BRAZIL - ECONOMIC GROWTH AND INFLATION SLOW

UNCLAS SECTION 01 OF 02 BRASILIA 001662

SIPDIS

SENSITIVE

NSC FOR BREIER, RENIGAR
TREASURY FOR OASIA - DAS LEE AND FPARODI
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON

E.O. 12958: N/A
TAGS: ECON EFIN
SUBJECT: BRAZIL - ECONOMIC GROWTH AND INFLATION SLOW

REF: A) BRASILIA 1456
B) BRASILIA 521
C) BRASILIA 1631
D) BRASILIA 682


1. (SBU) Summary: Brazil's economy slowed more sharply than
expected in the first quarter, clocking growth of 0.3%.
Growth expectations for the year, therefore, are being
downgraded, to the 2.5% to 3% range. The good news is that
previously intractable inflation and inflationary
expectations also have begun to fall, responding to the
cycle of Central Bank interest rate increases begun in
September 2004. This allowed the Central Bank's Monetary
Policy Committee (COPOM) to leave interest rates unchanged
at its June 14-15 meeting, after an eight-month adjustment
cycle that increased the bank's overnight rate (the SELIC)
from 16% to 19.75%. With growth settling back towards what
many believe to be the maximum sustainable level in the
medium term (about 3%),the economic policy focus shifts to
reforms to increase the economy's productivity, and thereby
its growth potential. The current scandal over vote-buying
in Congress (ref C),however, will make even more difficult
Congressional approval of President Lula's reform agenda.
End Summary.


2. (SBU) Economic growth slowed more quickly than
anticipated in the first quarter of 2005, according to GoB
data. The quarterly growth data (see table below) show, on
the demand side, declines in investment and private
consumption. These are reflected on the supply side in a 1%
drop in industrial output for the quarter. Taken together,
the data suggest that the Central Bank's monetary tightening
has been slowing growth, reducing investment, personal
consumption and industrial output. Despite the current
drought in southern Brazil, the data also show surprisingly
strong growth in agricultural output. According to Carlos
Mussi, an economist with the UN Economic Commission for
Latin America (ECLAC),the drought's impact will only begin
to show up in data for the second quarter. Exports turned
in another gravity-defying performance despite the
appreciation of the Real (ref A).


Brazilian GDP
Percent Growth - Seasonally Adjusted


Annual/1 Quarterly Growth/2
2003 2004 2Q04 3Q04 4Q04 1Q05

Total GDP 0.5 4.9 1.1 1.3 0.4 0.3

Supply Side
- Agriculture 5.0 5.3 0.5 -1.6 1.8 2.6
- Industry -1.0 6.2 1.0 2.6 0.4 -1.0
- Services -0.1 3.3 1.0 0.9 0.4 -0.2

Demand Side
- Consumption
(Private) -3.3 4.1 1.6 1.3 0.8 -0.6
- Govt. 0.6 0.1 -1.0 1.3 0.5 -0.1
- Investment -6.6 10.9 3.5 6.2 -3.9 -3.0
- Exports 14.2 18.0 4.1 2.1 3.3 3.5
- Imports -1.9 14.3 1.4 4.2 3.2 2.3

/1 Percent Change on Previous Year
/2 Percent Change on Previous Quarter, Preliminary
Source: Statistics and Geographic Institute (IBGE)


3. (SBU) Analysts, who previously were predicting growth of
3.5% to 4% for 2005, have been busily revising their growth
projections downward. The GoB's Institute for Applied
Economic Research (IPEA) now is projecting growth of 2.9% in

2005. The latest Central Bank survey of market
expectations, which averages the predictions of financial
institutions with economic models, shows the market is
predicting growth of 3.1% for the year. The IMF Resident
Representative told Econoff he expects growth of 2.75% to
3%.

4. (SBU) The Brazilian Geographic and Statistical Institute
(IBGE),which produces the official growth and inflation
numbers, also revised downward its initial estimate of
growth last year from 5.2% to 4.9%. Mussi explained to
Econoff that after receiving additional data from the GoB's
telecommunications regulatory agency, the IBGE re-estimated
the growth in telecommunication services, and made other
lesser adjustments. While Mussi expressed some doubt about
the precision of the IBGE estimates -- in particular their
methodology for seasonal adjustments -- it was clear, he
said, that the economy would expand less robustly than
before.


5. (SBU) The good news is that, along with slowing the
economy, Central Bank interest rate increases finally look
to be bringing stubborn inflation and inflationary
expectations under control. Inflation as measured by the
consumer price index (IPCA) dropped from 0.87% in April to
0.49% in May. Inflationary expectations likewise have
moderated. Since the beginning of May, Central Bank surveys
have shown market expectations for inflation consistently
falling. The market now predicts 2005 annual inflation of
6.16% (down from 12.5% in 2002, 9.3% in 2003 and 7.6% in
2004). While this is well above the 5.1% target, it remains
well within the 2.5 percentage point band on either side of
the target. Based on this shifting inflation scenario, the
Central Bank halted its eight-month cycle of interest rate
increases, voting at its June 14-15 meeting to keep the
benchmark SELIC rate at 19.75%. Mussi noted that although
inflation was clearly headed in the right direction,
structural rigidities and credit expansion (ref D) were
increasing the cost of marginal reductions in inflation.


6. (SBU) Comment: As GDP growth settles towards 3% --
within the ballpark of what most analysts believe is, in the
medium term, the economy's maximum sustainable expansion
rate -- this cycle of monetary tightening has made clear the
need to move forward with badly needed reforms (ref B).
While it is still early to draw firm conclusions, the
current political scandal over alleged Lula administration
vote-buying in the Congress (ref C) looks to have made the
GoB's already modest reform ambitions for the year (ref B)
even harder to achieve.

DANILOVICH