BRAZIL: SECOND QUARTER GDP GROWTH DISAPPOINTS

UNCLAS SECTION 01 OF 02 BRASILIA 002099 SIPDIS SENSITIVE SIPDIS NSC FOR FEARS TREASURY FOR OASIA - DAS LEE, J.HOEK STATE PASS USTR FOR S.CRONIN/M.SULLIVAN 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: ECON ETRD PGOV PREL EFIN EINV BR SUBJECT: BRAZIL: SECOND QUARTER GDP GROWTH DISAPPOINTS REF: A) BRASILIA 1630 B) BRASILIA 1151 This cable is sensitive but unclassified, please protect accordingly. ¶1. (SBU) Summary: Brazil's economy expanded by a scant 0.5 percent in the second quarter of 2006, a result below most analysts' expectations, due primarily to poor results in industrial production and investment. According to Central Bank survey data, the market now expects 2006 GDP growth barely to exceed 3%. As one analyst wryly observed of the news, "it's galling, but the Central Bank seems to be correct" in its assessment of Brazil's potential medium-term growth rate (i.e 3% to 3.5%). The Central Bank itself, however, so far is maintaining a forecast of growth close to 4%, and argues that the poor second quarter result primarily was due to one-off factors. Up to now, the ongoing presidential campaign has focused on corruption scandals and ethics, however, not on the pro-growth reform agenda that whoever wins the October 29 run-off will need to pursue. End Summary. ¶2. (U) According to official GOB data (see chart below),Brazil's economy posted worse-than-expected growth in the second quarter. GDP was up 0.5% over the previous quarter and 1.2% over the second quarter of 2005. On the supply side, industrial production, which contracted 0.3% from the quarter of 2006, was to blame for the poor showing. Examined from the demand side, investment was down 2.2% on the quarter, and the contribution of exports to GDP growth also was down, by 5.1% from the first quarter. Given the second quarter results, the markets have adjusted downward from 3.5% to 3.1% their annual GDP growth predictions over the course of the last three weeks, according to weekly Central Bank survey data. Brazilian GDP Percent Growth - Seasonally Adjusted Annual/1 Quarterly Growth/2 2004 2005 3Q05 4Q05 1Q05 2Q06 Total GDP 4.9 2.3 -1.2 1.2 1.3 0.5 Supply Side - Agriculture 5.3 0.8 -2.6 1.0 1.1 0.8 - Industry 6.2 2.5 -0.8 1.3 1.2 -0.3 - Services 3.3 2.0 0.2 0.7 0.6 0.6 Demand Side - Consumption (Private) 4.1 3.1 0.9 1.3 0.6 1.2 - Govt. 0.1 1.6 -0.4 0.2 1.2 0.8 - Investment 10.9 1.6 -0.9 1.7 3.7 -2.2 - Exports 18.0 11.6 0.9 0.5 3.4 -5.1 - Imports 14.3 9.5 1.9 -0.5 10.4 -0.1 /1 Percent Change on Previous Year /2 Percent Change on Previous Quarter, Preliminary Source: Statistical and Geographic Institute (IBGE) ¶3. (SBU) Alexandre Pundek, an advisor to the Central Bank (BCB) Board of Directors, told Econoff August 30 that the BCB believes that the negative second quarter industrial production result was influenced principally by one-off factors, and should not necessarily be seen as a new trend. Principal among these were maintenance being performed on one of the blast furnaces at a CSN steel plant and maintenance to seven Petrobras offshore oil production platforms, he said. The overall scenario for the year BRASILIA 00002099 002 OF 002 was still good, Pundek argued, and the Central Bank had not revised its GDP growth prediction of about 4%. Consumer price inflation (as measured by the IPCA index),he noted, was running at less than 3% over the last twelve months and would come in at less than 4% for the year. Credit was doing well, sparking continued strong growth in consumption, Pundek affirmed. Meanwhile, investment would grow between 5% and 6%, enough for the overall economy to post growth between 3.5% and 4%, according to Pundek. ¶4. (SBU) UN Economist Carlos Mussi, in a conversation prior to the release of the second quarter data, anticipated that these would show a GDP growth deceleration. There were many positive signs, however, which augured well for the rest of the year. Credit growth was still healthy, Mussi pointed out, a factor which was supporting consumption. The combination of growing wages and falling inflation suggested that productivity gains were being passed along to workers, Mussi noted. Mussi noted wryly that, regardless of how acrimonious the debate over the level of real interest rates had been and their effect on investment and growth sometimes became, the experience of the last several years suggests that the Central Bank's modeling of maximum potential growth rates, i.e. somewhere between 3% and 3.5%, is correct. Until the investment rate increased, he concluded, there was little hope of sustaining higher growth rates. ¶5. (SBU) Finance Ministry Economic Policy Secretary Sergio Gomes de Almeida acknowledged to visiting Treasury officers Bill Block and Jasper Hoek on September 27 that growth for the year likely would be lower than the GoB had hoped. While not proffering a prediction of his own, Gomes de Almeida nevertheless argued that the pessimists were well off the mark in predicting growth of only 3 percent. Gomes de Almeida recognized that investment levels were a problem, and stated the GoB hopes to increase investment by four percentage points of GDP. He hoped that increased investment in housing construction would help reach that goal. ¶6. (SBU) Comment: Debate over where in the 3% to 4% range the Brazilian economy will wind up this year and about the need for greater investment is interesting, but beside the point. To achieve sustainable growth at the higher rates necessary to dent entrenched poverty, Brazil needs to enact a series of microeconomic reforms (i.e. expenditure reform, tax reform, social security reform and labor reform),necessary to enhance productivity growth. Up to now, the ongoing presidential campaign has focused on corruption scandals and ethics, however, not on the reform agenda that whoever wins the October 29 run-off will need to pursue. SOBEL