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Cablegate: Brazil: July 11, 2007, Meeting Between U.S. Treasury

VZCZCXRO3786
PP RUEHRG
DE RUEHBR #1336/01 1971443
ZNR UUUUU ZZH
P 161443Z JUL 07
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 9515
INFO RUEHBR/AMEMBASSY BRASILIA
RUEHRI/AMCONSUL RIO DE JANEIRO 4772
RUEHSO/AMCONSUL SAO PAULO 0377
RUEHRG/AMCONSUL RECIFE 6943
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHAC/AMEMBASSY ASUNCION 6214
RUEHBU/AMEMBASSY BUENOS AIRES 4913
RUEHSG/AMEMBASSY SANTIAGO 6359

UNCLAS SECTION 01 OF 03 BRASILIA 001336

SIPDIS

SENSITIVE
SIPDIS

STATE PASS USTR FOR CRONIN
STATE PASS FEDERAL RESERVE BOARD FOR P.ROBITAILLE
TREASURY FOR OASIA - J.HOEK
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/SHUPKA
STATE PASS USAID FOR LAC

E.0. 12958: N/A
TAGS: ECON EFIN PGOV BR
SUBJECT: BRAZIL: July 11, 2007, meeting between U.S. Treasury
Secretary Paulson and Central Bank President Meirelles


SIPDIS

1. (SBU) Summary: In their July 11 Brasilia meeting, Central Bank
President Henrique Meirelles told Secretary Paulson that Brazil
appears to have overcome the extreme economic and financial
volatility it experienced in the past, and that Brazil's medium-term
growth and inflation outlook is positive. The recent improvement in
Brazil's economic performance is partly attributable to favorable
global economic growth, but is also attributable to Brazil's strong
fiscal and monetary policy performance as well as the reduction in
its external financial vulnerabilities. The strong appreciation of
the Brazilian real that has occurred in recent months reflects the
improvement in Brazil's economic fundamentals in addition to recent
credit rating agency upgrades of Brazil's sovereign debt. End
Summary.

2. (SBU) Meirelles opened the meeting by providing an overview of
Brazil's economic history over the past decade and also its current
economic outlook. Meirelles stated that Brazil has historically
suffered from "stop-and-go," boom-and-bust economic cycles largely
as a result of three factors: (1) erratic balance of payments
performance, (2) poor fiscal policy and resulting pressures for
monetary financing from the central bank that led to high and
volatile inflation, and (3) the extensive use of controls and
regulations rather than price and market mechanisms to allocate
economic resources, which increased the size of Brazil's public
sector and slowed private sector development in Brazil.

3. (SBU) Meirelles stated that the adoption of the Plano Real in
1994 was an important, but incomplete, step in Brazil's transition
toward economic stabilization. The Plano Real successfully ended
Brazil's hyperinflation. However, it did not address underlying
problems in Brazil's fiscal and balance of payments performance.
Largely as a result of Brazil's poor fiscal performance after 1994,
it suffered crises in 1998-99 and again in 2002. Meirelles stated
that it was only after all three factors came together in 2003-04 -
lower inflation, improved fiscal policy, and stronger trade
performance - did Brazil's economic performance begin to improve
measurably. Provided these factors continue, Brazil's growth should
be much more sustainable in the future than it has been in the past.


4. (SBU) Although Meirelles attributed some of Brazil's improved
performance in recent years to favorable global economic conditions,
he stated that Brazil has successfully leveraged benign global
conditions to implement reforms and improve public and private
sector balance sheets (for example, eliminating net external public
sector debt). Brazil's Central Bank is currently forecasting 4.7%
growth for calendar year 2007 (slightly higher than most private
sector forecasts). Personal consumption spending is expanding by 8%
(annualized), and investment is growing even more rapidly (rate not
specified). In contrast to Brazil's previous growth cycles, net
exports are now negative net contributors to Brazil's growth.
Inflation over the next three years is forecast to be in line with
the central bank's annual target (4.5%).

5. (SBU) Meirelles stated that Brazil's improved macroeconomic
outlook has had positive spillover effects on private sector
investment. Low and stable inflation has helped to reduce risk
premia and allowed private sector investors to project cash flows
over much longer time horizons, supporting faster growth in
investment spending. Domestic credit is currently expanding by 20%
(annualized). Brazil's domestic credit-to-GDP ratio has climbed from
21% in 2002 to 32% in 2007.

6. (SBU) Meirelles stated that the strong appreciation of the
Brazilian real (from 3.8/USD in 2002 to 1.89/USD at present) has
forced a "painful but necessary restructuring process on some
industries," and that currency appreciation has been an important
catalyst for some Brazilian industries to significantly improve
their global competitiveness.

7. (SBU) Secretary Paulson provided an overview of the global and
the U.S. economic outlook. He stated that he has never observed such
favorable global economic conditions as currently exist and that the
global economy is now "awash in cash." He stated that he is not
predicting a crisis, but that he also believes such favorable global

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conditions will not persist indefinitely. He reported that growth
prospects in many regions, especially in East Asia, remain strong.

8. (SBU) Discussing the U.S. economy, Secretary Paulson stated that
the outlook appears strong, that most sectors of the economy are in
good shape, and that the U.S. economy appears flexible and resilient
to most potential shocks it could experience. He stated that the
U.S. fiscal deficit (currently forecast for FY 2007 to be equivalent
to 1.5% of GDP) has surprised many people on the upside due to
stronger-than-expected revenue growth. Revenues are currently 18.4%
of GDP - consistent with the long-term U.S. historical average.
Secretary Paulson stated that key factor for continued U.S. growth

SIPDIS
is to ensure that inflation does not rise, which would force the
Federal Reserve to tighten monetary policy quickly and in a way that
might harm confidence and private sector spending.

9. (SBU) Secretary Paulson stated that difficulties in the sub-prime
housing market were fairly predictable as a result of the extended
liquidity buildup in U.S. real estate and the aggressiveness of U.S.
lenders. He stated that he believes that conditions in the sub-prime
market have probably bottomed out, but that the effects in this
market may persist for some time as banks work through these
non-performing loans. He said that sub-prime is a controversial
political issue in the U.S., but he believes the economic impact of
sub-prime housing market difficulties on the U.S. macroeconomy will
be limited.

10. (SBU) Discussing exchange rates, Secretary Paulson noted the
importance of allowing exchange rates to be market-determined.
Although he believes a strong dollar is in the U.S. national
economic interest, he also believes market forces should determine
foreign exchange rates and does not support efforts by some
countries - notably China - to manage their exchange rates in a
rigid manner. He noted that it would be helpful if Brazilian
officials communicated this message in their discussions with
China's leaders.

11. (SBU) In response to a question asked by Paulo Vieira da Cunha
(Director of International Affairs) about the potential risk posed
by global hedge funds, Secretary Paulson stated that hedge funds
have provided many important benefits to the global economy but that
he is concerned about possible risks they might create due to their
extensive use of financial leverage. Secretary Paulson currently
chairs an inter-agency working group (Treasury, Federal Reserve, the
Securities and Exchange Commission, and the Commodities Futures
Trading Commission) that is examining potential systemic risks that
might emanate from hedge funds. He stated that he believes imposing
new regulations to limit hedge fund risk is likely to be
ineffective, and instead prefers an alternative approach that
emphasizes the importance of improved transparency, greater
disclosure, and the implementation of best financial practices by
hedge funds.

12. (SBU) Secretary Paulson stated that he does not believe global
current account imbalances are likely to be resolved through
exchange rate movements. Although currency adjustments can be
helpful in correcting external imbalances, the deeper and more
important source of these imbalances lie in structural factors at
work within larger economies. In particular, Secretary Paulson
noted the high degree of precautionary saving that exists in China
due to the lack of adequate social insurance mechanisms and the
shallow capital markets there that force many firms to finance
investment spending via retained earnings rather than through
external borrowing.

13. (SBU) In response to a question about U.S. fiscal performance
asked by Mario Mesquita (Director of Economic Policy), Secretary
Paulson stated that the key fiscal challenge the U.S. faces is
medium-term rather than short-term. Recent short-term U.S. fiscal
performance has exceeded most forecasts. However, the U.S. has not
effectively addressed medium-term challenges it faces in reforming
health care and social security spending. He stated that these
problems are not analytically difficult, but that building a
political consensus on the reforms needed to ensure the long-term
solvency of these programs has proven difficult.

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Sobel

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