Cablegate: Why Brazil's Economy Will Just Keep Muddling Through

DE RUEHBR #2562/01 3411556
P 071556Z DEC 06






E.O. 12958: N/A


This cable is Sensitive But Unclassified, please protect

1. (SBU) Summary: By many measures, Brazil's economy has better
fundamentals today than it has had at any point over the last three
decades. The 1994 "Plano Real" brought previously unknown
macroeconomic stability to Brazil, defeating its traditional
inflation nemesis. Fiscal management has produced solid results:
the public sector routinely exceeds its primary surplus targets and
debt levels are falling. An ongoing export boom underpins continued
surpluses in Brazil's external accounts. But Brazilians are glum
about growth, which has averaged about 2.5% over the last twelve
years. Investment levels, currently about 20% of GDP, are simply
insufficient to support higher growth. There is no shortage of
reasons for this, ranging from Brazil's fiscal knot (ref A) to its
high taxes and onerous tax compliance burden, infamous bureaucracy,
lack of spending on research and development, infrastructure gap,
low levels of human capital, questionable priorities in education
spending, burgeoning social security deficit and burdensome labor

2. (SBU) Dealing with these will require a legion of reforms of
significant scope. Brazil's political system and societal
priorities, however, work to water down the ambition of attempts at
reform. Society is firmly supportive of low inflation policies and
fiscal responsibility, but has a knee-jerk reaction to talk of
(further) privatization. Meanwhile, Brazil's closet mercantilists
in industry and the foreign ministry help keep the economy
relatively closed, limiting the potential to increase productivity
through greater openness to trade. Together, these factors mean
that economic inefficiencies and low productivity growth will keep
sustainable GDP growth in the 3% to 3.5% range well into the medium
term. But neither is Brazil's economy headed for a crisis; it will
just keep muddling through with middling performance. End Summary.

Macro vs. Micro

3. (SBU) It is worth reflecting on how far Brazil has come in the
twelve years since the "Plano Real" was introduced in 1994. The
plan defeated the hyperinflation of the 1980's and, through
privatizations, placed much of the economy in private sector hands.
The current macroeconomic policy mix of a floating exchange rate,
inflation-targeting monetary policy and high primary fiscal
surpluses -- necessary to bring down high debt levels -- was
introduced in 1999 and has consolidated macroeconomic stability.
Inflation should be less than 3% this year and is expected to be
only 4% next year. Public debt levels are high (net debt of about
50% of GDP and gross debt of 72.1% of GDP) but strong primary
surpluses have brought the ratio down each year since 2003; in 2005
Brazil prepaid its IMF debt, and followed that up by paying off its
Brady bonds and Paris Club debt in 2006, both the legacy of its late
1980's debt default. Macroeconomic stability and privatization set
the stage for the Brazilian companies to be able to take advantage
of the current surge in world trade growth and the ensuing export
boom has solidified Brazil's external accounts tremendously.
Continued current account surpluses have allowed Brazil to pay down
external debt. Given lower debt and Central Bank purchases of
inflowing dollars, Brazil's public sector has become a net creditor
to the rest of the world. Moreover, the ghost of hyperinflation

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past still lingers in Brazil, helping create a clear societal
consensus in favor of low inflation and fiscal responsibility.

4. (SBU) But Brazilians now crave higher economic growth rates.
These have averaged 2.7% over the four years of the Lula presidency,
up from 2.2% over the eight years of the Cardoso presidency. The
key issues in reaching this goal are productivity growth (how well
one uses existing capital and labor) and investment levels (to build
up more capital stock), neither of which has grown enough to create
the capacity for Brazil's GDP to grow at the 5% level, a figure
which some politicians are urging be adopted as a growth target. A
recent study by the Applied Economic Research Institute (IPEA), an
independent think-tank attached to the planning ministry, concluded
that at current investment rates Brazil's capital stock would not
attain those levels necessary to sustain 5% annual GDP growth until

5. (SBU) The current transition between Lula's first and second
terms, and the renewal -- to an extent -- of his political mandate,
has brought sharper political focus to the growth debate in recent
weeks. Commentators, policy makers and policy wonks are flogging
various programs to address this or that perceived limitation on
growth. There also is public sparring between the
"developmentalists" who favor large state-led development models,
with the more orthodox economists who favor a focus on structural
and microeconomic reforms as the mechanisms to increase investment.

Table - Savings, Investment and GDP Growth
(Percent of GDP)

Domestic Gross Fixed
Year Savings Capital Formation GDP Growth
---- -------- ----------------- ----------

2001 16.75% 19.47% 1.3%
2002 18.51% 18.32% 1.9%
2003 20.38% 17.78% 0.5%
2004 23.17% 19.58% 4.9%
2005 22.4% 19.93% 2.3%
2006 21.6% /1 2.9% /2

/1 January through March of 2006
/2 Predicted 2006 GDP growth

Fiscal Issues Are the Biggest Problems

6. (SBU) The economic distortions and other structural problems that
reduce investment levels are legion. Foremost among these is
Brazil's fiscal knot, described in detail in ref A. The need to
service debt and finance a burgeoning social security deficit within
the confines of a rigid constitutional earmarking and fiscal
federalism framework has a three-fold effect: 1) Brazil has a high
tax burden, approaching 40% of GDP; 2) its financing needs crowd out
private investment; and, 3) the public sector makes only limited
investments itself. The constitutional amendments necessary to
begin to unravel the knot by reforming the social security system
and Brazil's fiscal federalism framework require congressional
super-majorities. According to published accounts, however, in his
quest to bring in the leftist PDT party to his governing coalition,
Lula may have promised to forego ambitious social security reform.

BRASILIA 00002562 003 OF 006

7. (SBU) Many businesses find much of Brazil's physical
infrastructure to be lacking. During its first term the Lula
administration, acknowledging the fiscal constraints on government
investment in infrastructure, touted public-private partnerships
(PPPs) as the solution to unlocking private investment in marginally
economical infrastructure projects. The Congress passed PPP
legislation in December 2004, but the reality of the bureaucratic
and substantive hurdles to issuing implementing regulations meant
that despite the hype, the federal government did not put out for
bid any PPP projects during Lula's first term. A few state
governments have moved with greater alacrity. The PPP example is
also a useful illustration of how slowly the Brazilian bureaucracy
can move. Turf fights between the ministries, in addition to a lack
of capacity to quickly hire consultants qualified to evaluate major
projects, have contributed to the PPPs glacially slow roll-out.

8. (SBU) Brazil's infamously high real interest rates also come in
for criticism as a factor limiting growth levels. Two key factors
in this tale of high interest rates are judicial insecurity and the
distortion of markets in savings and lending through directed credit
mechanisms and mandatory savings schemes that direct capital to the
national development bank (BNDES). The directed credit mechanisms
require banks to loan a significant percentage of their deposits to
agriculture at low real interest rates (about 5%). Workers also
contribute to the FGTS, a mandatory savings for unemployment scheme,
which finances the activities of the BNDES. As both the IMF and
OECD have pointed out, these measures have the effect of increasing
interest rates on all other lending as banks charge more on other
loans to make up for cheap agricultural lending and must pay higher
rates to compete for the pool of savings. Moreover, these
distortions limit the financial intermediation role played by banks,
which theoretically would route capital to its most efficient
economic use.

9. (SBU) Brazil's judicial system is infamous for the
unpredictability of its outcomes. Many analysts complain that
judges, particularly in the lower courts, take "social equity" into
account in rendering their decisions, making it difficult for a bank
to collect on loans or a company to enforce a contract. A chief
economist at a major Brazilian Bank told Econoff it could take as
long as 10 years for his bank to use the judicial system to collect
on a loan. The introduction of the concept of binding precedent in
the 2004 judicial reforms will, over time, help to make the system
more predictable. The courts also contribute to a general climate
of regulatory uncertainty. Although the regulatory framework in
many sectors is adequate, according to analysts, unpredictable
enforcement and changes in the rules, such as Lula's 2004 overhaul
of the power sector regulatory model, have hurt existing investors.

10. (SBU) Most employers find Brazilian labor laws very restrictive,
creating significant and expensive compliance burdens and limiting
the flexibility of businesses to work in new ways. Moreover,
various payroll levies, such as social security and the FGTS
unemployment insurance/mandatory savings scheme come close to
doubling the cost of labor to the employer. Most economists believe
reform of the outdated labor laws would help increase economic
efficiency and make business more competitive. But labor reform
would come only at great political cost for Lula, who requires
support from both the left wing of his own PT and some of the
smaller leftist parties to obtain congressional majorities.

No Societal Consensus Behind Micro Reforms

11. (SBU) In marked contrast to the consensus supporting low

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inflation and responsible fiscal policies, many deeper structural
and microeconomic reforms are manifestly unpopular. In a telling
moment in the recent presidential campaign, the Lula campaign
accused pro-business PSDB party candidate Geraldo Alckmin of
intending to privatize Brazil's remaining parastatals. Rather than
defend the many palpable benefits that successful privatization
already has brought to Brazil -- most obviously in the
telecommunications sector, where privatization brought efficient and
ubiquitous service at lower prices, in sharp contrast to the waiting
lists and prohibitive pricing that previously prevailed -- the
Alckmin camp issued denials that it had any intentions of pursuing
privatization. Fortunately, parastatals such as Petrobras and
Eletrobras already have been partially privatized (a fact many
Brazilians forget) and forced to face competition in their sectors.
Nor do Brazilian politicians dare to voice the politically sensitive
but economically sensible idea of reforming the directed credit
system. Another force for distortion, the development bank BNDES,
is almost universally popular among Brazilians despite the
regressive nature of its financing, which takes money from the
working class through the mandated payroll savings scheme and uses
it primarily to finance Brazil's biggest corporations.

Productivity Growth and Innovation

12. (SBU) Even with low investment levels, Brazil could sustain
higher growth rates were productivity growth higher. Brazil,
however, spends only 1% of GDP on Research and Development (half the
OECD average), and most of that is spent by government and
universities, not the private sector. An "innovation law" passed in
December 2004 aimed to improve the situation by promoting
partnerships between universities and companies to develop
technology. Total factor productivity, however, which can be used
as a proxy for innovation in an economy, has made only marginal (and
in some cases negative) contributions to Brazilian GDP growth over
recent years, according to data from the OECD and IPEA. Another
well-known obstacle to innovation and R&D in Brazil is spotty
enforcement of Intellectual Property Rights (IPR). In a meeting
with the Ambassador, Petrobras President Gabrielli implied a
negative opinion of Brazilian IPR protection by emphasizing how
important it was for Petrobras to obtain approval for its U.S.
patent application in order to move ahead with investing in
Brazilian production of H-Bio, a biofuel made by an innovative
distilling/refining process using a blend of petroleum and
plant-based oils (such as soybean oil).

13. (SBU) Finding adequate human capital is also a challenge for
businesses in Brazil. As of 2004, the average Brazilian had
attended school for 6.6 years and only 57% of students finished
primary school. Given constitutional earmarks for education
spending, the issue is less one of lack of money but of priorities.
Brazil spends about 4.3% of GDP on education, a level equivalent to
the OECD average. But the distribution is troublesome: Brazil
spends about as much on primary education per student as Paraguay
and much less than Mexico, Chile and Argentina. But it lavishes
spending at the tertiary level, supporting an expensive system of
free public universities, entry to which is governed by rigorous
entry exams. Access to this system is limited as only the
better-off can afford the costly preparatory courses that most
students find necessary to pass the entry exams; those public
universities serve only 5.1% of the college-age population.
President Lula has proposed incremental reforms to this system.

Trade -- Ideological Focus

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15. (SBU) One way to achieve greater productivity is through greater
competition, including openness to trade. But the Brazilian economy
is a relatively closed one, with imports accounting for about 10% of
GDP as of 2006 (albeit trending upward). The average applied tariff
of just over 10%, which is higher than OECD averages, also masks
higher protection levels for certain sectors, particularly
manufactures. Moreover, the foreign ministry's ideologically driven
focus on furthering south-south cooperation in its trade
negotiations has not helped Brazil significantly. A former finance
ministry Under Secretary pointed out to the Ambassador recently that
the several trade agreements Brazil (via the Mercosul Customs Union)
had concluded during President Lula's first term covered countries
accounting for only 3.6% of Mercosul exports and 1.2% of its
imports. But even these tiny figures are overstatements of the
accords' importance as most of them cover only a small fraction of
tariff line items -- 10% in the case of the South Africa-Mercosul
agreement and 5% in the case of the Mercosul-India agreement. The
former Under Secretary confided that he was roundly attacked in the
press by representatives of Brazil's influential Sao Paulo Industry
Federation (FIESP) after presenting this trade data and argued that
Brazil needed to pursue trade agreements with its major markets,
such as the EU and U.S.

Headline reforms vs. smaller measures

16. (SBU) Even if prospects are bleak for headline reforms, there is
much that smaller reforms can accomplish. For example, some of the
growth in credit, and particularly the reduction in spreads for
loans to individuals in recent years, is due to the creation of
payroll-deduction loans, in which loans repayments are deducted
directly from the borrowers' salary (or INSS pension payment).
These loans gave banks greater security and led to more lending to
individuals at lower cost. The IMF resrep believes much of this
lending went to support expansion of small businesses by family
members of the people who could get such loans. Another measure,
the SIMPLES regime, lowered and unified taxes for small businesses
(i.e. with revenues of up to 1.2 million Reais a year, or about USD
550,000). This allowed many small business to move out of
informality, boosting formal employment (and tax revenue) despite
the lower tax rates. Legislation to expand the program by
increasing the revenue ceiling to 2.4 million Reais is close to
final congressional passage. The Lula administration also passed
targeted tax breaks, along with complementary regulatory
adjustments, which together have helped spark a construction and
real estate boom. But these smaller measures, however effective in
accomplishing their focused goals, are typical Brazilian
work-arounds (the culture of the "jeitinho"), and leave untouched
the fundamental growth-limiting distortions in the Brazilian

But little societal ferment

17. (SBU) Brazil's middling growth rates are simply insufficient to
lift the masses out of poverty the way many Asian economies have.
Lula's Bolsa Familia program, however, is now reaching over 11
million families, helping raise the living standards of the poorest.
These income transfer programs do little to help recipients get
jobs or become less dependent on handouts, but by conditioning the
transfers on keeping children in school and their vaccinations
updated, they aim to improve the next generation's prospects and
break the intra-generational transmission of poverty. Transfer
mechanisms such as Bolsa Familia and the income transfer portions of

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the social security system, which subsidizes pensions for elderly
rural poor, are in part responsible for the improvement in Brazil's
GINI coefficient (a measure of inequality) over the last two years.
Brazil's economy has been creating record numbers of new formal
sector jobs. Taken together, these factors take the edge off of
social ferment that might otherwise result from lower growth levels.

18. (SBU) Comment: The political compromises that made possible the
signal economic achievements of the Real Plan were forced through
the political system by economic crises: hyperinflation, debt,
recession and devaluation. With a sound macroeconomic framework and
a largely market-based economy in place, however, Brazil today faces
no serious threat of near term crisis. Although Lula's re-election
has to an extent given him a renewed mandate, he has limited
political capital with which to forge a coalition. Unfortunately,
the most significant reforms, particularly in the areas of tax
reform and fiscal federalism, will require constitutional amendments
and congressional super-majorities. Absent the threat of economic
crisis, Brazilian politicians, reflecting both prevailing societal
preferences and their own interest in political self preservation,
will err on the side of moderation in reforms, condemning Brazil to
lower potential growth path into the medium term.


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