BRAZIL - STRONG 2005 MACROECONOMIC SCENARIO

UNCLAS SECTION 01 OF 04 BRASILIA 000417 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/EOS LON E.O. 12958: N/A TAGS: ECON EFIN PGOV EINV BR SUBJECT: BRAZIL - STRONG 2005 MACROECONOMIC SCENARIO REF: A) 04 BRASILIA 2711 B) 04 BRASILIA 3115 C) BRASILIA 210 ¶1. (SBU) Summary: Brazil enters 2005 in a position of relative macroeconomic strength. GDP growth, debt ratios, the trade balance and external accounts are all favorable or moving favorably. In conversations with industry and government economists, all were hard pressed to name a single economic factor or set of factors that could spoil what looks to be a good 2005 for Brazil. Credible GDP growth forecasts range from 3.5% to 4.3%, with consumption reviving, helping to drive growth. The GoB does face some challenges, including how high interest rates must go to reduce inflation more quickly. Debt, while falling as a percent of GDP, remains high and is the key remaining source of vulnerability. The GoB easily surpassed its 4.5% of GDP primary surplus target in 2004, registering a primary surplus of 4.61% of GDP. While there is little doubt the GoB will attain its 4.25% of GDP primary surplus for 2005, revenue growth should not be as strong this year. Post believes the GoB will graduate from its IMF program when it expires in March. Some analysts cited abrupt changes in U.S. interest rates or sharp swings in the value of the dollar, affected by the U.S. current account and budget deficits, as their biggest fears for 2005. End Summary. Continued Growth Momentum -------------- ¶2. (U) Brazil enters the first quarter of 2005 with strong growth momentum, the product of 2004's best-in-a-decade yearly GDP growth of 5%. The GoB has recognized this robust growth level by revising upward in late 2004 its GDP growth estimate for 2005 budgeting purposes from 4% to 4.36%. Despite this, there is still some divergence: the Central Bank has, to date, maintained its growth forecast at 4%; a Rio de Janeiro-based economist at Icatu Securities predicted 3-3.5% growth; Brazilian institute of Economic Studies economist Paulo Levy predicted 3.8%; and, an optimistic Rio de Janeiro Federation of Industries economist said 4.5%. (Comment: the divergence seems to be attributable to differences in the inflation outlook and its subsequent impact on SELIC rate hikes and the impact of the Real's appreciation. End Comment.) There are signs of some cooling. While 2004 industrial production, for example, attained its highest growth levels in eighteen years, (8.3%),it grew a relatively modest 0.6% in December. In recent conversations with economists in government, industry and the IMF, all were hard pressed to name a risk or set of risks that could spoil the outlook for 2005. Some analysts cited persistent inflation, the U.S. current account and budget deficits, which have devalued the dollar, and U.S. interest rates as the main risks to growth in 2005. ¶3. (U) While 2004 GDP growth was overwhelmingly led by exports (up 32%) and investment (7.7% growth in the twelve months through September 2004),private consumption should revive in 2005, helping drive growth. The recovery of employment over the course of 2004 -- down from over 13% in April 2004 to 9.6% in December -- should increase wages and, ultimately, consumption. Real incomes did, in fact, halt their decade-long slide in 2004 and showed some modest growth in the last quarter. They may grow one to two percent this year. An initial sign that this consumption- led growth scenario may be underway was the 4% growth in production of consumables and semi-durables in the fourth quarter of 2004, strongly outpacing overall industrial production growth during the period. Consumables production in particular has been highly correlated with changes in real income. Inflation Falling, But Slowly -------------- ¶4. (SBU) The Central Bank would like to take advantage of the moment to slay Brazil's traditional inflation dragon once and for all. Central Bank President Meirelles has emphasized to USG officials, including to the Ambassador on December 8 (ref B),his view that the Brazilian economy retains a significant inflationary bias. Meirelles argued that this legacy of Brazil's hyper-inflationary past, when businesses tried to earn money by raising prices faster than wages could adjust, was still alive. Such inflationary behavior, he said, must be wrung out of the system. This view appears to be a strong motivating factor behind the Central Bank's current round of interest rate increases, which have taken the basic short term interest rate (SELIC) from 16% in September to 18.25% today (the market expecting a further 0.5% increase when the Monetary Policy Committee meets February 15-16 and some predict further increases in the coming months). Despite the 2.25 percentage point increase in the SELIC, inflation expectations for the year remain at 5.7%, well above the 5.1% target. This slowness in adjusting may simply be a reflection that much of the inflationary pressure, such as steel price hikes and high oil prices, has been coming from the supply-side of the equation, rather than the demand side that Central Bank policy instruments affect more directly. ¶5. (SBU) The interest rate increases have been roundly unpopular. The GoB economic team, however, is speaking with one voice in defending the policy. Shortly after the January interest rate increase, President Lula echoed Meirelles' argument (made in private to the Ambassador) criticizing industry for their price hikes, which he argued were maintaining inflation expectations well above the target for the year. Industry has since fought back, blaming the Central Bank. Flavio Castelo Branco of the National Confederation of Industries (CNI),told Emboff that industry believes monetary policy has been too tight, fixated on meeting overly ambitious inflation targets. Moreover, he argued, high interest rates were contributing to the Real's appreciation, ultimately hurting exports. Debt and Fiscal Policy -------------- ¶5. (SBU) Strong revenues, falling interest expenditures and strong GDP growth have contributed to lowering the GoB's net debt-to-GDP ratio, from 57.2% at end-2003 to an estimated 51.8% at end-2004. The GoB continued to make significant progress in improving the composition of the debt. Dollar-linked domestic debt, for example, including foreign-exchange exposure on related swaps, has fallen to 9.9% of the total, from well over half two years before. As Brazil's exposure to dollar-linked debt has fallen, the current cycle of monetary tightening has highlighted the downside of its exposure to SELIC-linked debt (52.5% of the total). New measures lowering taxes on returns from investments held longer than a year have created demands for longer-term government bonds, according to the head of strategic planning in the Finance Ministry's public debt department, Anderson Delfino. This had helped the Ministry extend the average maturity of its debt. Delfino said it would take a "perfect storm"-style confluence of events to throw off the positive macroeconomic scenario, and in particular the improving debt dynamics. ¶6. (U) The GoB easily surpassed its 4.5% of GDP primary surplus target in 2004, registering a primary surplus of 4.61% of GDP. There is little doubt the GoB will attain its 4.25% of GDP surplus for 2005. While revenue growth should not be as strong this year as it was last, the IMF ResRep has told us that the fiscal scenario for 2005 looks solid. A decision to adjust the income tax brackets for inflation creep this year should also contributes to slower revenue growth. Castelo Branco of the CNI bemoaned the overall tax burden, but likewise predicts the GoB will meet the fiscal target. An official at the GOB's Institute of Applied Economics opined that the GOB would still maintain a surplus of around 4.1% of GDP even absent an IMF program, but that it would still like a "seal of approval." Strong External Accounts -------------- ¶7. (U) Brazil's strong external position makes the current growth cycle the most sustainable of any in recent memory. While exports would be hard pressed to match the stellar growth rates of 2003 and 2004, most current predictions are for a trade surplus of about $26 billion in 2005, based on exports of a little over $100 billion and imports of about $75 billion. This would anchor the BOP, and allow a current account balance of $2.1 billion, or 0.2% of GDP. Strong dollar inflows through the capital account, attracted in part by high interest rates, have further strengthened the external position. The Central Bank bought $2.7 billion dollars on the spot market in January to shore up reserves. The Central Bank denies that its purchases are meant to influence the Real's value. ¶8. (SBU) The 2005 trade surplus should narrow, as the appreciating Real drives import growth and reduces export growth. Recovering incomes and consumption growth also should spur imports. The IMF Resident Representative pointed out to Emboff that even though the Real had appreciated significantly against the dollar, its appreciation against the Euro and other leading currencies had been much more limited, resulting in a level of real- exchange-rate appreciation that was not overly concerning. Since less than a quarter of Brazil's exports are to the U.S., the appreciation's effect was limited. CNI's Castelo Branco was much less sanguine, worrying that Brazilian exports would lose their competitiveness. He nevertheless argued that there had been a structural change in Brazilian industry, with large firms in particular energetically pursuing export growth. The most recent data suggests the export boom continues, as the January 2005 monthly trade surplus of $2.2 billion was significantly above expectations despite continued import growth. Despite the strong external accounts, Brazil's overall external debt (public and private) of about $200 billion, or twice exports, leaves it vulnerable to swings in financial market confidence. Comment -------------- ¶9. (SBU) There has been much comment in the press recently over whether Brazil should renew its IMF program when it expires in March. While the politics of this are complex, we continue believe that the GoB will not seek a new Stand- by Agreement, and neither does the macroeconomic scenario justify it (ref A). The GoB would like, however, some sort of blessing from the Fund for President Lula's initiative to adjust the primary surplus target to allow for greater public investment expenditures. Increasing private investment and sustaining healthy growth levels, on the other hand, will depend on advancing necessary microeconomic and structural reforms (septel). That said, talk in local financial circles of Brazil attaining an investment grade credit rating in the 2007/2008 time frame is getting stronger all the time. ¶10. This cable coordinated with Consulates Rio de Janeiro and Sao Paulo. DANILOVICH