BRAZIL BUYS BACK BRADY BONDS

UNCLAS SECTION 01 OF 02 BRASILIA 000902

SIPDIS

SENSITIVE
SIPDIS

NSC FOR CRONIN
TREASURY FOR OASIA - DAS LEE, 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/SHUPKA
STATE PASS USAID FOR LAC

E.O. 12958: N/A
TAGS: EFIN ECON PGOV BR
SUBJECT: BRAZIL BUYS BACK BRADY BONDS

REF: A) BRASILIA 0366 B) BRASILIA 0790


1. (U) Summary: The GOB exercised its option to buy back its Brady
bonds on April 18. The operation involved bonds with a total face
value of US$6.63 billion, and was part of Brazil's broader effort,
taking advantage of the appreciated Real, to put behind it the
legacy of its 1980's default. Brazil also has prepaid most of its
rescheduled Paris Club debt. In a separate effort to improve its
debt profile, the GoB bought back US$3.7 billion of its Global
bonds, which were to mature in 2010. Repurchases of external debt
since January have totaled US$10.2 billion. The GoB hopes the
moves, which improve its external debt profile, will help it make
its case for an eventual investment-grade sovereign credit risk
rating. End Summary.

Legacy of 1980's Default
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2. (U) The appreciated Real, the product of high dollar inflows over
the last two years (ref A),has created opportunities for the GoB to
improve its external debt profile and to wipe from the books the
legacy of its late 1980's default. This effort, which will extend
the repayment profile of Brazil's debt and reduce near-term
payments, also is designed to enhance Brazil's bid for an
investment-grade sovereign credit rating. The GOB has been aided in
this effort by the record low spreads (as of May 9, 219 basis
points) at which it has been able to borrow overseas. To buy back
the Brady bonds, the GOB used US$5.7 billion of its international
reserves, which stood at US$58.9 billion on May 8 (up from 18
billion in 2003). The GoB in late 2005 also prepaid its $15.5
billion debt to the IMF. According to the Finance Ministry, external
government debt has now been reduced to US$65 billion, or 52.4% of
expected 2006 exports. However, with stagnant GDP growth in 2005
and increased levels of domestic debt, after marked improvement in
2003/2004, the overall public sector net-debt-to-GDP ratio (both
domestic and external) barely budged last year, down from 51.7% in
2004 to 51.6% in 2005.

Finance Minister: "Erases a Stain"
--------------


3. (U) Finance Minister Guido Mantega described the buyback as
erasing a stain from Brazil's record, declaring that "We are free
from ... the debt repayment moratorium in the 80s". Local analysts
tend to agree. By eliminating a reminder of Brazil's past failure to
honor its repayment obligations, the Brady Bond repurchase should
improve the perception of Brazil risk on international markets.

New focus: Domestic Debt and Investment Grade
--------------


4. (SBU) The GOB's recently-appointed Treasury Secretary, Carlos
Kawall, said that the Treasury's focus will switch ever more to
managing the domestic debt, with the particular goal of extending
its maturity and moving away from floating rate notes to fixed rate
and inflation-indexed bonds. In an aside directed at some local
critics of the government's Brady buyback, Kawall remarked that the
GOB expects that some of this US$6.63 billion used to repurchase
this external debt will return to the Brazil in the form of
investments in domestically-issued bonds. However, former Assistant
Secretary of the Treasury, Jose Antonio Gragnani, has admitted it

SIPDIS
would be hard to calculate how much of this money would return to
Brazil. Kawall stated the Treasury will now focus on the reducing
the proportion of floating rate domestic debt which is indexed to
the overnight benchmark rate (the SELIC) as well taking other steps
to move Brazil from the necessary two notches up to investment
grade. A Fitch-IBCA report noted that while the recent external
debt repurchases were positive, the action does not justify an
upgrade in and of itself. "There needs to be more clarity on the
structural reforms and fiscal programs, this would be essential for
an upgrade on Brazil" the report stated. (Note: Fitch's most recent
upgrade of Brazil's sovereign rating was based primarily on the
improvement in external solvency, based on Brazil's surprising
export/current account performance.)


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5. (SBU) Comment: As there will be no progress on the
structural/microeconomic agenda until after this presidential
election year, the GoB is limited to steps such as the Brady Bond
buyback and its other debt repurchases to build its case for an
investment grade credit rating. But there is only so much that
clever debt management can do. Overall debt levels remain high as
the GoB's external debt repurchases have, essentially, been financed
with additional domestic debt. The fiscal picture remains
complicated by constitutional spending earmarks and mandated
transfers to states and municipalities. And with previous strong
revenue growth beginning to falter (ref B),that leaves cutting
current expenditures beyond what is necessary to meet the 4.25% of
GDP primary surplus target as perhaps the only substantive step left
for this GoB to take to build its case for investment grade. But
with presidential elections looming, political scandals and a crisis
with Bolivia brewing, we do no expect the current government to
undertake such politically unpalatable choices. Instead, look for
the GoB to kick the fiscal can down the road a year, postponing the
investment grade rating along with it.

CHICOLA