BRAZIL: A COMBINATION OF INDUSTRIAL EXPANSION, LOW

UNCLAS SECTION 01 OF 08 SAO PAULO 000258

SIPDIS

SIPDIS

NSC FOR SCRONIN
STATE PASS USTR FOR SULLIVAN/LEZNY
DEPT OF TREASURY FOR FPARODI
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D
USDOC ALSO FOR 3134/USFCS/OIO/EOLSON/DDEVITO/DANDERSON
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STATE PASS OPIC FOR DMORONESE, NRIVERA, CMERVENNE
DOL FOR ILAB PEREZ-PKOPEZ AND WHOLEY

E.O. 12958: N/A
TAGS: ECON ELAB ETRD EFIN EINV EIND BR
SUBJECT: BRAZIL: A COMBINATION OF INDUSTRIAL EXPANSION, LOW
INFLATION, RECORD TRADE AND CURRENT ACCOUNT SURPLUS RESCUED THE
ECONOMY FROM STAGNATION IN 2005


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SUMMARY
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1. Brazil's record trade surplus combined with currency
appreciation that benefited imports and a substantial current
account surplus were the main economic surprises of 2005. Brazil is
recovering from a production slowdown in the third quarter of 2005
on the strength of year-end sales and companies replenishing
inventories. Unemployment dropped both in Sao Paulo and nationally,
accompanied by a slight increase in real wages. While the auto
industry celebrated increased sales, companies are concerned that
the strong Real and high interest rates may hinder their
competitiveness; at the same time, they are excited about the
success of flex-fuel engines. A huge trade surplus and foreign
direct investment inflows contributed to the current account
surplus, while low inflation generated a climate of stability and
confidence. End Summary.

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SAO PAULO INFLATION IN 2005 LOWEST SINCE 2000
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2. The Institute of Economic Research (FIPE) of the University of
Sao Paulo reported consumer inflation in Sao Paulo at 4.53 percent
in 2005, after repeating a 0.29 percent increase in December, the
same as in November. This was the lowest annual inflation rate
since 2000 and well below the 6.56 percent rate of 2004. Health
care services, tuition fees, and transportation tariffs accounted
for two-thirds of the consumer price index. Consumer inflation
measured by FIPE for the month of January 2006 was 0.50 percent.
Over a 12-month period ending in January 2006, inflation was also
4.53 percent. Listed below is total inflation over the past three
years as well as several significant Sao Paulo inflation factors for

2005.

Total Consumer Price Inflation (CPI) - Sao Paulo
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Year 2003 2004 2005
-------------- -------------- -------------- --------------

(Percent change) 8.18 6.57 4.53
Source: FIPE



CPI Factors - Sao Paulo
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Year 2005
-------------- --------------
Transportation 13.08
Food Products 0.47
Rent 2.77
Personal Care Services 3.87
Clothing 2.30
Tuition Fees 6.54
Health Care 9.26


(Percent Change from 2004)
Source: FIPE

Monthly CPI in 2005
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Jan Feb March April May June July Aug Sept Oct Nov Dec

0.56 0.36 0.79 0.87 0.49 (0.2) (0.3) 0.2 0.44 0.63 0.29 0.29

SAO PAULO 00000258 002 OF 008



(Percent change)
Source: FIPE

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NATIONWIDE INFLATION FELL IN 2005
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3. The Brazilian National Statistical Agency (IBGE) reported that
consumer prices nationwide, as measured by the National Broad
Consumer Price Index (IPCA),fell to 0.36 percent in December from
0.55 percent in November. IBGE attributes this decrease to weak
consumer demand, which left retailers with less room to increase
prices. Inflation slowed in 2005 for the fourth consecutive year
and was within the GOB targeted inflation range established in 1999.
A substantial supply of agricultural products and the effects of
the stronger Real were primarily responsible for reducing pressure
on the index. On the other hand, the index was negatively impacted
by high international oil prices, bus fares, publicly administered
(regulated) prices (e.g., electricity and telephone fees),and the
wages of industrial workers. Commenting on inflation, the Brazilian
Minister of Planning, Paulo Bernardo, said inflation continues
"absolutely under control" and that there is room for the Brazilian
Central Bank (CB) to continue reducing interest rates. [Background
Note: The IPCA serves as the primary benchmark for the GOB's
inflation-targeting goal. It records the average of daily price
variations in eleven major cities (Sao Paulo, Rio de Janeiro, Porto
Alegre, Belo Horizonte, Recife, Belem, Fortaleza, Salvador,
Curitiba, Brasilia, and Goiania). The IPCA statistical sample
includes families with incomes between one and forty times the
monthly minimum wage (i.e., up to approximately USD 3,880 in
December 2005). End Background Note].

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SAO PAULO INDUSTRIAL PRODUCTION CLIMBED IN 2005
-------------- --


4. The Sao Paulo Industrial Activity Index (INA),maintained by the
Sao Paulo State Federation of Industries (FIESP),rose 1.8 percent
in 2005 versus 9.2 percent in 2004. FIESP reported that the INA
rose in December compared to November. Nevertheless, the Director
of the Sao Paulo Industrial Center's Economic and Research
Department, Boris Tabacof, said "2005 was not a slack year for Sao
Paulo industry." According to Tabacof, "the sector only failed to
expand because of the negative effects of the exchange rate and
extremely high interest rates." He further noted that inflation has
been under control and industrial prices were not responsible for
causing undue pressure on the index. Therefore, Tabacof believes
there is no justification for keeping interest rates prohibitively
high, and he linked high interest rates to the country's
insignificant growth rate. Despite a deceleration of industrial
expansion, Tabacof feels that all factors that compose the indicator
show positive results when compared to 2004. For example, hours
worked in production increased 7.6 percent, real sales jumped by 13
percent, hours paid climbed 5.3 percent, and real salaries were up
11.3 percent. Among the explanations for the discrepancy in the
numbers, Tabacof cited the decline of capacity utilization from 79.7
percent in 2004 to 78.5 percent in 2005.


5. A private sector industry analyst in Sao Paulo said that some
sectors of industry are experiencing an increase in orders as
retailers restock. The packaging industry (cans, boxes, labels,
bottles, etc.) expects production to rise in the coming months as
supermarkets replace depleted stocks of processed foods, cleaning
supplies, and personal hygiene items. He cautioned, however, that
sales will pick up slowly because workers are saving money in case
they become jobless (see figures regarding increased unemployment
below).

Selected FIESP Data for 2005

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Percentage changes from 2004 to 2005:
- Industrial Activity Level (1) 1.8
- Hours worked in production 7.6
- Real median salaries 6.7
- Real Sales 13.1
- Use of installed capacity 78.5
(data not seasonally adjusted)

- (1)The activity level indicator (INA) is a composite of activity
indicators including real sales, employment, hours worked in
production, salaries, and capacity utilization. The INA index does
not measure industrial production per se.

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NATIONWIDE INDUSTRIAL OUTPUT INCREASED IN 2005
-------------- -


6. According to IBGE, Brazilian national industrial output grew a
meager 0.6 percent in November. Compared to November 2004,
industrial output also rose 0.6 percent. Cumulative output for
January-November 2005 was up 3.1 percent from the same period a year
earlier. Output for the 12-month period in November was up 3.5
percent but showed a declining trend compared to 4.1 percent
expansion in the 12-month period to October 2004.


7. Industrial production increased in November in 15 of the 23
activities surveyed compared to October 2004. The best performances
were registered by food products, up 2.2 percent; electrical
machines and materials, up 5.3 percent; rubber and plastics, up 2.9
percent; and toiletries and household cleaning products, up 6.1
percent. Negative performances were registered by chemical
products, down 1.9 percent; electronic materials and communication
equipment, down 4.1 percent; petroleum refining and alcohol fuel
production, down 1.5 percent; and tobacco, down 9.1 percent.
Capital goods production continued to recover, climbing a healthy
2.2 percent from October's 4.2 percent decline. In comparison to
the previous month, November 2005's intermediary goods output was up
0.2 percent and semi-durable and non-durable consumer goods rose 0.5
percent for the second consecutive month. A weak area was durable
goods, where production fell 1.4 percent compared to October,
suggesting that consumer credit growth has begun to slow down, after
climbing 2.7 percent in October.


8. In the cumulative January-November period, total industrial
output rose 3.1 percent compared to the same period of 2004, down
slightly from an increase of 3.4 percent through October, compared
with the same period a year earlier. Seventeen activities showed
production expansion: Vehicle production, up 6.9 percent,
maintained leadership in terms of impact on the general index.
Other positive impacts were reported in the mining extraction
industry, up 10.3 percent; electronic equipment and communications
material, up 14.7 percent; and printing, up 11.1 percent. On the
other hand, ten activities posted negative performance, with basic
metal products registering the sharpest decline at 2.4 percent.



9. Industrial production increased in November in 8 of the 14
principal Brazilian regions compared to November of 2004.
Pernambuco outperformed the national average, clocking 12.3 percent
growth. Other states with growth exceeding the national average
include Rio de Janeiro, up 4 percent; Minas Gerais, up 3.8 percent;
Espirito Santo, up 1.5 percent; Bahia, up 1.1 percent; and Para, up
0.9 percent. The states in which output increased below the
national average were the northeast region, up 0.5 percent; Sao
Paulo, up 0.3 percent. Meanwhile, industrial production fell in
Santa Catarina, down 2.2 percent; Amazonas, down 2.4 percent; Rio
Grande do Sul, down 3.4 percent; Goias, down 3.7 percent; Ceara,
down 6.2 percent; and Parana, down 10.4 percent.

SAO PAULO 00000258 004 OF 008




10. According to IBGE data released in the second week of February
2006, Brazilian industrial production rose 2.3 percent in December
2005 compared to the previous month. This is the best December
result since 1991, and it signals that the manufacturing sector is
recovering from a year-long slowdown. Sectors that performed
exceptionally well were electronic materials and communications
equipment, vehicles, pharmaceuticals, and machines and equipment.
Also, December's output rose 3.2 percent compared to December 2004.
Industrial output nationally climbed 3.1 percent in 2005. The
Institute for Industrial Development Studies (IEDI) has projected
3.5 percent industrial expansion for 2006. On the other hand, the
Institute for Applied Economic Research (IPEA) predicted a 4.1
percent increase, while a study by Austin Ratings Consultancy in Sao
Paulo has forecasted 4.7 percent industrial growth countrywide.
These research institutes believe that greater expansion in demand
for manufactured and semi-manufactured products and foods for the
domestic and export markets will encourage industrial production.


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NATIONWIDE INDUSTRIAL SALES ROSE IN NOVEMBER
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11. In November 2005, nationwide retail sales rose 0.26 percent in
volume and 0.18 percent in nominal value compared to October, in the
seasonally adjusted series. In the series without adjustment, sales
in volume increased 4.87 percent compared to November 2004 and were
up 4.82 the first eleven months of 2005. Sales in volume rose 5.53
percent in 12 months to November. In the same comparison, sales in
nominal value climbed 8.78 percent compared to November 2004 and
10.51 percent in the first eleven months of 2005. Sales revenue
rose 11.38 percent in the 12 months up to November. Four of eight
activities showed positive performance while the other half posted
negative performance. Activities that grew include household
appliances, petroleum, and by-products. Supermarket sales, food
products, cigarettes and beverages, clothing, and footwear posted
negative results. In extended retail trade, vehicles, motorcycles,
and parts grew 3.7 percent.

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SAO PAULO INDUSTRIAL EMPLOYMENT INCREASED IN 2005
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12. A FIESP survey showed a 2.16 percent decline in Sao Paulo
industrial employment in December for a loss of 45,818 jobs.
Although the month of December always reflects a decline of
industrial employment, this year's decline was higher than in the
past four years. Paulo Francini, the Director of FIESP's Economic
and Research Department, noted that December's industrial job
creation was disappointing and well below the department's
projections of 65,000 new jobs. Francini noted, "when the economy
loses steam, everything else slows." According to Francini, the
2005 results show just how badly industrial production has been
affected since the middle of 2005, due to "an overdose of an
equivocal monetary policy." In a FIESP survey of the 47 industrial
associations, 26 fired workers, 12 hired workers and nine reported
no net gain or loss. The largest number of dismissals occurred in
the fertilizers, footwear, and metal stamping industries. Most of
the added workers were in the marble and granite, beverages, and
animal rations (feed) industries.

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COUNTRYWIDE INDUSTRIAL EMPLOYMENT DOWN IN NOVEMBER
-------------- --------------


13. According to IBGE data, nationwide industrial employment was
down 0.6 percent in November over October. Nationwide industrial
employment also fell 0.9 percent versus November 2004. Cumulative
industrial employment was up 1.2 percent in the first eleven months

SAO PAULO 00000258 005 OF 008


of 2005 and 1.5 percent in 12 months to November. Workers' wages
fell 0.8 percent in November compared to October, but were up 2.2
percent from November a year ago. In the first eleven months of
2005 wages climbed 3.7 percent and 4.4 percent in the 12 months to
November.

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DECEMBER UNEMPLOYMENT FALLS IN GREATER SAO PAULO
-------------- ---


14. The total unemployment rate in the greater Sao Paulo area,
calculated jointly by the Sao Paulo State Statistical Institute
(SEADE) and the Labor Union-Funded Statistical and Research Center
(DIEESE) fell to 15.8 percent in December from 16.4 percent in
November. The Sao Paulo metropolitan area had over 1,607,000
workers looking for jobs in December compared to 1,648,000 workers
in November. The number of unemployed fell 41,000 in December, as
163,000 new jobs created were more than sufficient to absorb 122,000
workers who entered the labor market. (Note: The SEADE/DIEESE
index includes underemployed and discouraged workers and is
therefore higher than the open market rate measured by IBGE. IBGE
figures showed unemployment rate for greater Sao Paulo was 7.8
percent in December falling from 9.7 percent in November and 9.6
percent in October. End Note). The SEADE/DIEESE data showed that
the unemployment rate in the metropolitan area of Sao Paulo rate
fell for the fourth consecutive month in December to 15.8 from 17.1
percent in August.


15. Greater Sao Paulo's consumer population in December was
estimated at 10,173,000, up slightly from 10,051,000 in November and
10,008,000 in October. Meanwhile, the number of persons employed in
December was 8,566,000, up 1.9 percent from November. Of those
persons employed in December, 1.68 million were industrial workers;
1.40 million worked in commerce/retail; 4.50 million were in the
services sector; and 985,000 worked in other sectors including
construction and household services.


16. The SEADE/DIEESE workforce statistics reflected the following
performance by various sectors in December compared to November.

Job Generation/Loss by Sector
--------------
Industry 96
Services 99
Civil construction/household help 11
Commerce Retail 30
(Reported in thousands)
Source: SEADE/DIEESE (Note: The SEADE/DIEESE survey results differ
from FIESP's because SEADE/DIEESE limits its survey to the
metropolitan area of Sao Paulo; is conducted among 3,600 assorted
households, including self-employed and unregistered workers; and
surveys different households each month. FIESP's survey covers the
state of Sao Paulo; is limited to a fixed number of large industrial
firms, which are surveyed every month; and excludes self-employed
and unregistered workers. End Note.)

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NATIONAL UNEMPLOYMENT: STABLE IN NOVEMBER, FELL IN DECEMBER
-------------- --------------


17. According to a monthly survey carried out countrywide by IBGE
in the six largest metropolitan regions (Sao Paulo, Rio de Janeiro,
Porto Alegre, Belo Horizonte, Salvador, and Recife),the overall
unemployment rate for these regions in November continued stable
(9.6 percent) for the fifth consecutive month, down one percent from
November of 2004. Average real income increased 0.4 percent
compared to the previous month and 2.1 percent compared to November

2004.


18. After remaining constant for six months, the unemployment rate

SAO PAULO 00000258 006 OF 008


in December in the same six metropolitan regions fell to its lowest
level (8.3 percent) since March 2002 and, for the first time, the
number of unemployed persons remained below 2 million. The average
real income of workers in December increased 1.8 percent compared to
November and 5.8 percent versus December 2004. Compared to
November, unemployment fell in Sao Paulo from 9.7 percent to 7.8
percent; Belo Horizonte from 8.2 percent to 7.0 percent; and in Rio
de Janeiro from 7.7 percent to 6.8 percent. The other regions were
stable. The size of the workforce in the six metropolitan regions
was 20.2 million persons in December, the same number reported for
November, but 2.4 percent higher than December 2004. The average
real income in December was up 1.8 percent compared to November and
up 5.8 percent from December 2004.

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VEHICLE INDUSTRY BOASTS RECORD PRODUCTION AND EXPORTS
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19. According to the Brazilian Vehicle Manufacturers' Association
(ANFAVEA),the Brazilian vehicle industry set record high production
and exports in 2005, for the second consecutive year. Production of
all vehicles in 2005 was up 10.7 percent to 2.45 million units
compared to the previous year. Similarly, sales of autos, buses,
and trucks rose 8.6 percent to 1.71 million units and vehicle export
earnings totaled USD 11.2 billion, up 33.5 percent. This was an
all-time high for vehicles exported in any one year. ANFAVEA said
that auto industry successes in 2005 were largely due to dramatic
increases in export sales, rather than domestic sales, which
remained below the all-time high of 1997.


20. Auto industry sources predict a 5 percent increase in
production and a 7 percent increase in domestic sales for 2006. At
the same time, export sales in value are not expected to grow more
than 3 percent. ANFAVEA believes that 2006 will be a difficult year
for the Brazilian vehicle industry due to the overvalued Brazilian
currency, which has significantly reduced competitiveness in foreign
markets. In addition, the domestic market is hampered by the
world's highest interest rates. [Note: The Brazilian Central Bank's
overnight lending rate (SELIC) was recently reduced from 17.25 to
16.5 percent. End Note.] During a recent visit to Ford Motor
Company, Ford's corporate director and president of ANFAVEA, Rogelio
Golfarb, said that investments in Brazil over the last decade
modernized auto plants to enable them to compete in foreign
countries. Investment allowed manufacturers to introduce new
technology, increase competitiveness, and launch new vehicle models.
One retail sales representative cited the high cost of borrowing
money, unbearably high taxes for car buyers, and high labor costs as
barriers to increasing domestic sales.


21. Nonetheless, data released by ANFAVEA in January 2006 surprised
everyone. ANFAVEA said that never before had the auto sector
produced and exported so much in January. Domestic sales also
showed growth. Vehicle sales increased 20 percent in January 2006
compared to the same month a year earlier led by VW and followed by
GM, Fiat, and Ford. Golfarb attributed it to recent projections for
a stable scenario for the Brazilian economy (sustained low
inflation) and declining risk for foreign investors in 2006.
Nonetheless, some manufacturers including GM predicted that exports
will reduce substantially this year to due the appreciation of the
Brazilian currency and as a result of stiff competition from other
vehicle-exporting countries. In Brazil, the automotive industry
accounts for nearly 11 percent of industrial GDP. Brazilian
automotive production and distribution support over 500,000 direct
jobs and more than 760,000 indirect jobs.

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BRAZILIAN FLEX-FUEL ENGINES A GREAT SUCCESS
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22. Flex-fuel vehicle engines were first manufactured and

SAO PAULO 00000258 007 OF 008


introduced into the Brazilian market in 2003. In 2005, no less than
10 new vehicle models were running with the use of this new
technology. Flex-fuel engines can be fueled by gasoline, by
alcohol, or by any mixture of the two. In December 2005, sales of
such units set a new record. ANFAVEA said December flex-fuel car
sales totaled 183,600 units, up 16 percent from November. Flex-fuel
car sales are growing fast and accounted for 70 percent of total
vehicle sales in December, compared to 29 percent in December 2004.
In 2005, sales of new flex-fuel vehicles totaled more than one
million units. Among Brazil's 10 largest assemblers, GM, Ford, VW,
Renault, Peugeot, and Fiat are the principal manufacturers of cars
using flex-fuel technology.

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BRAZIL'S TRADE SURPLUS EXCEEDED EXPECTATIONS IN 2005
-------------- --------------


23. In 2005, Brazil outperformed expectations by registering a
trade surplus of USD 44.8 billion. Projections at the beginning of
the year estimated a surplus of not more than USD 28.5 bllion.
Export sales in 2005 reached new highs toaling USD 118.3 billion,
up 22.6 percent from th previous year. Manufactured goods
propelled ovrall exports with an increase of 23 percent compare to
2004, followed by exports of primary and sem-manufactured products.
All three categories reistered historical highs. A breakdown
shows tha oil and by-products, transportation equipment and
material, mineral metals, metal products, and eletronic equipment
were the key export products reponsible for the 2005 export
performance.


24. On the other hand, imports totaled USD 73.5 billin in 2005, up
17.1 percent. All import categoris reported increases: capital
goods rose 26.9 percent, consumer goods were up 23.7 percent, fuel
and lubricants climbed 15.7 percent, and raw materials and
intermediate goods posted 12.6 percent growth. Import demand for
raw materials, intermediate goods, and capital goods were the main
items that increased total imports.


25. Preliminary data released by IBGE showed a trade surplus of USD
2.8 billion in January 2006. This result derived from exports worth
USD 9.3 billion and imports of USD 6.4 billion. According to the
Ministry of Industry and Foreign Trade, the January 2006 surplus is
30 percent higher than in January of the previous year. In the 12
months to January 2006, total exports rose 22.4 percent, reaching
USD 120 billion. Over the same period, imports climbed 17 percent
to USD 74.7 billion, resulting in a surplus of USD 45.4 billion.
While the Brazilian currency remains overvalued, Brazil's trade
balance sets new records each month. The markets are projecting a
trade surplus of USD 40.0 billion for 2006.

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BRAZIL'S FDI HIGHER THAN EXPECTED IN 2005
--------------


26. The Chief of the Brazilian Central Bank's Economic Studies
Department (DEPEC),Altamir Lopes, reported net FDI closed December
with inflows of USD 1.4 billion. For 2005 as a whole, FDI inflows
totaled USD 15.2 billion, down 16.4 percent versus inflows in 2004,
but nonetheless higher than the USD 10-12 billion projected. Brazil
placed eleventh in global FDI rankings. [Note: 2004 FDI figures
were inflated by Belgian brewer Interbrew's acquisition of Brazilian
brewery AMBEV for USD 4.9 billion. This acquisition alone accounted
for 27 percent of Brazil's 2004 FDI inflows of USD 17.7 billion.
End Note.] The Brazilian Central Bank kept to its December forecast
of USD 16 billion FDI in 2006. The U.S. was the principal origin of
FDI in 2005 with a contribution of 21.5 percent followed by Holland,
14.8 percent; Mexico, 7.7 percent; France, 6.7 percent; Canada, 6.6
percent; Germany, 6.4 percent; Spain, 5.6 percent; Cayman Islands,
5.0 percent; Australia, 4.0 percent; Japan, 3.6 percent; and others
18.1 percent. FDI inflow in 2005 was distributed in the following

SAO PAULO 00000258 008 OF 008


sectors and proportions: Services, 59.7 percent; Industry, 30.2
percent; and agriculture and mineral extraction, 10.1 percent.

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BRAZIL POSTS CURRENT ACCOUNT SURPLUS IN 2005
--------------


27. According to data released by the Brazilian Central Bank,
current account transactions registered a surplus of USD 570 million
in December compared to compared to 1.7 billion in November. In
2005 as a whole, current accounts closed with a cumulative positive
balance of USD 14.2 billion, the highest value ever registered and
the third straight year of surpluses. This was equivalent to 1.79
percent of GDP, as compared to USD 11.7 billion and 1.94 percent of
GDP in 2004. The big contributor to the 2005 surplus was trade in
goods. While the Brazilian Central Bank has projected a USD 6.1
billion current account surplus for 2006, the market consensus is
that the surplus will reach USD 9 billion.


28. This message was coordinated with Embassy Brasilia.

MCMULLEN