VISITING TEAM FROM THE OFFICE OF THE COMPTROLLER

C O N F I D E N T I A L SECTION 01 OF 04 BRASILIA 002774

SIPDIS

NSC FOR CRONIN
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
AID/W FOR LAC/SA

E.O. 12958: DECL: 10/18/2015
TAGS: ECON EFIN PGOV
SUBJECT: VISITING TEAM FROM THE OFFICE OF THE COMPTROLLER
OF THE CURRENCY DISCUSSES MACRO AND BANKING ISSUES IN BRAZIL

Classified By: ECON COUNSELOR BRUCE WILLIAMSON, REASONS 1.4 (b)
and (d)


1. (SBU) Summary. The week of September 28 Robert J.
Scavotto, Senior International Economic Advisor in the
Comptroller of the Currency's International Banking and
Finance unit and Oliver Taft, Financial Economist in the same
office, visited Brazil to meet with a variety of government
officials and market analysts. Overall, both the OCC team's
public and private sector interlocutors provided an upbeat
assessment of the current state of Brazil's macro-economic
prospects. While all those the OCC team consulted agreed
upon the need for Brazil to move forward with its economic
reform agenda, given the current political scandal paralyzing
the Brazilian Congress no one saw any quick congressional
action on this front prior to the 2006 elections. End
Summary.


Discussions with the Finance Ministry and Central Bank
-------------- --------------


2. (C) In a September 28 meeting with the OCC team, Central
Bank Deputy Governor for Monetary Policy Rodrigo Azevedo and
Bank Deputy Governor for International Affairs Alexandre
Schwartsman spoke at length on the Brazilian macro-economy.
Overall, they were optimistic regarding the state of the
macro economy given stronger underlying fundamentals and a
benign external environment. They said that Central Bank
monetary policy, which many market analysts have found to be
conservative, is having a positive effect in retaining
central bank credibility for controlling inflation. Although
exports have been expanding for the past two years, Azevedo
and Schwartsman noted that most GDP growth stemmed from
domestic demand. They noted that imports of capital goods
are up 29% for this year and 24% in the past 12 months - and
have outpaced almost everything but oil. After a yearlong
tightening cycle, the two forecast a downward trajectory for
the Selic benchmark interest rate stating that a a nominal
interest rate of 13% by the end of 2006 may be achievable.
In addressing one of the structural rigidities that has
played a part in keeping real interest rates high, the two
noted that bank reserve requirements were being analyzed and
that some of the requirements may be phased out in the next
2-3 years.


3. (C) With respect to credit expansion, the two Central
Bankers, noted the growth, albeit from a very small base, of
payroll-linked loans. As loan payments are automatically
deducted from workers' paychecks, banks are able to offer
lower interest rates relative to those associated with more
traditional lines of credit (on average 2% per month, instead
of the customary 7-8%). They noted that the state-owned bank
Caixa Economica Federal was leading the market in terms of
offering this product, although Banco do Brasil, and now the
privately-owned banks, were getting into this market as well.
Strong sales of durable goods were helping to boost demand
for payroll-linked loans.


4. (C) The team also met with the Ministry of Finance's
Secretary for Economic Policy Bernard Appy. According to

SIPDIS
Appy, Brazilian society strongly supports the Lula
administration's macro-economic policies and will not accept
any major changes in economic direction as the country has
paid a high price to get to where it is today. Appy declared
that the objective of his team was to grow the economy so as
to ensure that if a financial crisis occurred Brazil would
not be in as vulnerable a position as it had been in the
past. Appy further stated that the GOB was working to reduce
its current expenditures as a percentage of GDP. Additional
reform of the tax regime in order to reduce tax arbitrage
amongst the states was also mentioned as part of the reform
agenda. However, it was observed that the reform agenda
would likely be postponed until after the 2006 elections.


5. (C) Carlos Mussi, an economist at the local office of the
Economic Commission for Latin America and the Caribbean,
emphasized the overall positive market fundamentals that now
characterize the Brazilian economy. He said that he has
identified a large volume of FDI coming from European Union
and wondered whether such investment would continue given the
uncertainties in the GOB's energy regulatory framework.
Mussi also briefed the team on discussions regarding the
proposed CCA - i.e., a reciprocal compensation agreement
involving the Latin American central banks whereby payments
of goods imported would be made directly by the central banks
to the foreign vendor. Brazil was against this, Mussi
observed, as such a situation would transfer the risk of
non-payment from the importers to the Brazilian Central Bank.


6. (C) Anderson Silva, Coordinator General for the Ministry
of Finance's National Treasury Secretariat, spoke of the
advances that the GOB has made regarding its outstanding debt
and in particular the efforts to increase the maturity of
future obligations and reduce the percentage of fixed rate
debt. Silva had just gotten back from Washington where he
gone to help promote the country's debut auction of
real-based bonds overseas. According to Silva, the US$ 1.5
billion issuance was oversubscribed, with strong demand for
the bonds, in part spurred by tax incentives, from foreign
investors. Still, Silva did not want to predict the results
of any future such issuances in either the short or the
long-term. He did state, however, that during the 2006
election year economic/political risk should be considerably
lower compared to 2002. Companies are less leveraged now and
they are able to find domestic finance given that corporate
losses are the lowest they have been in the last 10 years. He
predicted that the
National Treasury would continue with its current path
regarding bond issuance and does not expect to roll-over all
of its international obligations over the next 2 years
(anticipated roll-over rate of 76%).

Meetings with Sao Paulo Market Analysts
--------------


7. (C) In their September 26-27 meetings in Sao Paulo, the
OCC team met, inter alia, with Daniel Araujo, Director,
Financial Services, Standard & Poor's; Thomas Malaga, Chief
Economist, Banco Itau; Nilton Teixeira, Chief Economist ,
CSFB; and Mauricio Oreng, Economist, UNIBANCO. Generally
speaking, the four economists agreed that Brazil's economic
growth is robust, notwithstanding the current domestic
political crisis. They provided the following outlook on the
country's economic and political perspective.


8. (C) Araujo (strictly protect) gave a brief description of
the banking system and said that the Central Bank's November
2004 intervention in Banco Santos had had little impact on
large banks like Bradesco, Itau, Unibanco, HSBC, Citibank and
BankBoston. He said the large banking institutions, in fact,
benefited somewhat from the intervention because it helped
them to lend money to the small and mid-size banks that had
felt the impact of the Banco Santos collapse. Changing the
subject a bit, Araujo pointed out that the two banks, BMG and
Banco Rural, linked to the ongoing political corruption
scandal, had no S&P credit rating. Fortunately, these two
banks had not caused any serious damage to the banking
sector, with the exception of the Banco do Brasil and Caixa
Economica, both state-owned banks, which already had had
investments with Banco Santos.


9. (C) Finally, Araujo thought there was little chance of
more state-owned banks being privatized in the near-term and
did not see any possibility of sale, merger or incorporation
of big banks among themselves, as most of them were
family-owned and highly profitable. Nevertheless, Araujo
predicted that smaller banks would face difficulties over the
long-term if the GOB's reform agenda remained stalled in the
Brazilian Congress. He noted that large and mid-size banks
were already on the lookout for the acquisition of banks
doing retail business. With respect to foreign banks,
despite their size and years operating in Brazil, Araujo did
not foresee them getting deeply involved in the consumer
loans business.


10. (C) On the issue of paycheck secured loans, Araujo noted
that this market was primarily being pursued by small banks,
because the larger banks were not particularly interested in
this type of business. While the small banks were attracted
by low risks of such loans, the amount of credit extended
could not exceed 30 percent of the employee's salary.


11. (C) Itau Chief Economist Malaga (strictly protect) opined
that Brazil was doing a great job in several areas, but that
economic growth was still insufficient. He said that the
Central Bank's stringent monetary policies had stabilized the
economy, inflation was well under control and the substantial
trade surplus was keeping the exchange rate low, thus helping
to restrain inflationary pressures. Progress on inflation
would allow the Central Bank to consistently lower the
benchmark SELIC interest rate, with it stabilizing somewhere
around 16.4 percent at the end of 2006. He thought that the
political crisis put a question mark on Brazil's ability to
continue doing business in an ethical, serious and confident
manner, but nonetheless was happy that the international
environment had been favorable up to now. Malaga declared
that the economic reforms concluded in past years were
yielding positive results and that implementation of the
Fiscal Responsibility Law had compelled administrators to
control expenditures, which in past years left huge deficits
at the end of an elected official's mandate.


12. (C) Partially answering his own question as to whether
Brazil could repeat its extraordinary economic performances
of the past two years, Malaga stated that "he did not foresee
any serious economic crisis in Brazil, given the favorable
international environment." This positive outlook was based
on the lack of any foreseeable internal or external economic
crisis that could affect the country's trade performance,
which was propelled mainly through exports of commodities and
manufactured goods. Brazil soon would become the world's
largest exporter of commodities, he added.


13. (C) CSFB Chief Economist Teixeira (strictly protect)
noted that it was important to remember that today's Brazil
cannot be compared to the Brazil of 1997. In the past,
monetary guidelines were not observed and other macro targets
were never met because of economic shocks which distorted
economic and fiscal fundamentals. Now, he said, there is
greater discipline and a tighter monetary policy helps keep
inflation under control. He saw automatic inflation indexing
of wage contracts gradually decreasing and (hopefully)
phasing out by 2008. Teixeira foresaw energy risks ahead in
2008/2009, given the lack of investment in the energy sector.
If Brazil wants economic growth averaging 5 percent a year,
he noted, then huge investments in energy production will be
needed, which will take about five years to mature.


14. (C) With respect to the GOB's reform agenda, Teixeira
said that passage of these measures needed the urgent
attention of Congress. The country's labor legislation was
obsolete and needed to be completely overhauled and brought
into line with global standards. Nevertheless, he said that
approval of such reforms would be a lengthy process and
wasn't sure the Brazilian Congress would be willing to deal
with it as the election year grew closer. Given the delays,
he did not expect Brazilian sovereign debt to reach
investment grade status until 2009.


15. (C) UNIBANCO's Mauricio Oreng (strictly protect) noted
that the reversal of global economic growth trends, fast
weakening of the USD, continued hikes in oil prices, and
international terrorism were all potential external risks
that had to be looked at carefully. On the domestic front,
the probable risks Brazil faced were the 2006 elections and
related political corruption scandals; an inappropriate
political reaction to a less favorable economic environment;
and difficulty in maintaining the quality of its fiscal
adjustment.


16. (U) This cable was cleared with the OCC team prior to
being transmitted.
DANILOVICH