BRAZIL - THE ECONOMICS OF A POLITICAL CRISIS

UNCLAS SECTION 01 OF 03 BRASILIA 001682

SIPDIS

SENSITIVE

STATE PASS USTR
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 - THE ECONOMICS OF A POLITICAL CRISIS

REF: A) BRASILIA 1456
B) BRASILIA 521
C) BRASILIA 1631
D) BRASILIA 1290
E) BRASILIA 682
F) BRASILIA 1662


1. (SBU) Summary: Rattled by a mounting scandal over
alleged Lula administration vote-buying in the Congress, the
GoB has, among other measures, attempted to shore up support
among the economic elite by enacting a decree to remove
certain taxes on capital investments by exporters. The
scandal has toppled Lula's powerful Chief of Staff (ref C)
and will likely hasten the planned departure of Central Bank
President Henrique Meirelles, currently under investigation
on unrelated tax charges (ref D). Financial markets have
hardly blinked: the GoB placed USD 600 million in Eurobonds
on June 20 at lower interest rates than it had been able to
obtain in a February 2005 offering and the Real has resumed
its pre-scandal appreciation against the dollar. The GoB
also is trying to shift the public's focus by proposing a
dramatic tightening of fiscal policy, which it hopes would
create space for large reductions in Brazil's unpopular high
interest rates. The political scandal, however, makes it
extremely unlikely that the GoB will be able to obtain
passage of these fiscal measures, a critical piece of which
must be approved by a three-fifths majority of Congress.
The GoB's broader microeconomic reform agenda (ref B) is in
similarly difficult straits. Without significant reforms,
however, expect GDP growth in the election year of 2006 to
be only marginally better than the modest growth expected
this year (2.5% to 3.0%). End Summary.

Central Bank President a Lame Duck
--------------


2. (SBU) Along with the downfall of President Lula's
powerful chief of staff Jose Dirceu, the vote-buying scandal
(ref C) looks likely to hasten the departure of Central Bank
President Henrique Meirelles. Meirelles is under
investigation by the Supreme Court on charges, unrelated to
the scandal, i.e., that he evaded taxes, engaged in illegal
money transfers and violated electoral laws in his 2002
Congressional campaign (ref D). While Meirelles long had
been planning to leave the Central Bank by end-August to
prepare his planned run for governor of Goias state in 2006,
the vote-buying scandal has made his tenure at the Central
Bank less tenable. The leading candidate to replace
Meirelles, Vice Finance Minister Murilo Portugal, who was
Brazil's Executive Director at the IMF until April, has a
sterling reputation as a fiscal and monetary conservative
and would likely maintain Bank policies along the lines set
by Meirelles and his team.


3. (U) Accordingly, financial markets have been taking the
political scandal in stride. After an initial wobble, the
Real has resumed its trend of appreciation against the
dollar (ref A),and is close to its three-year high against
the dollar. On June 20, the GoB placed a $600 million ten-
year Eurobond at a spread of a mere 363 basis points over
U.S. treasuries. By comparison, the yield on this bond
offering, 7.73%, was down from the 7.9% yield on Brazil's
February $1 billion offer, although the spread over U.S.
treasuries on that offer was 10 basis points lower.

Pork over Payola
--------------


4. (SBU) The GoB moved quickly after the scandal broke to
try to shore up its support with industry by speeding up the
issuance of a Provisional Measure (MP),previously under
consideration, which creates a grab-bag of goodies for
several sectors. (Note: MPs are a form of executive decree
with immediate force of law, but which nevertheless require
congressional ratification to become permanent legislation.)
MP 252, issued by Lula on June 15, enacts a series of
changes in the tax system to benefit multiple sectors. The
"Recap" tax regime would suspend certain taxes on the sales
and importation of capital goods for firms of which 80
percent or more of revenues are export-related, while the
"Repes" provides specific exemptions for software and IT
exporters. The MP also makes more flexible a tax credit
regime applicable to capital investments. Some Brazilian
analysts have questioned the WTO-consistency of the tax
benefits for exporters; see septel for an unofficial
translation of the relevant provisions.


5. (SBU) MP 252 also enacts tax measures to help the
construction industry, including an income tax exemption on
the capital gains on the sale of a home if the seller buys a
new home of equal or greater value within 180 days. In
conjunction with several related MPs, MP 252 also seeks to
create incentives for innovation by doubling tax deductions
on the amount a firm spends for research and development.
While Congress has not yet acted on MP 252, given the
popularity of tax cuts the measure, in some form, is likely
to be approved.


6. (SBU) The Finance Ministry has estimated the cost of MP
252, in foregone revenues, at 1.5 billion Reals this year
(approximately $625 million) and 3.3 billion Reals ($1.3
billion) next year. Despite the measure's cost, there is
little risk that the GoB will not meet its primary surplus
target. Revenues continue to grow faster than GDP and the
GoB retains discretion not to spend amounts authorized in
the budget. Moreover, IMF Resident Representative Max Alier
and UN economist Carlos Mussi emphasized to Econoff that,
even if it wanted to, the GoB would find it hard to try to
"buy" its way out of the scandal. Fiscal Responsibility Law
(LRF) provisions requiring that new spending be matched with
a funding source are not easily bypassed, Alier argued.
Mussi observed that, to avoid even the hint of impropriety,
the knee jerk response of Lula's orthodox-minded economic
team to a political crisis will be to trend even more
conservative on spending decisions. Others within the GoB
have made much the same point; i.e. with macroeconomic
stabilization and the resumption of economic growth
representing the principal achievement to date of the Lula
administration, the president is loathe to tinker with his
orthodox macroeconomic policies.

Fiscal Policy to Attack Interest Rates
--------------


7. (SBU) To reaffirm its credentials with the market -- and
attack a principal cause of roundly unpopular high interest
rates -- the GoB is debating a relatively bold series of
fiscal measures to tighten fiscal policy. Principal among
these is moving, over the course of four to five years, from
targeting a primary surplus to an overall balanced budget
(nominal deficit of zero). The idea, which has some
traction with fiscally conservative elements in Congress, is
to create space for dramatic interest rate reductions in the
medium term by significantly reducing the GoB's borrowing
requirements. This would reduce crowding out of credit to
the private sector and allow interest rates to fall. (Note:
Many other factors also influence Brazil's infamously high
real interest rates -- see ref E.) The plan's proponents
(among them Federal Deputy and former Finance Minister
Delfim Netto) argue that falling interest rates would have a
"virtuous circle" effect, and by reducing GoB interest
costs, further reduce the borrowing requirement.


8. (SBU) For the plan to work, the GoB would require greater
flexibility in prioritizing expenditures and the ability to
use a greater proportion of revenues for debt service.
Currently, the vast majority of GoB revenues are subject to
constitutional earmarks and revenue sharing requirements
with state and municipal governments. The GoB would have to
obtain Congressional support for a constitutional amendment
enlarging the current de-earmarking measure (or DRU, in its
Portuguese acronym) from 10% of overall federal revenues to
20% or 30% of revenues. Moreover, not all of the mooted
measures have GoB-wide support. While supporting a move
towards a nominal fiscal balance, the Finance Ministry has
pointed out that a strict target would require volatile
primary expenditure patterns if the GoB had to act to offset
sudden interest rate and exchange rate shifts. For similar
reasons, in a conversation with Econoff, the IMF's Alier
also questioned the wisdom of a firm nominal balance target.
The overall idea of using greater fiscal restraint and
expenditure flexibility to create room to reduce interest
rates, however, has found a sympathetic audience among
politicians and businessmen weary of sky-scraping interest
rates.

Comment
--------------


9. (SBU) A significant part of the GoB's response to the
political vote-buying scandal has focused on economic
policy, which is at best a secondary tool in dealing with
the problem. Nevertheless, it is to the GoB's credit that
its proposed reforms to attack (unpopular) high interest
rates are grounded in orthodox economics. Moreover, its
pork-barrel MP will not vitiate its ability to meet its
primary surplus targets. But, with a poisoned congressional
atmosphere, it is difficult to see the GoB obtaining passage
of any significant legislation to tighten fiscal policy,
much less getting the three-fifths majority necessary to
modify constitutional earmarking requirements. In addition,
Lula's microeconomic reform agenda (ref B) looks dead, with
the exception of measures that do not require congressional
action, such as implementation of already-approved public-
private partnerships (PPPs). Without significant reforms,
however, GDP growth next year should not be much better than
this year's expected 2.5% to 3.0%. All of this must weigh
heavily on the mind of a reelection-minded President, who,
absent some unexpectedly deft political management, is in
danger of becoming seriously politically weakened with more
than a year to go before the 2006 elections.

DANILOVICH