BRAZIL - HOW MUCH SPENDING SEQUESTRATION IS ENOUGH?

UNCLAS SECTION 01 OF 03 BRASILIA 000490

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 - HOW MUCH SPENDING SEQUESTRATION IS ENOUGH?

REF: A) Brasilia 43
B) 04 Brasilia 291
C) 04 Brasilia 1098
D) Brasilia 387


1. (SBU) Summary. The GoB is preparing to issue on
February 25 a decree sequestering Reals 5 to 10 billion
(approximately USD 2 to 4 billion) of spending called for in
the 2005 budget law passed by the Brazilian Congress
December 29. This is part of an annual exercise in which
the executive branch walks back some of the spending and
revenue assumptions made by the Congress in the budget law
to reflect its own evaluation of the likely fiscal scenario
for the year. This is a precautionary exercise, and the
money may ultimately be spent. In 2004, the Congress's
projections proved to be much closer to the mark than those
the GoB used to justify its February sequestration of about
Reals 7 billion in expenditures, all of which was later
spent. The biggest wildcard this year is the social
security deficit. Recent projections of healthier social
security contributions, due to increasing employment, may
significantly reduce the amount the GoB sequesters on
February 25. End Summary.


2. (U) The Brazilian Congress passed on December 29 a
Reals 482.5 billion federal budget (ref A). As is
traditional, the Congress topped up both revenue and
spending levels from the budget proposal that the Executive
submitted (see chart 1 below). The Congress is free to
indulge in this political maneuvering because execution of
the budget as passed by Congress is not mandatory, but
rather serves merely as an authorization -- something that
newly elected speaker of the Chamber of Deputies Severino
Calvacanti says he wants to change (ref D). The executive,
however, currently retains responsibility, under the Fiscal
Responsibility Law, to sequester spending (within thirty
days of the signing of the budget) to match its own revenue
projections. While this has been invaluable tool for the
GoB to enforce fiscal discipline and meet its primary fiscal
surplus targets, the process places squarely on its
shoulders, and not those of Congress, public opprobrium over
spending cuts. The system also creates significant gaps,
both positive and negative, between what the executive
branch proposes, what the Congress passes and what is
ultimately executed.


Chart I - Brazil's Budget
Billions of Reals


2004 2004 2005 2005
1st As Budget Budget
Rev Executed Proposal Law

Total Revenue 406.1 424.5 457.4 482.5
(% of GDP, approx) 23% 23.5% 24.3%
- Transfers
to States &
municipalities 62 65.1 69.9 78.3

Net Revenue 344.1 359.4 387.5 404.1

Expenditures 344.1 361.2 389.5 404.1

- Payroll 84.3 88.6 90.3 91.3
- Other non-
discretionary 32.2 30.9 32.1 36.3
- Judicial and
Legislature
Expenditures 3.7 3.3 4.6 4.6
- Social Security
Benefits 121.5 125.8 140.0 140.0
- Discretionary 60.8 62.6 77.2 84.6
- Primary
Surplus
Target 41.6 50 45.3 47.3

Source: Ministry of Planning and Budget


3. (SBU) Ana Teresa Holanda, the director of the Office of
Fiscal Affairs in the Ministry of Planning and Budget, told
Emboff February 3 that the GoB is preparing to sequester
about Reals 10 billion in spending to adjust the budget law
for more recent projections of revenues. This compares to
about Reals 7 billion sequestered last year (ref B).
Further adjustments can be made throughout the year to
reflect actual revenues. For example, the GoB later spent
the Reals 7 billion it sequestered early in the 2004 when
strong economic growth and changes in the PIS/COFINS taxes
boosted revenues significantly. Holanda was uncertain what
categories of spending would bear the brunt of the
sequestration. The 2004 sequestration primarily reduced
expected investment spending.

Table II
Social Security Deficit
Reals Billion

2003 Executed 24.5 (1.99% of GDP)
2004 First Review 28.3
2004 Executed 32.0 (1.9% of GDP)
2005 Budget Proposal 32.3
2005 Budget Law 32.3 (1.55% of GDP)
January 2005 projection 40.9
February 2005 projection 35.5

Source: Ministry of Planning and Budget


4. (SBU) The social security deficit currently is the
biggest wild card for budget planning, according to Holanda.
The 2004 deficit had come in Reals 3.7 billion above
projections, and the GoB had estimated in January that the
deficit could jump to Reals 40.9 billion. This Reals 8.6
billion increase represents the lion's share of the Reals 10
billion sequestration, she said. The primary culprit for
the increased deficit had been an unexpected flood of small
claims court decisions requiring readjustment of benefits to
beneficiaries whose pensions were not indexed correctly in
the switch to the new currency at the beginning of the Plano
Real in 1994.


5. (U) The GoB has since come out with another social
security deficit projection, this one of Reals 35.5 billion.
This rosier estimate is based on higher projections of
revenues, reportedly justified by strong job growth and
falling unemployment, which should increase social security
revenues. If adopted, the lower social security deficit
projection could justify reducing the amount to be
sequestered, by as much as Reals 5 billion. The GoB would
need to weigh, however, the possibility that another major
pending court decision on the calculation of social security
benefits will be decided against it. The GoB has lost this
case at the appellate court level. If the Supreme Court
upholds that earlier decision, this would force payment of a
reported Reals 6.8 billion in back benefits and increase
monthly outlays by Reals 105 million.


6. (SBU) Comment: The positive news on economic growth
and expectation of continued strong revenue performance have
helped make the sequestration process this year remarkably
low key. This stands in sharp contrast to last year, when
the GoB was subject to routine attacks over its
sequestration of investment spending. It is clear, however,
that the social security deficit remains a significant
fiscal vulnerability. While the deficit may fall as a
percent of GDP this year (as it did from 2003 to 2004),even
the healthy social security revenues projected for 2005
would cover barely a quarter of social security outlays.
Clearly, the system requires further reform to reduce its
vulnerability.

DANILOVICH