SECOND MEETING OF TREASURY-FINMIN "GROUP FOR

UNCLAS SECTION 01 OF 05 BRASILIA 001160

SIPDIS

SENSITIVE

TREASURY FOR U/S TAYLOR, DAS LEE AND SSEGAL
NSC FOR DEMPSEY
STATE FOR EB/IFD/OMA/O'REILLY
STATE PASS FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 3134/USFCS/OIL/WH
USDOC FOR 4332/ITA/MAC/WH/OLAC

E.O. 12958: N/A
TAGS: ECON EFIN PGOV ELAB PREL EINV BR
SUBJECT: SECOND MEETING OF TREASURY-FINMIN "GROUP FOR
GROWTH"


This cable is Sensitive but Unclassified, please protect
accordingly.


1. (SBU) SUMMARY: Treasury U/S for International Affairs
John Taylor, Ministry of Finance Treasury Secretary Joaquim
Levy, and Economic Policy Secretary Marcos Lisboa presided
on April 19 in Rio de Janeiro over the second meeting of the
Treasury/Ministry of Finance Group for Growth (GfG),an
outcome of the June 2003 summit between Presidents Lula and
Bush. The GfG meeting's main themes were infrastructure
investment and access to credit; prospects for growth in
both countries were also presented. This cable reports on
the extensive general discussion of Brazil's economic
situation and the GoB policy agenda. Lisboa pronounced
Brazil's 2002-2003 macroeconomic stabilization efforts a
success, with the current sharp drop in inflation, stable
debt-to-GDP ratio, and lowest real-interest rates in a
decade. Levy added that Brazil is now less vulnerable to
external shocks, thanks to to lower exchange-rate
volatility, reductions in dollar-based debt, and increased
exports. The GoB officials maintained their expectation of
3.5% economic growth this year and claimed that solid
recovery began in the second half of 2003. Lisboa also
focused in detail on the GoB's microeconomic and structural
reform agenda, which aims to sustain growth by decreasing
banking spreads, creating incentives for entrepreneurship,
sparking innovation, and providing an affordable social-
safety net. Levy addressed the fiscal situation in more
detail, discussing debt-servicing, the rising tax burden,
and falling central-government investment levels. He said
the single biggest fiscal challenge facing the GoB is the
social-safety net. END SUMMARY.

Background
--------------


2. (U) Treasury U/S for International Affairs John Taylor,
Ministry of Finance Treasury Secretary Joaquim Levy and
Economic Policy Secretary Marcos Lisboa presided over the
second Group for Growth (GfG) meeting in Rio de Janeiro on
April 19. The GfG is an outcome of the June 2003 summit
meeting of Presidents Bush and Lula. The first GfG meeting
was held in Washington in September 2003 and focused on
productivity growth. This second meeting focused on
infrastructure issues and access to credit, including micro
credit, as well as on current prospects for growth in both
countries. The U.S. delegation, led by U/S Taylor, included
Treasury DAS Nancy Lee, DAS for Public Affairs Tony Fratto,
Western Hemisphere Office Director Ramin Toloui, Brazil Desk
Officer Stephanie Segal, Regional Treasury Attache Matthew
Haarsager, Rio Econoff and Emboff. In addition to Levy and
Lisboa, the Brazilian delegation was rounded out by Ministry
of Finance staffers Aline Diegues and Daniel Silgemann.
Additional presentations were made by Armando Castelar of
Brazil's Institute for Applied Economic Studies, who spoke
on infrastructure and investment, Elizabeth Wallace of the
European Bank for Reconstruction and Development (EBRD),who
outlined a micro-credit pilot project being implemented in
Russia and former Soviet republics, and Carlos dos Santos of
Brazil's technical assistance agency for small businesses
(SEBRAE),who spoke on SEBRAE's role in the provision of
micro-credit.

The Starting Point
--------------


3. (U) Lisboa gave an extensive briefing on Brazil's
current economic situation and the GoB policy agenda. The
2002 crisis, he said, arose from a combination of external
shocks with fiscal imbalances, which resulted in a sharp
exchange-rate devaluation, acceleration of inflation,
increased country risk, and difficulties rolling over public
debt. The new GoB's macroeconomic stabilization effort has
reduced inflation to an expected 6% in 2004, after a spike
of 17.2% in 2003. The increase in interest rates necessary
to combat the sharp increase in inflation, however, led to
reductions in real wages, a fall in domestic demand and
ultimately to negative real GDP growth of 0.2% in 2003.
Those factors notwithstanding, Lisboa pointed out that this
result compared favorably to financial/payments crises in
other countries such as Russia in 1998, Mexico in 1994 and
Thailand in 1997, where the subsequent falls in GDP were
much sharper, ranging from -4.9% in Russia to -10.5% in
Thailand.

Successful Adjustment
--------------


4. (SBU) Lisboa pronounced GoB 2002/2003 stabilization
efforts a success. The goal was to control inflation so as
to stop the slide in real wages, reduce real interest rates,
and mitigate sources of external vulnerability, thus laying
a foundation for more sustainable growth. Fiscal adjustment
was key to all these goals and was the first priority upon
President Lula's entering office. The increase in Brazil's
national tax burden, up from 28% in 1998 to 36% of GDP in
2003, has been the single most important long-term
contributor to fiscal adjustment.


5. (SBU) Levy and Lisboa emphasized that Federal non-
interest expenditures fell as a percentage of GDP in 2003,
contributing to the adjustment. They admitted that it had
occurred in large part through real reductions in the
government wage bill. The fiscal adjustment (and the return
of financial-market confidence),in turn, allowed an easing
of interest rates. Real interest rates are now at their
lowest since the Plano Real was introduced in 1994.
External vulnerability had been reduced by sharply reducing
the quantity of exchange-rate-linked public debt. Stellar
export growth has reduced the net-external-debt-to-exports
ratio from 3.6 in 1999 to 2.2 in 2004. The current account
turned positive in 2003 for the first time since 1994 and is
expected to remain so this year.


6. (SBU) The biggest challenge to fiscal sustainability,
according to Levy, is the social-safety net. Brazil in 2002
paid out almost 11% of GDP on public and private sector
pension benefits, a level comparable to that of Sweden, even
though Sweden's retirement-age population, as a percentage
of its workforce, is almost double that of Brazil. The
issue is primarily with the private-sector (INSS) system,
Levy said, as last year's reform of the public-sector
pension system had halted the growth of the deficit in that
system. Levy predicted that the GoB would be forced to make
hard decisions in the near future, including a cap on
pension benefits in the INSS system.

Current Growth Scenario
--------------


7. (U) Lisboa maintained there is considerable evidence
that the economy has already returned to a growth
trajectory. Industrial production of consumer durables,
capital goods, and intermediate goods all recovered in the
last quarter of 2003 and continued to grow in the first
months of 2004 (although there was a drop in both consumer-
durables and capital-goods production from January to
February 2004). The retail-sales index shows a similar
evolution. Unemployment data, Lisboa said, was mixed. The
official unemployment rate, based on household surveys in
only a few major cities, has risen. However, Lisboa opined
that the increase was because many who had formerly stopped
actively seeking work, thus falling off the statistical
radar, are now hopefully re-entering the job force, swelling
the ranks of the unemployed for purposes of the calculation.
Other measurements, including surveys of hiring by firms,
showed 3.37% growth in formal jobs from March 2003 to March

2004. Much of this job growth reported by firms was taking
place outside the large urban centers, however, and so was
not reflected in the official unemployment-rate calculation.
Lisboa presented a breakdown showing job growth of 4%
outside urban centers, much of this from agribusiness, and
only 2.5% job growth in urban areas. This added up to
almost 100,000 more jobs created, in absolute terms, outside
of urban areas than in urban areas, he said.

Longer-Term Sustainability
--------------


8. (U) Macroeconomic indicators aside, Lisboa
acknowledged that the microeconomic agenda is key to
sustainable growth. One GOB priority is passage of the
Public-Private Partnerships (PPP) law to attract private
infrastructure investment. Lisboa added that the Finance
Ministry has been working to eliminate barriers to
entrepreneurship and to promote innovation. On the former
front, Lisboa reported success in obtaining agreement from
all but one of Brazil's states on a unified system and set
of procedures for setting up a business. The next step is
to obtain the same agreements from each of Brazil's 5000-
plus municipalities. Lisboa hoped to complete this
painstaking task within another one to two years. The
result would be a one-stop shop, allowing anyone to fill out
one form to create a small business. Still under debate in
the Senate, the bankruptcy law, modeled on the U.S. Chapter
11, aims to create a more rational system that better
secures creditor rights while giving businesses a chance to
emerge from bankruptcy whole, something that does not happen
today. Reform of the competition law, also planned, would
help create a more benign environment for small business.


9. (U) Levy argued that, at heart, the GoB's evolving
industrial policy is "an innovation policy," aiming to
strengthen a network of laboratories and create incentives
for research and development work. A key part of this
effort is to strengthen the Intellectual Property Institute
(INPI) so as to clear the backlog of patent applications and
give innovators some hope of securing their rights. Lisboa
added that a new Innovation Law would allow professors and
their universities to benefit from the profits of their own
research, as U.S. universities do.

Access to Credit
--------------


10. (U) In the discussion about increasing access to
credit, Levy and Lisboa outlined several macroeconomic and
structural issues that contribute to Brazil's infamously
high interest-rate spreads and difficulties of small firms'
access to credit. The primary, well-known reason offered
was that the Government's high borrowing needs crowd out
private sector and consumer credit, forcing interest rates
higher. While that problem may not be fixable in the near
future, the GOB is attacking the problem from the other
side, such as with a current bill which favors applying anti-
trust laws in the financial sector. Other initiatives aim
to improve the functioning of housing markets, including by
creating a framework for new financial instruments and
securitization of mortgages, and to require banks to share
credit information with other financial institutions at the
borrower's request (personal credit histories should improve
a borrower's ability to shop among banks.)


11. (U) Carlos dos Santos, of the Federation of Industries'
technical assistance agency for small businesses (SEBRAE),
outlined the stark reality of access to credit by small
businesses in Brazil. A government survey recently found
that of 10 million micro-enterprises (those with 6 or fewer
employees) in Brazil, most are informal and only 4.9% had
access to credit. While formally-registered firms
theoretically have a few more options, a survey of 400,000
small but formal businesses in Sao Paulo found that 79% had
no access to banking credits. Those that could get
financing often relied on supplier credits (64% of cases),
state-owned banks (3%) or loan sharks (3%). Many
entrepreneurs wind up using credit cards at usurious rates.
When small businesses can get bank loans, they are at
spreads of up to 43.5% above the base SELIC rate. Factors
contributing to spreads were credit risk, taxes (up to a
quarter of the spreads),lack of judicial enforcement of
collateral, and lack of competition among banks, Santos
said.


12. (U) Elizabeth Wallace, who manages a pioneering micro-
credit program for the European Bank for Reconstruction and
Development (EBRD),outlined the program's market-oriented
approach to train banks and bankers in techniques to make
micro-credit lending a profit center. The EBRD program
leverages existing banking infrastructure but emphasizes
training and technical assistance to alter banks' business
models and loan-officers' mindsets as well as transfer
credit technology, introduce credit analysis and streamline
procedures. The program also stresses the importance of
commercial pricing of loans, and of adequate scale to spread
fixed costs in order to ensure the viability of micro-credit
lending. Competition among micro-lenders to bring down
spreads is also critical. The EBRD program has achieved
costs as low as $59/loan in origination and administration
fees, without sacrificing portfolio quality, a far lower
rate than comparable programs administered by NGOs, asserted
Wallace.

Infrastructure Investment
--------------


13. (U) Armando Castelar Pinheiro of the Institute for
Applied Economic Studies noted that periods of higher
investment rates have clearly been correlated with higher
productivity growth in Brazil. Investment rates, however,
declined significantly early in the 1980s. Subsequent
economic reforms at the beginning of the 1990's helped
increase investment rates and concomitant productivity
growth, but investment still remains low in comparative
terms, at 19% of GDP. The picture was further complicated
in the late 1990's and early 2000's by increasing public
deficits, which reduced public investment and soaked up
private savings.


14. (U) Levy and Lisboa outlined steps the GoB is taking to
increase savings and investment. It has created a new set
of investment accounts that allow investors to rebalance
their portfolios without being subjected to the financial
transactions tax (CPMF). This should help reduce the CPMF's
distortion of investment decisions. The GoB also has begun
to exempt capital goods from the industrial production tax
in hopes of encouraging firms to invest.


15. (U) The centerpiece of the GoB's efforts to increase
investment is its draft law on Public-Private Partnerships
(PPPs). The PPP bill, currently undergoing Senate scrutiny
after passage in the Chamber of Deputies, would create a
framework for long-term private investment in infrastructure
to be paid back through user fees. Importantly, in cases
where the return on the project is not sufficient to justify
private investment, the public sector could subsidize the
project or top-up the payment stream. A guarantee fund
would give long-term security to the private investors.
Castelar lauded those positive points of PPPs, but pointed
out several problems with their application in the Brazilian
context. These include the uncertainty over the conduct of
Brazil's sometimes mercurial judges and over project
jurisdiction, the absence of a sound regulatory framework in
many sectors, as well as problems in obtaining environmental
licenses (and judicial intervention in that process),and
open questions regarding the appropriate
budgeting/accounting treatment for PPPs. Uncertainty over
the commitment of future administrations to PPP guarantees
could be overcome if the public sector makes a sufficient
down payment up-front, Castelar noted.

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


16. (SBU) This GfG meeting was characterized by candid
discussion of Brazil's current economic situation and the
challenges that the GoB's policy agenda faces. The
discussion of the EBRD micro-credit experience in Eastern
Europe and Eurasia provoked the most numerous and pointed
questions from Levy and Lisboa, sparking discussion of what
pieces might be applicable in the Brazilian context. The
failure of many of Brazil's past micro-credit efforts make
improving access to such credit a special limus test.


17. This cable cleared and coordinated with AmConGen Rio
and Treasury.

HRINAK