECAST FOR FDI: According to the Organization for
Economic Cooperation and Development (OECD), this all adds up to an
unattractive investment climate. Per OECD Secretary General Donald
Johnson, "The USD 18 billion that Brazil received in foreign
investment in 2004 was more a function of the size of the country
than of an attractive and favorable investment climate. In Brazil,
much remains to be done." Johnson noted that with appropriate

SAO PAULO 00000692 003 OF 006


reforms, Brazil could overtake China as the number one destination
for investment in emerging markets. In 2004, Brazil received three
percent of foreign direct investment (FDI), whereas China received
10 percent of FDI. Johnson specifically mentioned improvements in
the tax environment, citing Brazil's "overwhelming tax burden. It's
not that Brazil has a hostile investment climate, but with
regulatory reform and advances in Private Public Partnerships
(PPPs), Brazil could receive much more than its already impressive
USD 18 billion per year," said Johnson. He continued, "Structural
reforms need to be made so that the entire country can benefit from
globalization." This is also reflected in A.T. Kearney's 2003-04
FDI Confidence Index (which measures 25 countries in terms of their
attractiveness for FDI), wherein Brazil fell eight places. By
comparison, in A.T. Kearney's 1998 study Brazil was the second most
attractive country on the list; today it is 17th.

DIAGNOSIS: PAUCITY OF INVESTMENT IN INNOVATION
--------------------------------------------- -

7. (U) LOW PATENT COUNT: Brazil trails behind China, India, and
Russia in the field of research and innovation, according to a
recent study by the World Intellectual Property Organization (WIPO).
The WIPO study showed that Brazil registered fewer international
patents than the other three BRIC nations in 2005 and ranked 27th
overall out of 128 countries. In 2005, Brazil registered only 238
patents with WIPO, an increase of 0.07 percent, or two patents, over
the previous year. Russia registered 500 patents with WIPO in 2005.
China increased its WIPO patents by 47 percent, with 2,452
registered in 2005, up from 1,706 in 2004. And India registered 648
patents with WIPO last year. The WIPO ranking is one gauge of a
country's investment in innovation.

8. (U) PRESCRIPTION FOR INNOVATION: Brazil has a longstanding
problem with moving university-based research, in which it does
invest, out of the lab and into industry. Concrete approaches to
the problem, however, only came into being recently, first with the
advent of a Patent Law in 1997, next with the establishment of
sector funds for innovation and development in 1999, then with the
introduction of the 2004 "Innovation Law," and most recently with
Provisional Measure 252, passed last year, offering tax incentives
to businesses that invest in technical innovation. The government's
hope is that these measures, in particular the changes introduced by
the innovation law, will help to merge research from universities
and public institutions with business and industry.

9. (SBU) Whether the Innovation Law will indeed enable Brazil to
generate the research and investment needed to create wealth is an
open question. That measure encourages the public and private
sector (particularly small and medium-sized enterprises) to share
staff, funding and research facilities. However, it takes a
government-centric approach, charging newly-created federal, state
and municipal agencies with management of the entire innovation
system, i.e. selecting parties for technology licensing, helping to
arrange terms for exclusive licensing for commercial exploitation,
and ensuring that licensed technology is commercially exploited "in
the public interest." Once an invention or new procedure is
created, instead of having the relevant innovation support agency
step back from the process, the law contemplates that this entity
would acquire a partial share - as opposed to ceding title in full
to private industry. Officials at one of the country's leading
research incubation centers have told us that while the concept of
an innovation law is nice, given the heavy government involvement
(and, ironically enough, the lack of implementing regulations), they

SAO PAULO 00000692 004 OF 006


had no plans to take advantage of the law's provisions and would
proceed on their own.

10. (U) For others, greater cooperation between academia and
industry is not really the solution. One of the principal symptoms
of weak industrial innovation in Brazil is the size of qualified
workforce with advanced degrees dedicated to research and
development. According to Carlos Henrique de Brito Cruz, Scientific
Director of FAPESP (Sao Paulo Research Foundation), "In Brazil,
there is a mistaken assumption regarding the place of research in
the university system. In industrialized countries, more than half
of research is conducted in the industrial sector, not at
universities. And this industrial research generates 90 percent of
all patents." For example, in South Korea, the developing country
with the largest number of WIPO patent registrations, of 124,000
professionals in the research sector, 60 percent are employed in
industry. In Brazil, only 18 percent are in industry. Moreover, in
Korea, 64 percent of those in industrial research have masters
and/or doctoral degrees. In Brazil, only 14 percent have graduate
degrees. Brazil's weak showing in international patent
registrations is a symptom of broader problems in Brazil's ailing
innovation sector.

PRECIOUS PRODUCTIVITY
---------------------

11. (U) REDUCED POTENTIAL: Taken together, these business
challenges redound in lower growth potential. A report released in
April of this year by Brazil's National Confederation of Industries
(CNI) shows Brazil falling to second-to-last (22nd) place in
productivity rankings of the 23 largest economies. Between 2001 and
2005, Brazil increased its average productivity by 1.3 percent, down
from 6 percent between 1996 and 2000 (when Brazil ranked 4th) and
also down from 7 percent between 1991 and 1995 (when it ranked 6th).
Italy, with negative growth, came in at last place in the CNI
ranking. According to the study, India experienced the greatest
average yearly growth in productivity at 10.1 percent. CNI points
to Brazil's low productivity growth as a warning sign for future
exports, saying, "A great part of our recent export growth is
attributable to productivity gains during the 1990s; low
productivity growth tends to compromise future export growth." CNI
attributes Brazil's decline in productivity to high interest rates
and low investment. The group advises that in order to regain
productivity growth and secure future export growth, Brazil needs to
raise its investment levels, especially investment in technological
innovation. Unfortunately, according to recent rankings, Brazil's
investment climate is unattractive.

THREE KEY REFORMS
-----------------

12. (U) TAX REFORM: The American Chamber of Commerce (AmCham)
advocacy agenda recently has focused on three key reforms: tax
reform, regulatory agency autonomy and intellectual property
protection. Brazil's infamously burdensome taxation system
repeatedly has been cited by multinationals as the primary factor
encouraging companies to draw down employment and/or move operations
outside of Brazil. Brazil's taxation system engenders widespread
tax evasion and helps stimulate the prevalent informal or shadow
economy. According to AmCham, there are currently 40 measures
within 27 different pieces of legislation that guide taxation of
goods and services. Other items closely related to needed tax
reform include: combating tax evasion, encouraging businesses to

SAO PAULO 00000692 005 OF 006


enter the formal economy, and designing a better way for businesses
to receive proof of tax credits with the federal government.

13. (U) REGULATORY AUTONOMY: Brazil's young regulatory agencies are
in many cases struggling to find their feet. For the last three
years, AmCham has been working to influence policy-makers regarding
the role of Brazil's principal regulatory agencies -- the food and
drug administration-equivalent (ANVISA), the Electric Energy Agency
(ANEEL), the National Telecommunications Agency (ANATEL), and the
Council on Fair Competition (CADE)). AmCham studies also point out
that frequent changes in the regulatory framework legislation are
problematic for long term investments, particularly in energy and
infrastructure. Furthermore, AmCham's most recent evaluation of
ANVISA faulted its lack of internal norms regarding decisions
(resulting in uncertainty when applying for pharmaceutical
licensing, for example); its inefficiencies in the use and
integration of information technology (contributing to ANVISA's
average 5-year backlog for permit approval); its lack of internal
training for permit-approving officials; and the absence of any
measures to reduce its processing time. A pharmaceutical executive
at Eli Lilly remarked, "We have commercial operations in more than
140 countries. When Eli Lilly decides to invest, ANVISA's
inefficiencies weigh against our investing here in Brazil."

14. (SBU) INTELLECTUAL PROPERTY PROTECTION: Internationally,
concerns about Brazil's intellectual property protection have
dampened the enthusiasm of some investors. To its credit, Brazil
has done much over the last two years to improve its copyright
protection, in part due to concerns over potential USG revocation of
Brazil's Generalized System of Preferences (GSP) benefits. The GSP
review, while shining a spotlight on copyright issues, failed to
motivate similarly significant changes on the patent and trademark
front. While the GoB is working to improve the performance of the
National Patent Institute (INPI), which has a tremendous backlog of
unprocessed patent applications, the effort is nascent (ref C).
Much remains to be done to emphasize the benefits of a strong patent
and trademark regime, especially in terms of attracting
high-technology investment and spurring innovation.

BRAZIL: COMPETITIVE IN INEQUALITY
---------------------------------

15. (U) THE RICH-POOR GAP PEER GROUP: Brazil has long fared poorly
in global rankings of income equality, such as the World Bank's
World Development Index, frequently rating among the world's five
worst countries alongside the likes of the Central African Republic,
Sierra Leone, and Swaziland. The United Nations 2005-2006 Human
Development Index estimates that in Brazil, the richest 20 percent
claim 85 cents out of every dollar earned, while the poorest 20
percent earn 3 cents, leaving 12 cents to the middle 60 percent of
the population. Moreover, according to a February 2006 publication
by the World Bank entitled "Poverty Reduction and Growth: Virtuous
and Vicious Circles," Brazil's highly concentrated wealth can limit
growth potential by negatively impacting on such areas as education
levels, longevity, skilled labor, and innovation. The World Bank
study also tied inequality to competitiveness, and stated that only
with an active policy of reducing inequality can Brazil achieve
sustained growth. Stating further that Brazil will only be able to
catch up and compete with China and the Asian "tigers" if it combats
poverty in a more aggressive manner, the World Bank report linked
key reform issues, such as access to credit and capital for the
poorer classes, to the alleviation of poverty and inequality.


SAO PAULO 00000692 006 OF 006


-------
COMMENT
-------

16. (SBU) Although Brazil is heading in the right direction, its
pace leaves something to be desired. Part of this is a question of
emphasis. By contrast with some of its major emerging market
competitors, Brazil has invested time and resources over the past
twenty-two years in building up its democratic institutions. These
often do not engage in economic reforms with tremendous speed, but
they do give the system legitimacy. The institutionalization of the
fiscal responsibility law is a useful example. But Brazil must do
better if it is to address entrenched poverty and reduce inequality
and if its institutions are to maintain legitimacy. An important
first step will be addressing the twin issues of fiscal and tax
reform during the first year of the new administration, to be
elected in October 2007. END COMMENT.

17. (U) This cable was coordinated with Embassy Brasilia.

MCMULLEN

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