BRAZIL: FISCAL PACKAGE CLAIMS FIRST BUREAUCRATIC VICTIM

UNCLAS SECTION 01 OF 02 BRASILIA 000060 SIPDIS SENSITIVE SIPDIS STATE PASS USTR FOR CRONIN STATE PASS USAID FOR LAC TREASURY FOR OASIA - J.HOEK NSC FOR FEARS USDOC FOR 4332/ITA/MAC/WH/OLAC/jandersen/adriscoll/mwar d USDOC FOR 3134/ITA/USCS/OIO/WH/RD/SHUPKA E.O. 12958: N/A TAGS: ECON EFIN PGOV BR SUBJECT: BRAZIL: FISCAL PACKAGE CLAIMS FIRST BUREAUCRATIC VICTIM REF: A) 06 BRASILIA 2490 B) 06 BRASILIA 2562 ¶1. (SBU) Summary: The fiscal battle over President Lula's planned package of economic measures -- which the GoB is now referring to prosaically as a "package to accelerate growth" (PTAG) -- has claimed its first bureaucratic victim. Finance Ministry Treasury Secretary Carlos Kawall (under-secretary equivalent) resigned just SIPDIS prior to the New Year, after Lula overruled the finance ministry on the size of its proposed minimum wage increase and then postponed the package's planned December 21 announcement, asking his economic team to make it more "daring." Kawall, a fiscal hawk, claimed personal reasons for resigning. His resignation surprised market actors, but as the overall course of GoB fiscal policy for the near term is already set by the 2007 budget and the medium term budget directives framework law, the resignation did not appear to concern markets. This is because fiscal hawks such as Vice Minister Appy remain in place and Brazil's fiscal accounts can accommodate moderate loosening. But the incident reinforces the judgment that the GoB will not be pursuing an ambitious fiscal reform agenda in ¶2007. End Summary. ¶2. (SBU) The Finance Ministry had proposed a minimum-wage increase from the current Reais 350 (about USD 167) to Reais 367 (USD 174), but Lula reportedly insisted on Reais 380 (USD 180),a figure which was subsequently inserted in the 2007 budget by Congress. As the minimum social security pension level is constitutionally linked to the minimum wage, the increase also will affect the rapidly growing social security system deficit. The postponement of the announcement of the plan reportedly was driven by a divergence of views on how to offset the fiscal costs, under the terms of Brazil's fiscal responsibility law, of the minimum wage increase. To do so, Kawall and the Finance Ministry proposed to reduce the scope of targeted tax breaks originally included in the package (ref B),but Lula reportedly rejected that idea and asked for more "daring" approach from his economic team. ¶3. (SBU) Finance Minister Mantega has named Assistant Secretary Tarcisio Godoy to replace Kawall on an interim basis. Godoy, a respected technocrat, seems unlikely to remain in the job long, but will face the challenge of balancing the presidency's demands with the fiscal responsibility law. The presidency plans to announce the contents of the PAG on January 22. Meanwhile, both Lula and Mantega went on vacation, leaving their staffs to sort out the details. ¶4. (SBU) A former Finance Ministry Under-Secretary told Emboff January 9 that while he foresaw fiscal policy becoming less "stringent," it would by no means become populist. He pointed out that there were few downside risks for the GoB in this approach, given the current strength of external accounts, falling inflation and strong international liquidity. He stated that he fully expected the GoB to begin to put on the table in the first half of 2007 for public debate some of the potential components of a structural reform package. Even if these were not eventually adopted, he argued, it would be healthy for the process for these technical options to be discussed. The official acknowledged, however, that there was no indication that President Lula's key advisors were convinced that Brazil should seize the opportunity to cut through its rigid and distortionary fiscal system despite the political costs. ¶5. (U) Despite the GoB's apparent reluctance to hew to as tight a fiscal line as it did during Lula's first term, some factors augur well for the continuation of relative health. Former Central Bank Director Alexandre Scwhartsman, who now chief economist for Latin America at ABN Amro, recently publicized his own study on the evolution of the fiscal scenario. Schwartsman's study pointed up that the faster-than-anticipated fall in the real interest rates the GoB is paying on its debt has opened up additional fiscal space. Given the reduced financing costs, Schwartsman has calculated that the GoB is in a much better position to continue reducing its net-debt-to-GDP ratio, even if it runs lower primary surpluses. By his calculations, the GoB could maintain the current 50% debt-to-GDP ratio in 2007 by running a primary surplus of a mere 2.5%, well below the 4.25% target. The GoB is mooting the idea, as part of the BRASILIA 00000060 002 OF 002 PTAG, of using an adjustment mechanism that would deduct certain infrastructure investments from the primary surplus target. If fully implemented this would, de facto, reduce it's primary surplus target to 3.75% of GDP. The GoB, however, has included the adjustment mechanism in each of its last two budget but has not used it to run primary surpluses below the 4.25% of GDP target. ¶6. (SBU) Comment: Brazil's fiscal policy position is an orthodox one, with ongoing elevated primary surpluses being used to reduce debt levels. Its past positive performance has put it in a relatively comfortable position and the GoB can afford to loosen fiscal policy moderately without compromising its fundamental fiscal health. At issue in the current fiscal battle, however, is whether Brazil will seize the opportunity presented by a benign economic situation to take larger, more significant steps to put its fiscal house in order. That outcome appears ever more doubtful. SOBEL