BRAZIL - THE MICROECONOMIC REFORM AGENDA

UNCLAS SECTION 01 OF 04 BRASILIA 000521

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SENSITIVE

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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 PGOV EINV BR
SUBJECT: BRAZIL - THE MICROECONOMIC REFORM AGENDA

REF: A) 04 BRASILIA 3115
B) BRASILIA 043
C) BRASILIA 210
D) BRASILIA 417
E) BRASILIA 447
F) BRASILIA 387
G) BRASILIA 024


1. (SBU) Summary: In contrast to Brazil's recent
outstanding macroeconomic performance, its progress on the
microeconomic and structural reforms necessary to sustain
healthy growth levels has been mixed. The GoB has a well-
articulated reform agenda and continues to push key
measures through Congress. It obtained congressional
approval in the closing moments of 2004 for laws allowing
for the creation of public-private partnerships (PPPs) in
infrastructure investment, reform of the bankruptcy code,
an innovation incentives law and judicial reform (ref B).
President Lula, however, has named only four reform
priorities for 2005: a second round of tax reform to unify
state-level VAT tax rates; labor union reform; reform of
the University system; and, regulation/implementation of
the PPPs. While not singled out as a priority by Lula,
many other reforms, including Central Bank autonomy and a
framework law to govern regulatory agencies (ref E),
remain on the agenda. The surprise defeat of Lula's
candidate in elections for Speaker of the Chamber of
Deputies (ref F) may complicate relations with the
Congress and contribute to the slimmed down set of
presidential reform priorities for the year.
Nevertheless, the GoB views reform as a long-term process
in which it is important not to lose momentum and will
look for alternate ways to advance more technical level
measures. End summary.


2. (SBU) It is a matter of gospel among the GoB economic
team that Brazil needs to sustain healthy growth levels
for some time to begin to make an impact on entrenched
poverty and its skewed income distribution. What the
sustainable rate of economic growth is, however, remains
much debated. Central Bank Chairman Meirelles put the
rate at 3% to 3.5% in a December conversation with the
Ambassador (ref A). More optimistic analysts put the
number closer to 4%. But, all recognize there is a need
for continued reform to boost productivity and, thereby,
the sustainable growth rate. The GoB's microeconomic
reform agenda aims to, among other things, improve the
functioning of credit markets, promote long terms savings,
reduce bureaucratic hurdles for businesses, cut payroll
taxes and decrease judicial uncertainty. While pieces of
this well articulated agenda have already been
implemented, one contact, Mauricio Mendonca of the
National Confederation of Industries (CNI),observed to us
that political realities have frequently reduced the
ambition of GoB's reform proposals and delayed their
passage.

Recent Reforms: PPP, Bankruptcy Law and Judicial Reform
-------------- --------------


3. (SBU) The Lula administration championed PPPs as the
centerpiece to its plans to increase infrastructure
investment. The idea is to make marginally profitable
commercial investments in infrastructure, which
nevertheless have a high societal return, more attractive.
This can be accomplished by, among other things,
guaranteeing a minimum return, providing an operating
subsidy or fronting part of the initial investment,
including through contributions in kind. The law was
approved December 22, 2004 and the GoB hopes to issue
implementing regulations and launch the first projects for
bids in late 2005. Some observers (including some within
the GoB - ref A) have argued that the GoB has
overemphasized PPPs and should instead focus on projects
that would be profitable as straight concession contracts.
In any event, implementing regulations remain to be
elaborated. The business community, according to
Mendonca, believes the Congress improved the PPP
legislation that the GoB submitted, but nevertheless feels
it had taken unduly long to do so, delaying implementation
for the sake of marginal improvements.


4. (U) The Congress passed on December 13 a major
overhaul of the bankruptcy code. Modeled on Chapter 11 of
the U.S. bankruptcy statutes, the law makes it possible
for companies in financial straits to negotiate
restructuring arrangements with their creditors outside of
the courtroom. Resorting to bankruptcy under the previous
code was, effectively, a death sentence. The new code
gives higher priority to commercial creditors and limits
labor claims, all of which should enhance creditors'
ability to recover their money. The reform ultimately may
have a significant impact on Brazil's infamously high
lending spreads (on average about 24 percentage points
above the benchmark SELIC rate for businesses and 45
points for individuals),but it remains to be seen how the
code holds up in the court system.


5. (U) Another frequently cited culprit for high lending
spreads in Brazil is the uncertainty that individual
judges will enforce creditor claims. The judicial reform
enacted in December 2004 should, over time, begin to
improve the situation. Key among the several improvements
enacted is the concept of binding precedent (ref G).
Decisions by appeals courts or the Supreme Court will be
binding on lower courts in future cases where the same
point of law is in question and when the case was decided
by a super-majority of the judges. In addition to
reducing uncertainty, this should help reduce the workload
on the overburdened courts.


6. (U) Variously billed as an innovation law and an
industrial policy law, Law 10.973 of December 2, 2004
enacts a series of measures to spur investment in research
and development. These measures include, among other
things, authorizing financial markets to create technology
mutual funds, allowing private enterprises to fund
university research, and creation public-private
technology incubators. A separate law (11.080 of December
30, 2004) creates an agency to manage the GoB's industrial
policy.


7. (U) Along with these headline measures, the GoB
enacted multiple lower profile reforms, including:
reduction of taxes on long term investments, measures to
improve mortgage market functioning, a program to finance
capital equipment modernization and reduction of a
financial transactions tax on life insurance.

On the Agenda for 2005
--------------


8. (SBU) President Lula announced on February 15 his
four priority reforms for 2005, including: a second round
of tax reform to unify state-level VAT tax rates; labor
union reform; reform of the University system; and,
regulation/implementation of the PPPs. Only the first
three of these would require congressional action.

-- The tax reform would unify the state-level ICMS tax, a
VAT with rules and rates that currently vary from state to
state. ICMS unification, along with a national-level VAT,
formed part of Lula's original 2003 tax reform package,
but its consideration was postponed as part of a political
compromise.

-- Labor-union reform, as currently envisioned, would
revamp the rules for labor union activities but would not
modify Brazil's rigid workplace rules, which firms
complain is a major disincentive to hiring. Broader labor
reform would be postponed until next year (i.e. after the
October 2006 election).

-- The university reform measures aim to increase access
by Afro-Brazilian students to federal universities through
quota systems and grant certain poor students free
education at private universities.


9. (SBU) Lula's list of priorities did not include a
number of other reform measures currently pending in
Congress. These include Central Bank independence, the
regulatory agency law (ref E),the second tranche of
judicial reform (ref G),a law allowing expanding use of
mediation to resolve legal disputes, a micro-credit
program, simplified labor and tax requirements for very
small businesses and legislation to refine rules against
anti-competitive practices in financial markets. The
Finance Ministry also has a long list of other reform
proposals that have no yet made it to Congress. These
include reducing payroll taxes, reform of the tax system
for small and medium-sized enterprises, creation of a
positive credit reference database, liberalization of the
market for reinsurance and creation of a national value
added tax (envisioned for 2007). The Secretary of
Economic Policy at the Finance Ministry, Marcos Lisboa,
has emphasized to us on multiple occasions the importance
he places on maintaining reform momentum in what he views
as a long-term reform process. The Finance Ministry
accordingly has moved forward with alternate lower-profile
and more technical measures, such as the tax rate changes
to promote long-term savings -- enacted via decree in mid-
2004 -- at points when Congressional action has been slow.

Business Priorities
--------------


10. (SBU) CNI's Mendonca told Emboff February 23 that
industry's top priorities are labor reform and a
comprehensive tax reform. He lamented that labor reform
appears to be off the agenda for this year. While he
expected the Congress to unify the ICMS tax, Mendonca
dismissed this as an isolated effort, far short of the
overhaul that industry believes the tax system requires.
Mendonca argued that the current system, which
consistently taxes production and investment, must move to
one that taxes consumption and profits. While there might
be consensus that the tax system is broken, Mendonca said,
Brazil's high debt service creates a "fiscal
straightjacket" that makes overhaul of the tax system a
risk to revenues that Brazil can little afford. This
means that major tax system changes would likely have to
be postponed until debt service levels have been reduced.
Mendonca nevertheless argued that Brazil was moving
methodically and steadily, albeit slowly, in the right
direction, having sustained a process of continual reforms
for a decade through three administrations and two very
different presidents.

Comment
--------------


11. (SBU) The surprise election of dark horse candidate
Severino Cavalcanti as Speaker of the House of Deputies
appears to have reduced the ambition of the GoB's 2005
reform agenda. Lula's four priorities, only three of
which require congressional action, slimmed down what had
been expected. Lula notably made no mention of Central
Bank independence, a measure Cavalcanti has said he
opposes, but which the Finance Ministry was pushing as a
priority for the year. While much can change quickly in
the world of Brazil's congressional politics, 2005 looks
to be a slow one for Brazil's microeconomic reform agenda.
That said, we expect the Finance Ministry to find ways to
push lower-profile technical measures and maintain
positive reform momentum.

DANILOVICH