BRAZIL - ECONOMY CONTRACTS, CRITICISM EXPANDS

UNCLAS SECTION 01 OF 03 BRASILIA 003207

SIPDIS

SENSITIVE

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

E.O. 12958: N/A
TAGS: ECON EFIN ETRD PGOV EIND BR
SUBJECT: BRAZIL - ECONOMY CONTRACTS, CRITICISM EXPANDS

REF: A) BRASILIA 3150

B) BRASILIA 3092
C) BRASILIA 3043


1. (SBU) Summary: Brazil's economy contracted 1.2% in the
third quarter of 2005, falling further than even the
pessimists had predicted. Growth expectations for the year,
therefore, are being downgraded to the 2.3% to 2.7% range.
The unexpectedly abrupt fall in GDP has intensified
criticism of the Central Bank from across the political
spectrum. Prominent orthodox economists have joined the
chorus of disapproval, arguing that the Central Bank was
over-zealous in its monetary tightening earlier in 2005.
While there is a palpable sense of disappointment here that
Brazil will not repeat its strong 2004 GDP growth
performance (4.9%),the new growth projections are not far
below the 3% level that most analysts believe is Brazil's
maximum sustainable (and non-inflationary) level of growth
in the medium term absent significant reforms to increase
productivity. Moreover, growth in 2006 has a good chance of
being stronger as current interest rate cuts spark a
positive credit cycle and the GoB places greater emphasis on
spending. The lack of any progress on President Lula's
microeconomic reform agenda in Congress and a clear downward
trend in investments, however, suggest there is little hope
for sustaining faster growth rates. End Summary.


2. (U) Brazil's economy contracted 1.2% in the third quarter
of 2005, according to recently released GoB data. Parsing
the numbers, the quarterly growth data (see table below)
show, on the demand side, declines in investment and
government consumption. The supply side saw sharp drops in
agriculture (-3.4%) and industrial output (-1.2%),while
services showed no movement (0% growth). While overall
export growth continued to be strong in spite of the
appreciation of the Real, there is some evidence that price-
sensitive agricultural exports, such as bulk grains, were
damaged by the exchange rate; it also has contributed to a
fall in planted area for the upcoming crop. Along with
exports, the only bright spot in the third quarter numbers
was personal consumption, which grew 0.8%. Private sector
analysts now are predicting overall GDP growth for 2005 will
be between 2.5% and 2.7%; the latest Central Bank poll of
market expectations shows an average predicted growth of
2.66%. Meanwhile, a Planning Ministry think-tank (IPEA) has
issued an even lower growth estimate of 2.3% for the year.


Brazilian GDP
Percent Growth - Seasonally Adjusted


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

Total GDP 0.5 4.9 0.8 0.2 1.1 -1.2

Supply Side
- Agriculture 5.0 5.3 0.8 0.4 1.7 -3.4
- Industry -1.0 6.2 0.9 -0.8 1.4 -1.2
- Services -0.1 3.3 0.6 -0.2 1.2 0.0

Demand Side
- Consumption
(Private) -3.3 4.1 1.1 -0.2 0.9 0.8
- Govt. 0.6 0.1 0.5 0.3 0.9 -0.4
- Investment -6.6 10.9 -2.8 -3.1 4.7 -0.9
- Exports 14.2 18.0 4.4 2.8 2.6 1.8
- Imports -1.9 14.3 3.6 2.5 1.9 1.4

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


Chorus of Disapproval
--------------


3. (SBU) The negative growth result has intensified
criticism of the Central Bank from across the political
spectrum. While not questioning the basic thrust of
monetary policy, several prominent orthodox economists,
among them former Central Bank President Arminio Fraga and
former director Sergio Werlang, have criticized the extent
of the Central Bank's interest rate hikes. These saw the
benchmark SELIC overnight rate jump to 19.75% and real
interest rates reach about 13%, a level local economists
claim are the highest of any major economy in the world.
The Central Bank's monetary policy committee (COPOM) will
almost certainly cut the SELIC target rate by 50 basis
points at its December 13-14 meeting, to 18%, continuing its
current cycle of monetary easing, which began in September.
Some Central Bank directors have lashed out at the Brazilian
Statistical and Geographic Institute (IBGE),questioning
(with some justification) the reliability of the IBGE
estimates. Lula and Palocci both have publicly backed the
Central Bank and its continued independence to set interest
rates.

Role of the Weak Dollar/Strong Real
--------------


4. (U) The strengthening Real, which in recent months has
consistently traded at relatively appreciated levels against
the dollar (a band between 2.15 and 2.3 Reals per dollar),
may be beginning to affect price-sensitive agricultural
exports. There is anecdotal evidence that the strong Real
is affecting investment decisions at the margins. One
recent prominent example was a decision by Arcelor, reported
in the press on November 29, to cancel a joint venture
project with Brazilian mining giant CVRD to build a steel
plant in the state of Maranhao due to the strong Real, which
reduced the expected competitiveness of the plant's export-
destined production. China's Baosteel, according to the
press, also cited the appreciated Real when it called off
its plans to construct a steel plant in the northeast.
While these are only anecdotal data points, the fall in
investments (-0.9%) in the third quarter IBGE data was the
third such contraction in the last four quarters and
suggests that investment is on a clear downward trend. This
raises concerns about the foundations for future growth.

Will 2006 Be Better?
--------------


5. (SBU) Not all the data was negative. Carlos Mussi, an
economist with the United Nations Economic Commission for
Latin America and the Caribbean, pointed out in a December 2
meeting with Econoff that private consumption had posted
good growth for the second consecutive quarter. This
consumption is being fueled in part by continued access to
credit at lower interest rates available under new payroll
deduction loans, which give banks greater assurance of being
repaid. He argued that falling interest rates, when
combined with stable employment and higher personal incomes,
have created the conditions for a positive credit cycle that
could sustain increased personal consumption, laying the
foundation for stronger growth in 2006. This scenario gains
credibility in light of a November poll which found consumer
confidence to be at its highest level in recent years.


6. (SBU) Growth in 2006 also should benefit from a fiscal
stimulus over the next six to eight months. Lula Chief of
Staff Dilma Rousseff has led a political charge to force the
Finance Ministry to spend (rather than save) any revenues
above the primary surplus target, reportedly set informally
by Lula and Palocci at between 4.6% and 4.7% of GDP
(somewhat higher than the formal 4.25% of GDP target
included in the budget). The GoB was running a primary
surplus well ahead of this level (at least 5.1% of GDP in
the first nine months of 2005),cushioned by better than
expected tax revenues, which creates room for substantial
end-of-year spending without endangering overall fiscal
restraint. There also will be pressure to obligate as much
money as possible during the first six months of the 2006
election year, after which point election-related limits on
signing large new contracts go into effect until after the
October 2006 election. The extent to which significantly
increased expenditures on investment projects is possible is
debatable, however, as the GOB's administrative capacity to
spend is severely handicapped by its dysfunctional
bureaucracy. While it is true that Palocci has been stingy
in handing out funding to the ministries, many agencies have
proven unable to spend a significant portion of the public
investment monies they have received.


7. (SBU) Comment: Lula's more forceful recent backing of his
finance minister and efforts to plaster over differences
within his administration on fiscal policy mitigate the
concern that Palocci might be forced out in a policy
disagreement, despite the poor third quarter GDP result.
While December 6 statements by Lula to the effect that there
will be "adjustments" in GOB macroeconomic policy on the
surface sound ominous, in the end it will be the ultra-
orthodox Ministry of Finance and Central Bank that implement
any adjustment (likely in the manner they see fit). Palocci
nevertheless remains vulnerable should evidence emerge to
support the many allegations of wrongdoing made against him
(refs B and C),as this would likely would lead to his
departure. Specifically, his upcoming mid-December
appearance before the congressional committee investigating
illegal bingo operations could prove particularly difficult.
To date, his previous two congressional appearances have
been softball affairs in front of the upper and lower house
economic committees.


8. (SBU) Even political survival, however, may be cold
comfort for Palocci should the economy continue to perform
as poorly as it did last quarter. And, while there is clear
potential for 2006 to be a better year for Brazilian
economic growth than 2005 now looks to be, the falling
investment trend and death of Lula's microeconomic reform
agenda exacerbate concerns about the sustainability of
robust growth levels. Look for continued middling economic
performance from Brazil into the medium term.

LINEHAN