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