BRAZIL'S PUBLIC-DEBT VULNERABILITY LESSENS, FOR NOW

UNCLAS SECTION 01 OF 08 BRASILIA 000450 SIPDIS NSC FOR SHANNON, DEMPSEY, CRUZ TREASURY FOR OASIA/SEGAL EXIMBANK FOR DIRECTOR FOLEY FED BOARD OF GOVERNORS FOR ROBATAILLE USDA FOR U/S PENN, FAS/FAA/TERPSTRA USDOC FOR 4322/ITA/IEP/WH/OLAC-SC SOUTHCOM FOR POLAD SENSITIVE E.O. 12958: N/A TAGS: EFIN ECON EINV ETRD PREL PGOV SOCI BR SUBJECT: BRAZIL'S PUBLIC-DEBT VULNERABILITY LESSENS, FOR NOW REF: (A) 03 BRASILIA 3682, (B) 03 BRASILIA 3911 SUMMARY -------------- ¶1. (U) Brazil's nominal net public debt and debt/GDP ratio both continued to rise in 2003, but there are grounds for guarded hope that the debt burden is not now the imminent threat it has been in recent years. The debt/GDP ratio (58.2% end-December) is far down from its brief late- 2002 spike of 64% and is forecast to decline year-on-year in 2004 -- a first since 1993. The GoB has worked well to reduce the debt's exchange-rate vulnerability: foreign public debt grew fractionally in 2003, but the dollar-linked component of domestic debt was steeply down, to 10% of the total (20.5%, including swap exposure) from end-2002's 20.3% (53.5%, including swap exposure). The Real's appreciation since late 2002 from almost four to under three per USD has in itself greatly eased service of the debt's foreign- currency component. And Brazil's soaring exports have added a new shock-absorber against sudden depreciation of the Real and consequent surges in dollar-linked debt. ¶2. (U) Eighty percent of the total debt is domestic, i.e., denominated in Reals. Half of that 80% is tied to the Central Bank's benchmark SELIC interest rate. Thus, the SELIC's drop from 26.5 to 16.5% since June 2003, if continued, means future-year savings in interest payments of 1.5-3.0% of GDP, as the GoB replaces or retires old debt issued at high SELIC rates. In a "virtuous-circle" effect, the return of market confidence during Lula's first year has allowed the GoB to improve the composition of its securitized debt by issuing more fixed-rate paper, as well as (since August) lengthening maturities. GoB optimists speak of cutting debt-service costs enough to achieve nominal/nominal balanced budgets by 2008, paving the way for debt/GDP to decline to the low 40% range within the decade. ¶3. (SBU) Yet Brazil's public debt remains far too close for comfort to a macroeconomic knife's edge. The Lula government's hard-won primary surplus of 4.32% of GDP in 2003 still covered less than half of the interest payment (9.49%) on its debt stock. The overall nominal debt and debt ratio each thus still grew by around three percent. (The Real's appreciation partly counteracted the nominal- deficit effect, by shrinking the valuation in Reals of foreign-exchange-linked debt.) For 2004, the GoB itself projects only a modest reduction in the ratio, to 57.3% -- even assuming 3.5% GDP growth. Domestic and/or external shocks could reverse recent positive trends. Meanwhile, the huge costs of debt-service sap the GoB's ability to make investments needed for growth, without which the debt burden will become more intractable. Bottom line: Lula's team in its first year made more progress in managing the public debt than even they might have dreamed possible -- but the debt worry looks sure to remain, hovering like a ghost over his entire term. END SUMMARY. Scope and Structure -------------- ¶4. (U) Brazil's net public-sector debt rose in 2003 from 881 to 913 billion Reals (from 55.5 to 58.2% of year-end GDP). Converted at the then-exchange-rate of Reals 2.89 per USD, the end-2003 total amounted to $316.1 billion. That dollar figure may mislead, however. Net public foreign debt constituted just USD 64.6 billion, or 20.4% of the total. The other four-fifths was domestic and denominated in Reals. Thus, the GoB can finance itself almost entirely on the local market. About 90% of new debt issued is domestic; recent modest external issues have involved simply rolling over foreign-exchange debt. The domestic debt admittedly includes foreign-exchange exposure of about USD 55.8 billion in the form of domestic securities tied to the exchange rate or currency swaps issued in parallel with those securities. The total foreign-exchange-rate exposure of Brazil's public debt thus amounts to roughly USD 121 billion, 30.4% of the total (40.9% including swaps). ¶5. (U) FOREIGN-DEBT NOTE: The GoB (and IMF-approved) figure for Brazil's foreign public-debt total is net/net of official gross/gross reserves. The latter at end-2003 were below USD 60 billion, of which over USD 38 billion represented IMF loans. Net reserves then were under 20 billion, a small fraction of their average since the early 1980s. The GoB has since increased its net reserves by over two billion dollars via open-market purchases, an ongoing process. END NOTE. -------------- Table 1 -------------- Brazil's Consolidated Net Public Sector Debt (1998-2003, End-Year),Billion Reals 1998 1999 2000 2001 2002 2003 Net Debt 385.9 516.6 563.2 660.8 881.1 913.1 (% of GDP) 41.7 48.7 48.7 52.6 55.5 58.2 Foreign 1/ 57.2 108.8 111.3 130.8 226.8 186.4 (in dollars) 47.3 60.8 57.0 56.4 64.2 64.6 (% of GDP) 6.2 10.3 9.6 10.4 14.3 11.9 Net Domestic 328.7 407.8 451.8 530.0 654.3 726.7 (% of GDP) 35.5 38.4 39.1 42.2 41.2 46.3 -1/ Net of Central Bank foreign exchange-denominated assets including gross reserves; converted at contemporary exchange- rate. Sources: Central Bank and Finance Ministry. -------------- Table 2 -------------- Breakdown of Public-Sector Debt Billions of Reals December 2003 NET PUBLIC SECTOR DEBT 913.1 Gross Debt 1,344.6 - Federal Government 940.0 - Central Bank 312.4 - State Governments 21.9 - Municipal Governments 5.2 - Federal para-statals 51.2 - State para-statals 13.9 - Municipal para-statals 0.3 Assets netted out -431.5 - Federal Government -203.3 (primarily domestic assets of the Workers' Guarantee Fund, assets of similar domestic funds and renegotiated state debts to federal government) - Central Bank -161.5 (primarily international reserves) - State Governments -11.3 - Municipal Governments -2.5 - Federal para-statals -52.6 (includes foreign exchange deposits, renegotiated debt, other credits) - State para-statals -0.3 - municipal para-statals -0.1 Source: Central Bank ¶6. NOTE: To avoid confusion amongst specialist followers of Brazilian finances, it should be noted that Brazil's net public domestic debt ("divida liquida") is not the same as its Federal Domestic Securitized Debt (FDSD -- "divida mobiliaria"). The latter includes some GoB paper which does not reflect net debt, e.g., extra issuances to sterilize the CB's open-market purchases of dollars to boost reserves, or other monetary-policy operations. FDSD thus is sometimes greater, sometimes less, than net domestic debt, as a comparison of Table 1 above with Table 3 displays. -------------- Table 3 -------------- Federal Domestic Securitized Debt (1998-2003),Billion Reals 1998 1999 2000 2001 2002 2003 Stock 323.9 414.4 510.7 624.1 623.2 731.4 -(% of GDP) 35.0 39.1 44.2 49.7 39.2 46.1 Source: Central Bank and Finance Ministry How Did We Get Here? -------------- ¶7. (U) Multiple dynamics raised Brazil's federal debt/GDP level from 1994's 30% to the current 58+%. The key drivers have been: a) high nominal deficits (and, before 1998, primary deficits),generated fundamentally by the high interest rates to which successive GoBs have resorted to stabilize the currency and fight inflation in the face of various shocks; b) centralization of state, municipal and other liabilities at the federal level after the mid-1990s; c) currency devaluation since 1998; and d) stubbornly low GDP growth. High, Interest-Driven Deficits -------------- ¶8. (U) Before the 1997-99 emerging-market financial crisis, the GoB ran not just nominal but primary consolidated budget deficits. The Cardoso government of that era maintained an overvalued exchange rate by means of high interest rates. When forced to float the Real in 1999, it raised interest rates still further to control inflation. These factors help explain how interest costs of what was initially a relatively modest stock of debt have for years been so high. ¶9. (U) The years since 1998 have seen primary-budget surpluses of 3.2% of GDP or better. However, in those same years debt service has grown to 7-9% of GDP in interest payments alone. This tremendous expense soaks up as much as a quarter of government revenues (federal and state.) It has been the primary agent behind Brazil's fiscal deficits since the Plano Real in 1994. To illustrate: the Lula government's hard-won 4.32% of GDP primary surplus covered less than half its interest expenditures (9.49% of GDP) in ¶2003. Result: a nominal deficit of 5.16% of GDP. Table 4 illustrates the impact of debt service on Brazil's fiscal accounts over the last half-decade. -------------- TABLE 4 -------------- Interest Payments Drive Fiscal Deficits (In Billions of Reals and Percent of GDP) Year 1998 1999 2000 2001 2002 2003 -Nominal Interest 68.3 87.4 78.0 86.4 114.0 145.2 -% GDP 7.5 9.0 7.1 7.2 8.6 9.5 (accrual basis) -Primary Surplus 0.1 31.1 38.2 43.7 52.4 66.2 -Pct of GDP 0.0 3.2 3.5 3.6 4.0 4.3 -Nominal Deficit 68.2 56.3 39.8 42.7 61.6 79.0 -Pct of GDP 7.5 5.8 3.6 3.6 4.6 5.16 Source: Ministry of Finance and Central Bank ¶10. (SBU) NOTE: Unibanco's chief economist once lamented to Econoff that his former employer, the World Bank, had ever convinced the IMF to fix primary surpluses instead of actual deficits as program benchmarks. This policy, he said, masks the extent of a country's fiscal problems. In Brazil's case, even the current 4.3% of GDP primary surplus is not enough to bring down the debt-to-GDP ratio, he argued. END NOTE. "Skeletons" -------------- ¶11. (U) The Cardoso administration's responsible process through the late-1990s of acknowledging bad state, municipal and parastatal debt, plus some other liabilities, has also driven up the official GoB debt level. Much of these debts, commonly referred to as "skeletons", have been centralized in the federal government. "Skeletons" added an officially estimated 8.62% of GDP to the stock of federal public debt in the eight years to December 2003. Pessimists opine that more skeletons remain to be unearthed, perhaps another 5-8% of GDP, but this upper figure seems increasingly unlikely. Currency Depreciation -------------- ¶12. (U) Since 1998, the dominant factor in worsening the debt/GDP ratio has been the exchange rate. This was reflected by the jump in the ratio after the GoB was forced to float the Real in early 1999. From 41.7% in 1998, the ratio leapt to 48.7% at the end of 1999. (The particularly high interest rates briefly imposed in 1999 were also a factor, but those rates themselves stemmed from the need to staunch capital flight and inflationary effects arising from the devaluation.) The Real's renewed plunge from April into October 2002 -- combined with the effects of high interest rates employed to combat inflation and restore market confidence during the presidential campaign -- likewise took a toll, causing the brief spike at 64%. ¶13. (U) A CSFB study gave as the rule-of-thumb for the second half of 2002 (with the Real in the 3.50-4.0/dollar zone) that a 10% currency devaluation translated to a 2 percent rise in Brazil's debt/GDP. At its worst, in November 2002, it meant a 3.4% increase. This effect was not mainly due to Brazil's relatively modest foreign public debt. Rather, it was driven by the then-burgeoning level of the dollar-linked portion of domestic public debt. That, in turn, was generated by the GoB's practice, adopted out of necessity, of holding down interest rates on its new debt by increasing issuance of dollar-linked instruments. As part of this process, starting in April 2002 the Central Bank also began issuing dozens of billions of dollars' worth of swaps in parallel with new Treasury SELIC issuances. (IMF rules forbid Treasury from selling swaps or other derivatives.) ¶14. (U) Lula's GOB has assiduously reduced this exposure to exchange-rate volatility. As market confidence in his financial team has grown, the latter has been able to retire, rather than roll over, massive portions of dollar- linked debt coming due, replacing them with non-dollar- linked debt. In 2003, it retired from the market over $20 billion in dollar-linked debt and debt-related swaps. By year's-end, the dollar-linked part of the domestic debt had halved, from 20.3 to 10.0%, year-on-year. Including swaps, the drop was from 33.5 to 20.5%. The process has accelerated since, with a total of $7.6 billion more in dollar-denominated debt retired in the first two months of 2004, according to the latest GoB figures. -------------- Table 5 -------------- COMPOSITION OF DOMESTIC FEDERAL DEBT End-2002 Sept.'03 End-2003 -------------- -------------- -------------- Fixed-interest 1.5% 6.9% 9.5% Floating-interest 42.4% 48.9% 46.5% Inflation linked 9.2% 9.8% 10.3% Total Dollar and Dollar-linked 45.8% 33.0% 32.4% Others 1.6% 1.4% 1.4% Source: Central Bank and Finance Ministry FLOATING INTEREST RATE EXPOSURE -------------- ¶15. (U) As the debt's foreign-exchange component has shrunk, its interest-rate component has grown. Half the domestic debt is floating-rate, linked to the Central Bank's discount (SELIC) rate. To illustrate the potential downside of this factor: the Central Bank's interest-rate hikes in response to the crisis of confidence in 2002 increased average interest on Brazil's domestic public securitized debt to a peak of 31.7% in November 2002. ¶16. (U) The GoB has begun to turn the tide in this area, as seen in Table 6. New financial-market confidence has allowed it to reduce interest rates, increase issues of fixed-rate debt (from under two to over twelve percent of the total, year-on-year by end-2003) and, beginning in August 2003, also to lengthen maturities. By December 2003, the SELIC had dropped to 16.5% from 26.5% in mid-2003, and the average interest rate on domestic debt was down to around 22%. This, to be sure, still left the real rate well in the double-digit range. As for foreign-debt service: by January 2004, the GoB was able to launch a 30-year Eurobond with a spread of 377 basis points above U.S. Treasuries -- quite remarkable after the spreads of 24% above U.S. Treasuries little more than a year before. -------------- TABLE 6 -------------- DOMESTIC SECURITIZED FEDERAL DEBT INDICATORS/1 End 2002 Sept 03 Dec 03 Ave. maturity (months) 33.20 31.20 31.34 - fixed rate 3.06 6.64 6.50 - SELIC linked 21.83 22.38 22.74 - Dollar linked 35.47 40.82 40.51 - inflation link 79.18 75.29 77.88 Duration (months) 20.0 15.2 Percent maturing within one year (total) 38.9 32.1 33.4 - fixed rate 96.8 86.9 85.9 - SELIC linked 48.8 30.9 28.9 - Dollar linked 31.1 33.5 42.7 - inflation link 1.3 1.7 1.4 Average Interest Rate - w/swap exposure 20.9 18.6 - w/out swaps 29.1 21.2 Exchange-Rate Exposure (Billions of Reals) - Dollar-linked 139.47 83.24 78.67 - Swaps 91.10 103.37 82.72 - Total 230.57 186.62 161.39 1/ Federal domestic debt in the form of securities held by the public Source: Ministry of Finance and Central Bank GDP: The Stagnant Variable -------------- ¶17. (U) The final variable in the debt/GDP equation is GDP itself. Brazil's anemic growth over the last several years has exacerbated the ratio's increase. Growth in 2004 is widely forecast to recover to 3.5%. But even if that scenario is borne out, along with market expectations of relative exchange-rate stability (3.1-3.2 Reals/$) plus a further decline in the SELIC interest rate to 13.5% at end- year, private-sector specialists calculate debt/GDP at end- 2004 will still be 58%. The GoB itself forecasts just a modest fall, to 57.2%. ¶18. (U) After 2004, projections of declining debt/GDP levels depend critically on sustained growth rates of at least 3.5 to 4%. Indeed, the public debt will only be payable to the extent that Brazil solves its longer-term growth problem. That solution, in turn, hinges on the raft of microeconomic reforms necessary to increase economic efficiency and promote investment (Ref A.) ¶19. (U) Meanwhile, Brazil's debt level in itself stymies longer-term growth. Most GoB borrowing is to roll over maturing debt and to pay current fiscal deficits. Public investment has dried up, squeezed both by debt service and constitutional spending earmarks which leave only about 9% of the federal budget as discretionary spending. COMMENT -------------- ¶20. (SBU) Financial-market enthusiasm for Brazil debt-paper seems ready for the long-haul. Certainly Brazil has come a good way from the "vicious circle" near-panic induced by the presidential campaign of 2002, with that period's plummeting exchange rate, interest-rate hikes, and extreme difficulty in debt-rollover. But, for all the debt-management skill and progress of Lula's first year, Brazil's public-debt profile could quite easily again fall prey to negative turns of market mood if, e.g., local interest-rate or global risk- capital trends take a bad turn, and/or domestic growth in the real economy continues not to materialize. ¶21. (SBU) Beyond keeping its fingers crossed against external and domestic shocks, the GoB can now best improve its debt sustainability by enacting structural and microeconomic reforms to attract investment and boost growth. Unfortunately, the early results of its efforts to reform the tax, pension and regulatory systems have been economically underwhelming, however politically resolute. The phantoms of doubt about Brazil's debt have withdrawn to the wings for now, but will surely hang around, ready again to haunt the GoB, through Lula's term. HRINAK