The Ever-Rising Real Part II: The Emergence of Dutch

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E.O. 12958: N/A
TAGS: EFIN ETRD BEXP ECON EINV PGOV BR
SUBJECT: The Ever-Rising Real Part II: The Emergence of Dutch
Disease?

REF: Brasilia 366


1. (U) This is the second of a two-part series on the
macro-economic consequences of the recent rise in the Brazilian
real. The first cable in the series, Brasilia 366, looked at the
GOB's macro and debt management policies. This cable, authored by
ConGen Sao Paulo, considers the effect of the strengthening real on
the business sector.


2. (U) Summary. As the real reaches its highest level in five
years (reftel),some economists believe the Brazilian economy may be
suffering from a form of "Dutch disease," a diagnosis stoutly denied
by government officials. Nonetheless, Development/Industry/Trade
Minister Furlan has warned that the current exchange rate threatens
exports and has called for adjustments. Export-dependent industries
are increasingly concerned about their future competitiveness if the
real continues to strengthen, and many are freezing or cutting back
investment. Even some import-competing industries, such as
textiles, are beginning to feel pressure. More ominously, some
agricultural giants are feeling the pressure and are moving major
production facilities to other countries. End Summary.

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DUTCH DISEASE: A DIRE DIAGNOSIS
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3. (U) Critics of Brazil's monetary policy have added a new concept
to their artillery: "Dutch disease." Originally given the moniker
"national resource curse," the term was coined by The Economist
magazine in 1977. Dutch disease refers to the deindustrialization
of a nation's economy owing to the discovery of a natural resource,
the export of which raises the value of that nation's currency,
thereby making manufactured goods less competitive with those of
other nations, increasing imports, and decreasing exports. The
phenomenon was first noticed in the Netherlands in the 1960s after
the discovery of North Sea gas. In recent weeks, several prominent
Brazilian economists, such as Professors Carlos Eduardo Goncalves
and Joaquim Eloi de Toledo of the University of Sao Paulo, and
Francisco Eduardo Pires de Souza, advisor to the Department of
Planning at the state-owned National Bank for Economic and Social
Development (BNDES),have argued that Brazil is suffering from Dutch
disease symptoms.


4. (SBU) Some analysts claim that Dutch disease has afflicted
Brazil because of the rise in the country's exports of minerals and
high-priced commodities like soybeans. In 2005, agribusiness
accounted for nearly 86 percent of Brazil's trade surplus, which
came in at a record USD 44.8 billion. Domestically, the effects of
the strengthened real are already reportedly affecting industries
that generate many jobs, even those that don't export (e.g.,
footwear and textiles) forcing factories to shut down in the face of
increasing competition from Asian countries, such as China. Recent
estimates claim the strong real forced nearly 1,000 companies,
principally small and medium-sized enterprises, out of the export
market last year. Officials at CIESP, a prominent Sao Paulo state
industry federation, note that while Brazil registered record
exports in 2005 - US$118 billion -- the country's export base was
quite narrow: 40 companies were responsible for 45% of exports
while 60 companies accounted for 65% of exports. Trade balance
figures released February 19 showed that imports grew more than
exports in the third week of February. The trade surplus (exports
minus imports) fell from US$ 881 million in the previous week to US$
579 million.


5. (SBU) Carlos Velloso, a prominent economist with links to the
opposition PSDB party, argued to Econoffs that Brazil is seeing
Dutch Disease-like effects due to burgeoning exports of high priced
commodities. These effects, he pointed out, extended to all
tradable goods sectors, including import-competing sectors such as
textiles. And while low-priced Chinese textile imports were a key
competitive threat for the Brazilian textile sector, he said, so was
the appreciated Real.

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GOB DENIALS
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6. (SBU) Brazilian government officials are quick to dismiss the
notion that the country has caught Dutch disease. In a recent press
interview, BNDES President Guido Mantega said, "Dutch disease does
not apply to Brazil, which faces no risk of deindustrialization, or
of returning to an agro-exporter past." Mantega, a former
Minister of Planning and one of the leading economists in the
governing Workers' Party (PT),noted that manufactured products
comprise a majority of Brazil's exports, and that "Brazilian
industry has never been stronger." Mantega further observed that
Brazil's share of the world market is growing and that the Brazilian
car industry exported 33 percent more vehicles in 2005 than in 2004.
Mantega pointed out that the automotive industry was the sector
that posted the highest level of growth in the past three years,
with increases in output, productivity and job creation. (Note:
Many of the low-priced vehicles manufactured in Brazil are exported
for sale to consumers in Mexico; in turn, Mexican producers
manufacture vehicles for sale in the more lucrative U.S. market.)


7. (U) Minister of Development, Industry and Foreign Trade Luiz
Fernando Furlan also argues that Dutch disease does not apply to
Brazil, pointing out that the country can boast of a wide variety of
export sectors, of which industrial products represent a large
share, with no single commodity or sector dominating. Nevertheless,
both Furlan and Mantega acknowledge that the continued rise in the
real is worrisome. With respect to the decline in the trade surplus
announced last month, Furlan publicly noted that this was the first
time in recent years the trade surplus had dropped in the month of
February in comparison with February of the previous year.


8. (SBU) Local economists are divided on the subject. Some have
"diagnosed" the disease and maintain that the country has already
suffered deindustrialization as a consequence. Others insist that
the difficulties faced by Brazil's industrial sector are the result
of overly high interest rates and taxes, combined with shortcomings
in infrastructure and technology. Although most interlocutors tell
EconOffs that the strong real is their main concern, all agree that
Brazil's unfavorable business climate would still be a hindrance
even if the real remained weak. Brazil's non-competitive business
climate is generally blamed for Brazil's failure to grow, while it
is the strong real that has been blamed for actual export shrinkage.



9. (U) Fernando Cardim de Carvalho, a professor at the Federal
University of Rio de Janeiro, believes that although the situation
differs from the experience of the Netherlands, Brazil is in fact
suffering the effects of currency overvaluation. In a recent
interview, Carvalho argued that the overvaluation of the national
currency is not an inevitable consequence of the surplus of dollars
brought about by exports of products for which world market prices
or export volumes have rapidly risen. He pointed out that Argentina
and China have also experienced major growth in export revenues, but
have maintained exchange rates favorable to exports, and low
interest rates, converting their trade surpluses into currency
reserves, unlike Brazil. Carvalho contended that the problem with
Brazil lies with high benchmark interest rates set by the Central
Bank, which make it too costly to expand reserves the way that China
and other countries with large trade surpluses have done. In
addition, he added, high interest rates have attracted speculative
capital (as opposed to Foreign Direct Investment),which has further
exacerbated the overvaluation of the real. Carvalho warned that
depending on agricultural or mineral exports is "bad business,
because world market prices for primary sector commodities are
highly unstable." Regardless of whether Brazil is facing Dutch
disease or not, economists and government officials agree that
export industries are suffering from the strong real.

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INDUSTRY FEELS THE PAIN
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10. (SBU) The business newspaper Valor Economico cites a poll

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conducted in the U.S. with 203 American companies operating in
Brazil, which shows an abrupt change in their plans to invest here.
According to the study, disappointment with poor GDP results in 2005
and the increasing valuation of the real vis-a-vis the dollar have
led U.S. companies to reduce investments in Brazil. Interlocutors
throughout the Sao Paulo consular district (which accounts for close
to 70 percent of Brazil's GDP) have consistently complained to
EconOffs that the strengthening real is hurting local industry and
that the effects of the weakened dollar will be evident in 2006
first quarter reports. While most complaints have involved
industrial sectors (auto, machinery, etc.),recent trends show that
the strong real is starting to affect Brazil's agricultural sector
as well. This is especially bad news, given that agro-business
accounted for 86 percent of Brazil's 2005 record trade surplus.
Although strong international prices for commodities buoyed
agro-exports during the real's 2005 rally (gaining almost 17
percent),it appears that large agro-business is finally feeling the
real's pinch. This is evident in the experiences of agro-business
companies Bunge and Archer Daniels Midland (ADM).

Agro Agony
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11. (U) American agro-giant Bunge, which processed 13 million tons
of soy in Brazil last year, announced in February that it will have
to close brand new factories that it just completed constructing in

2005. In December, it suspended processing at 7 of its 49
fertilizer plants, and shut down 2 of its 12 soy processing
factories. Meanwhile, Bunge just finished construction on a soy
plant with a capacity to process 19 million tons a year in
neighboring Argentina. Bunge states that it is transferring a
portion of its Brazil operations to Argentina for tax and
"competitiveness" reasons. Moreover, Bunge investment in Brazil
over the next four year will be cut by 70 percent. Bunge
representatives remarked, "the impact of the exchange rate has
become violent for our company. The only way to maintain viable
operations that would still be acceptable to our shareholders was
for us to reduce operations."


12. (SBU) But the damage is not confined to the closing of
factories. Bunge representatives warned of unfolding
deindustrialization in the Brazilian agro-sector. According to
Bunge, "tax difficulties, the exchange rate, and infrastructure and
logistic problems are leading soy producers to gradually reduce
operations." The Brazilian Association of Vegetable Oil Industries
warns that while Brazilian grain exports will grow 10 percent in
2006, exports of processed products (such as soy oil and meal) will
fall by four percent. Bunge claims that they already experienced
this four percent decrease in 2005. Bunge's export volume for 2005
was a mammoth USD 2.2 billion, but company executives note that this
high figure masks an underlying problem: high exports represent an
increase in prime material (grain) and a reduction in processed
goods (oil and meal). According to Bunge, "this dramatic reduction
in industry is not easily reversed. Brazil is turning into a
world-class provider of prime material, but it's losing industrial
capacity. This is not a trend that will simply reverse itself once
it's discovered."


13. (SBU) U.S. company Archer Daniels Midland Company (ADM),
another of Brazil's principal soy producer, is experiencing the same
problems as Bunge. ADM has reduced soy processing operations in
Brazil by 30 percent. Factories in the southern cities of Tres
Passos, Rio Grande do Sul and Paranagua (Parana state),with
capacities to process 1,000 tons of soy per day, will not return to
operations for the 2006-07 crop. ADM remarks, "the increasing cost
of the real has provoked a loss in international competitiveness.
This has forced us to refrain from investing and close down
factories." Although it was in the middle of its corporate
investment cycle, ADM has suspended further investment in Brazil,
though the company could return to invest again if the exchange rate
softened. ADM admitted, "with the current exchange rate, Brazil is
not the export platform it used to be."

Auto Anguish

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14. (SBU) The effects of the strong real are felt most acutely by
businesses that produce manufactured and semi-manufactured goods,
with strong dependence on low internal costs. Damiel Prates, a
researcher at the Center for Political Economy at the University of
Campinas, remarked, "the exchange rate is critical in the area of
manufactured goods. Brazil has just started to face the realities
of exchange rate politics. The figures already show that industrial
exports are falling by the wayside." The irony, according to Jose
Ricardo Roriz Coelho of the Federation of Industries of Sao Paulo
State (FIESP),"... is that the real's 2005 increase of 16.75
percent is an effective tax break on imports, while at the same time
an increased tax on exports." This export tax is being felt across
industrial sectors. For example, the American company Eaton, which
produces automotive power train components in Brazil, has felt the
pinch. With 30 percent of its revenue tied to exports, Eaton has
already received demands from clients: reduce costs or we'll seek
alternative suppliers. According to Eaton's Vice President for
Latin America, Carlos Alberto Briganti, "the automotive industry has
already asked for a 10 percent cut in costs. The strong real limits
new gains in productivity in the automotive supply chain, a sector
that has not dealt with inflation for a long time." Briganti notes
that Eaton's challenge isn't just maintaining contracts, but also
acquiring new contracts. "The real concern is the future," says
Briganti.

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Strong Real: Weak Growth?
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15. (SBU) Comment: The real concern is the future. This sentiment
is prevalent among our business interlocutors. Brazil experienced
less-than-mediocre GDP growth of 2.3 percent in 2005 (in the
hemisphere, only Haiti performed worse). While many estimates for
2006 range between 3.5 to 4 percent, achieving this could be
difficult as export industries feel the squeeze of the strong real.
And, while the Dutch Disease-diagnosis seems to us to be premature,
should these nascent deindustrialization trends consolidate, Brazil
could lose some of the ground it has gained in industrial exports
and see itself returning to its previous status as primarily an
export platform for raw materials and prime agricultural goods. The
Lula administration has resorted to targeted benefits for certain
export-oriented sectors in an attempt to ameliorate the effect of
the appreciated Real on export industries. Given current
expectations that the Real will appreciate further and remain strong
into the medium term, however, the GoB may find such simple
palliatives wanting. But, we have no expectation that broad-based
tax reform or other necessary microeconomic reforms, which could do
much to offset the effects of the exchange rate by reducing costs
for businesses and increasing their competitiveness, will be
addressed by the Congress at all during this presidential election
year. End Comment.


16. (U) This cable was coordinated with Embassy Brasilia.

McMullen