BRAZIL - FOREIGN EXCHANGE LIBERALIZATION AND MARKET

UNCLAS SECTION 01 OF 02 BRASILIA 001008 SIPDIS SENSITIVE SIPDIS NSC FOR CRONIN TREASURY FOR OASIA - DAS LEE, D.DOUGLASS 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/SHUPKA STATE PASS USAID FOR LAC E.O 12958: N/A TAGS: EFIN ECON EINV PGOV BR SUBJECT: BRAZIL - FOREIGN EXCHANGE LIBERALIZATION AND MARKET VOLATILITY REF: BRASILIA 0366 ¶1. (SBU) Summary: Growing pressure from exporters for some sort of GoB action in the face of the Real's appreciated levels has forced Finance Minister Guido Mantega and Central Bank President Henrique Meirelles to state they will put forward a proposal to liberalize the country's foreign exchange regime. Recognizing that Brazil's solid fundamentals (continuing strong trade and current account surpluses, along with net positive investment flows) will continue to underpin the strong Real, exporters will continue pressing for liberalization despite the almost 4% depreciation of May 22, which was due primarily to external market jitters. While the GoB has said it will build on industry's February liberalization proposal to Congress, which would revoke current requirements that exporters repatriate earnings and allow domestic dollar-denominated bank accounts (reftel),Mantega implied during a May 22 meeting with A/S Tom Shannon (see septel reporting cable) that the GoB would not any pursue substantial relaxation of the rules governing foreign exchange transactions. Separately, Finance Ministry International Secretary Luiz Pereira told Shannon he expects the markets to remain SIPDIS volatile until the Federal Reserve makes its interest rate intentions clearer, but that Brazil was well-placed to weather the storm. End Summary. Competing Ideas Regarding Reform -------------- ¶2. (U) Continuous pressure from industrial and agricultural exporters, who allege increasing loss of competitiveness due to the appreciated Real, has forced the GoB to state it will consider liberalizing the foreign exchange transaction regime. Exporters have criticized current regulations, which require repatriation of earnings within 210 days of the export sale and ban domestic dollar-denominated bank accounts, as increasing demand for Reals, thus, they argue, strengthening the exchange rate. Mantega met Meirelles on May 18 to discuss foreign exchange regime liberalization, according to the press. Meanwhile, on May 19, Sao Paulo Federation of the Industries (FIESP) President Paulo Skaf presented Mantega with a "Foreign Exchange Manifest" stating the case for a looser foreign exchange regime. Mantega told FIESP representatives that the GoB would build on FIESP's February liberalization proposals in elaborating a liberalization measure. ¶3. (SBU) Many analysts question whether full foreign exchange liberalization would in fact affect the exchange rate. Former Central Bank director for International Affairs Alexandre Schwartsman has argued that while FIESP's liberalization bill would reduce exporters' transaction costs, it would have little or no effect on the current exchange rate since the regulations do not prevent exporters, once they have repatriated their dollars, from immediately remitting them abroad again. Doing so, however, increases the number of foreign exchange transactions a company undertakes: FIESP estimates that changes in the regulations would save companies 3% to 4% of total export costs. The Central Bank is nevertheless hesitant to support any such measure because it believes liberalization would make it harder to combat money laundering or to deal with a foreign exchange crisis. In a May 22 meeting with A/S Shannon, Mantega, while acknowledging that many in industry felt the exchange rate to be over-valued, did not list exchange rate liberalization among the reforms the GoB plans to make a priority. Separately, UN Economist Carlos Mussi commented to Econoff that the Central Bank views the vestigial exchange controls as an institutional hedge, which could be activated in a crisis. Brazil Positioned to Weather Market Volatility -------------- - ¶4. (SBU) Mantega's International Affairs Secretary, Luiz Pereira, separately noted to Shannon that the uncertainty in international financial markets over the course of the Federal Reserve's future interest rate decisions drove the nearly 4% depreciation of the Real on May 22. (Note: this was followed by an almost 5% depreciation on BRASILIA 00001008 002 OF 002 May 24.) Pereira stated that Brazil was well-prepared for a period of market volatility, with continuing strong trade and current account surpluses driving a marked improvement in the country's external position. Both the GoB and private sector have reduced external debt. The GoB, moreover, has built up a large stock of international reserves (US$63.5 billion as of May 12),which was now almost equal to its net external debt and well in excess of short term debt. Pereira expected that the markets would find a new equilibrium once the Fed's intentions became clear. ¶5. (SBU) Comment: Although the Real's depreciation of the last few days may give the GoB some respite, we do not expect exporters to reduce their pressure for some action that would give them relief from the appreciated Real's effect on their bottom line. The GoB's commitment to a floating exchange rate as a fundamental pillar of its macroeconomic policy -- a commitment President Lula reiterated on May 23 -- limits its options as it attempts to be seen as politically responsive to its exporters. Indeed, the Central Bank sees full exchange transaction liberalization as a clear danger should a crisis come -- an argument that current market volatility may strengthen. Instead, look for window-dressing liberalization, with the GoB extending the period which exporters have before they must repatriate earnings, among other minor measures. CHICOLA