BRAZIL: LULA'S SECOND TERM ECONOMIC GROWTH PACKAGE

C O N F I D E N T I A L SECTION 01 OF 04 BRASILIA 000149

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TREASURY FOR OASIA - DAS LEE, J.HOEK
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
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E.O. 12958: DECL:01/15/17
TAGS: ECON EFIN PGOV ETRD PREL EINV BR
SUBJECT: BRAZIL: LULA'S SECOND TERM ECONOMIC GROWTH PACKAGE
UNDERWHELMING

REF: A) 06 BRASILIA 2490
B) BRASILIA 0060
C) BRASILIA 0140

Classified by Economic Counselor Bruce Williamson, reasons 1.4
(b) and (d).


1. (SBU) Summary: The GoB announced on January 22 a series of
measures, the Program to Accelerate Growth (PAC),meant to
enliven Brazil's current lackadaisical economic growth rates.
The measures, a combination of targeted tax breaks and new
public spending, along with the recycling of a few existing
initiatives, primarily are aimed at boosting investments in
infrastructure and construction. A few additional pieces of
legislation would streamline bureaucracy, particularly in the
area of environmental permits for large projects, and improve
the investment climate. The GoB has spun the PAC as potentially
pumping Reais 500 billion (USD 235 billion) into the economy
over the next four years, but the figures are notional and
depend to a great extent on the implementation of over 21
individual initiatives requiring congressional approval, as well
as investment decisions by private actors. Overall, the package
reflects the Lula Administration's preference for use of the
state -- as opposed to the private sector -- as the engine for
increased economic growth. Analysts have welcomed the steps as
useful, but note they are only a modest attempt at addressing
the fundamental structural distortions that dampen the potential
growth of the Brazilian economy (refs A and B). The two most
urgent issues, tax/fiscal reform and reform of the social
security system, were not addressed by the PAC, although
President Lula stated that these issues as well would be dealt
with separately (in an unspecified time frame). Ref C reviews
the PAC's political prospects and impact. End Summary.


2. (SBU) The GoB announced on January 22 its long-awaited
economic package for Lula's second term. The unveiling was
delayed for close to a month after Lula's dissatisfaction with
the lack of "daring" in the Finance Ministry's initial
proposals. The bureaucratic infighting over the package led to
resignation of the Finance Ministry Treasury Secretary, Carlos
Kawall, whose more fiscally conservative stance Lula ultimately
overruled, notably in increasing the minimum wage to Reais 380
(USD 180) per month. In the end, the GoB put forward a group of
twenty-one pieces of legislation -- five of which already had
been submitted to Congress in years past and have yet to be
approved -- with the primary purpose of increasing investment in
infrastructure and construction. The five bills already under
Congressional consideration, most of which were aimed at
improving the investment environment, are: 1) the regulatory
agencies law; 2) a law to regulate the natural gas market; 3) a
law to strengthen the competition policy framework; 4)
legislation to improve social security management and reduce
fraud; and, 5) a bill to unify the social security and federal
government tax collections systems ("super-receita"). Seven
provisional measures (MPs) were issued to enact a series of
targeted tax breaks. (Note: MPs are presidential decrees that
take immediate effect but must nevertheless receive
congressional ratification within a certain period of time to
become permanent law.) A further three MPs dealt with the
minimum wage increase and created rules to try to limit the
growth of the government's wage bill and create a more
predictable system for granting future minimum wage increases.

Targeted Tax Breaks, New Spending
--------------


3. (U) The PAC contained seven MPs that implemented a series of
tax breaks and spending measures to try to boost infrastructure

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investment, both private and public, and boost the construction
industry. One MP shortens, from 25 years to 24 months, the
period over which new construction projects can claim already
existing PIS and COFINS tax credits, injecting an estimated
Reais 1.15 billion (USD 540 million) into the construction
sector. Another MP exempts from federal income tax investment
earnings from new private sector infrastructure investment
funds. A related measure creates PIS and COFINS tax exemptions
on the sales of materials and services used in new
infrastructure projects such as ports, sanitation, and power
generation and distribution. A law to create a more streamlined
and coordinated system of granting environmental licenses for
major infrastructure projects, thus addressing a major business
complaint, complements the infrastructure-related tax breaks.


4. (U) New spending on construction and infrastructure also is
on tap under the PAC. One MP calls for a Reais 5.2 billion
hybrid loan/capitalization instrument from the GoB to the
para-statal bank Caixa Economic Federal (CEF). The loan draws
on GoB assets on deposit at the Central Bank, and thus does not
impact the primary fiscal surplus. The CEF will on-lend the
money for low income housing and sanitation projects. Another
MP, aimed at increasing resources for low-income housing
projects, will allow the PAR, a national program which built and
leased low-income housing, to sell the homes to their occupants
should they desire. This would create additional liquidity for
the PAR fund and allow additional low income housing
construction.


5. (U) The most controversial measure in the PAC is the creation
of a new governmental infrastructure investment fund financed
from the profits and "net capital" of the unemployment insurance
fund (FGTS). The FGTS, which is funded by payroll taxes, by law
is the primary source of funding for the Economic and Social
Development Bank (BNDES). BNDES profits are returned to the
fund and build up its capitalization. Labor groups already have
challenged the constitutionality of the PAC's plan to use Reais
5 billion (USD 2.4 billion) from FGTS to finance the new
government infrastructure fund (ref C).

Fiscal Unease
--------------


6. (SBU) CSFB economist Nilto Calixto pointed out to Emboff in
January 25 conversation that the PAC made it clear that the GoB
would reduce its primary surplus in the future. This could
theoretically begin to happen in 2007, as the GoB more than
doubled the size of the Pilot Investment Project (PPI) (from
Reais 4.3 billion to Reais 11.3 billion -- about USD 5.4
billion, or 0.5% of GDP). Under the GoB's budget rules, federal
investments through the PPI (which require a vetting process to
ensure they have positive economic returns) are not counted
against the primary surplus target, so full implementation of
the PPI would imply a reduction in the primary surplus target
from 4.25% of GDP to 3.75% of GDP. Calixto cautioned, however,
that the GoB's dismal record of budget execution -- including
under the PPI in 2005 and 2006 -- meant that it was unrealistic
to expect that the PPI would be fully executed.


7. (SBU) The CSFB economist predicted the GoB would actually run
a primary surplus of close to 4.25% of GDP in 2007, as the
machinery of public spending would take some time to adjust. To
illustrate the point, Calixto noted that the GoB posted a
primary surplus of about 4.4% of GDP in 2006, despite a
concerted effort to increase public investments in the run up to
the elections. The only category of spending where the GoB had
over-performed was on salaries and benefits, as the GoB
increased the minimum wage substantially and gave civil servants

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significant wage increases. After 2007, however, Calixto
expected the primary surplus would begin to fall below the
current 4.25% of GDP target.


8. (SBU) Calixto noted that, given falling interest rates, which
have significantly reduced the GoB interest bill, there is room
for the GoB to continue reducing the debt-to-GDP ratio even as
it runs smaller primary surpluses. By his calculation, the GoB
need only run a primary surplus of 2% of GDP in 2007 to keep the
debt-to-GDP ratio roughly stable at the current 50% of GDP.
Looser fiscal policy, therefore, need not signal fiscal
irresponsibility. The fundamental question is how quickly
Brazil reduces its stock of debt and borrowing requirement,
which still soaks up significant amounts of private capital, in
order to increase the space for private investment. Through the
PAC, the GoB is signaling it intends to use the fiscal space to
finance higher public spending, not facilitate greater private
investment. Calixto's study, however, had concluded that the
benefits of a quicker reduction in debt, which would open the
doors to greater (and more efficient) private investment,
exceeded the benefits of higher public spending, even were the
public spending directed entirely to infrastructure investment.


9. (SBU) While key items to extent both constitutional budget
de-earmarking provisions and a financial transactions tax (CPMF)
were not included in the PAC -- but likely will be contained in
separate legislation -- it does incorporate a few measures meant
to assuage doubts about the GoB's commitment to fiscal
responsibility raised by other parts of the plan. In order to
contain the growth of public spending on salaries and benefits,
including social security benefits, which constitutionally are
linked to the minimum wage, the PAC creates rules for future
adjustments in public sector salaries and the minimum wage. One
MP links annual salary increases to inflation plus a real
adjustment of 1.5% per year. If implemented, this would likely
reduce the proportion of public spending going to salaries. A
second MP links future minimum wage increases to inflation in
the previous year plus the rate of real GDP growth in the year
before that (i.e. t-2). CSFB's Calixto and prominent fiscal
expert Raul Velloso both questioned the effectiveness of the
spending rules, however, arguing that over time such rules tend
to become floors for future increases, instead of ceilings.
Another bill, already in Congress, would tighten management of
the social security system and try to reduce fraud. A final
measure, not yet submitted to Congress, would implement a
constitutional amendment passed in 2003 to reduce the generosity
of the public sector employees' pension benefits.

Topping up the "MP do Bem" benefits for Electronics
-------------- --------------


10. (U) Two MPs will create additional tax breaks meant to
stimulate research and development for digital television
products by granting tax exemptions (PIS, IPI, COFINS and CIDE)
on the sales of digital transmission equipment and investment in
capital goods and transfers of technology for the development of
this equipment under a program called PATVD. A program labeled
PADIS will create similar tax incentives for semiconductor
investments.

Former Presidential Candidate Alckmin: Not Far Enough
-------------- --------------


11. (SBU) Echoing comments that Sao Paulo state Governor Serra
made to the press January 25, Geraldo Alckmin, unsuccessful
candidate of the Brazilian Social Democracy Party (PSDB) for
president last year, told CG Sao Paulo Poloff on January 23 that
the PAC is a positive measure and it will help stimulate growth,

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but it doesn't go far enough. It will not reduce the tax
burden, which is the major factor driving the informal economy,
he said. There are simply too many obstacles to economic
growth, such as high interest rates, Alckmin said. He explained
that if the government reduces the primary surplus, as it will
have to increase spending to stimulate growth, this will make
the task of lowering interest rates both harder and longer. For
the past few years, structural reform, which is needed to
attract investment and stimulate growth, has been stopped, he
said. (Note: Alckmin gave us the familiar litany of needed
reforms: political reform, tax reform, social security reform
and labor reform, all of which he had proposed to do if elected
president. End note.) The PAC will bring growth to some
sectors of the economy, but won't affect the macro elements:
budget, interest rates, and the exchange rate. He opined that
when Lula came into office, the Workers Party (PT),provided
good continuity in macroeconomic policy but got the dosage
wrong: the high interest rates were appropriate to the FHC era
because he faced so many international economic crises and slow
world growth, but the past few years have been a good period for
the international economy, and Lula didn't make the appropriate
adjustments to reflect that, Alckmin concluded.


12. (C) Comment: A more "daring" economic program, to borrow
Lula's term, would have addressed the central economic
distortions in the Brazilian economy, the solutions to which
begin with reforming the soon-to-be bankrupt social security
system, the burdensome tax system and the rigid fiscal
framework. While there are measures of incremental merit in the
PAC, the program that Lula meant to be the economic foundation
of his second term in office seems to be mostly beside the
point.

SOBEL