SOARING FOOD PRICES WOLDWIDE AND FOOD INFLATION IN BRAZIL

UNCLAS SECTION 01 OF 03 SAO PAULO 000227

STATE PASS USTR FOR KDUCKWORTH
STATE PASS EXIMBANK
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE
DEPT OF TREASURY FOR JHOEK
USDOC FOR 4332/ITA/MAC/WH/OLAC

SIPDIS
SENSITIVE

E.O. 12958: N/A
TAGS: ECON ELAB EIND EAGR ENRG KTDD EINV BR
SUBJECT: SOARING FOOD PRICES WOLDWIDE AND FOOD INFLATION IN BRAZIL


SENSITIVE BUT UNCLASSIFIED--PLEASE TREAT ACCORDINGLY

REF: Sao Paulo 207


1. (SBU) SUMMARY: Brazil has suffered less from skyrocketing world
food prices than other emerging markets. As a net global food
supplier, Brazil's agricultural exports earnings are climbing.
However, rising global inflation - particularly higher oil prices,
which affect both the cost of fertilizers and the costs of
transportation - has spilled over into domestic prices, driving up
inflation expectations, and forcing the Central Bank to raise
interest rates. This quick, anti-inflationary monetary policy and
the net benefits that rising food prices have on Brazil's balance of
payments mean that Brazil remains well-positioned to address
near-term food inflation pressures. In the medium term, Brazil does
face some risk from food inflation via a potential decrease in
long-term global demand for biofuels. To the extent that rising
food inflation affects global perceptions regarding biofuels,
Brazil's longer-term economic outlook could be affected given its
significant investments to develop and promote a global biofuels
industry. END SUMMARY.

RISING FOOD INFLATION IN BRAZIL; THE ECONOMIC RISKS
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2. (SBU) Rising food inflation poses four near-term economic risks
for Brazil: First and most immediately, it will intensify headline
inflation and pressures on central banks to tighten monetary
policies, especially those with inflation targets, such as Brazil.
A second risk is a potential decline in fiscal discipline as
governments expand subsidies or price controls in response to food
inflation. A third risk is balance of payments shocks for countries
that are net food importers. A final risk is an increase in trade
protection. Argentina, for example, has raised tariffs on food
exports, a measure that has resulted in protests by farmers that
could reduce local production and raise food prices there further.
Other countries have banned food exports, a move also likely to
restrict supplies and further pressure food prices. Brazil has
joined this group by stopping some rice exports in order to supply
the domestic market with this important staple.


3. (SBU) In the near-term, food inflation (which is significantly
tied to rising petroleum prices) has been a primary cause for higher
headline inflation. Over the past year, food prices have risen by
12 percent in Brazil compared with a three percent increase in
non-food prices and a 4.7 percent increase in the Consumer Price
Index (CPI). The price of soybeans showed the steepest increase,
(126 percent) followed by meat, (23 percent) and bread (13 percent).
Food inflation will remain much higher than non-food inflation for
the next year. In the past year, the CPI rose 1.25 percent, while
inflation expectations rose by more than 0.5 percentage point to 4.8
percent over the past six months. Concerned about rising inflation,
the Brazilian Central Bank (BCB) recently began a tightening cycle
and raised the benchmark Selic rate by 0.5 percentage points on
April 16 to 11.75 percent. Market forecasts for credit expansion
and investment growth this year have been reduced accordingly.
(Comment: S&P's move to upgrade Brazil to investment grade on April
30 may revise expectations of investment growth upward and will be
reported septel. End Comment.) According to Luiz Fernando
Figueiredo of Maua Investments, the investment community expects two
more interest rate hikes of 0.5 percentage points each between now
and July. There is little expectation that the current tightening
cycle will result in rates rising more than 1.5 to two percentage
points.


4. (SBU) While the medium-term impact from food inflation should be
limited, there remain some areas of concern. Biofuels have been
increasingly blamed for the rising scarcity of global food supplies
and the resulting rise in food prices. As a result, Brazil and the
U.S., the world's two largest ethanol producers, have been accused
of exacerbating food inflation and pushing up to 100 million people
closer to poverty, according to a World Bank estimate. A prolonged
cycle of food inflation and concerns about the rising social costs

SAO PAULO 00000227 002 OF 003


of biofuels could cause a permanent downward shift in some
countries' demand for biofuels, especially in Europe. However, the
vast majority of ethanol is used for domestic consumption and that
demand is growing rapidly (reftel). Further, the largest share of
ethanol exports go directly or indirectly to the United States,
where demand for ethanol is likely to increase and which does not
seem to be affected by the outcry over sustainability. Overall, the
impact on Brazilian exports should be small, but there remains the
potential for the food versus fuel debate to hurt Brazilian exports,
and undermine Brazilian economic and political investments in
internationalizing the sector.

BRAZIL SET TO WEATHER THE STORM?
--------------


5. (SBU) Compared to many other countries, Brazil appears
well-positioned to withstand near-term food price pressures. This
conclusion is based on the following factors: (1) Brazil's share of
food consumption in household budgets is lower than in many other
countries. Food represents 21 percent of average household
consumption in Brazil compared to higher shares in many other
countries (over 50 percent in much of Africa and 70 percent in the
world's poorest countries). This more limited role will help to
contain broader inflation spillovers and reduce Brazil's relative
need for monetary tightening. (2) The BCB is acting preemptively
against rising inflation. The decision last month to raise rates by
0.5 percentage points was double the expected hike, and was the
first of several hikes expected this year. Recent Central Bank
statements have been hawkish. While tighter policy will slow
near-term growth, it should decrease the risk that inflation could
spiral upwards as well as help stabilize monetary policy over the
medium-term. In contrast, central banks in many other countries
have reacted more slowly. Several governments have responded by
tightening price controls - a measure that will repress inflation in
the short-run but risks a price spike once controls are lifted. (3)
Brazil's fiscal policy is more firmly anchored than many other
countries. Although Brazil does not have an explicit fiscal target,
it maintains an informal primary surplus target of 3.8 percent of
GDP that is closely watched by markets. With GOB expenditures
equivalent to roughly 40 percent of GDP, Brazil has little fiscal
space in which to expand public spending. (4) Brazil is a net food
exporter and perhaps most importantly, Brazil's trade account
benefits directly from higher food prices through improved
terms-of-trade. Food represents one-third of Brazilian exports and
a large share of its overall trade surplus. Major food exports
include beef, chicken, soy, rice, sugar, orange juice, and coffee,
all goods whose prices have risen. Brazil's situation contrasts
with most other developing countries, 70 percent of which are net
food importers and whose external financing needs are increasing as
a result of rising food prices.


6. (SBU) Nonetheless, Brazil does face some near-term challenges.
For example, with 31 percent of Brazil's population below the
national poverty line and one-third of its population suffering from
"food insecurity", ever-present pressures exist to expand Brazil's
social safety net. Rising food prices could increase demands to
raise public wages - an issue on which President Lula's government
has a weak track record. Faster wage growth could likely be paid
for only through reductions in spending on the government's growth
acceleration plan (PAC),slowing Brazil's future growth potential.

COMMENT
--------------


7. (SBU) Brazil is well-positioned to cope with the near-term and
mid-term effects of rising food inflation. Monetary policy has
responded quickly to rising prices, fiscal policy is well-anchored,
and Brazil's current account balance benefits strongly from higher
food prices. There is a potential risk that food inflation may have
a significant negative spillover into long-term global demand for
Brazilian biofuels exports. To the extent food inflation harms
perceptions about the costs and benefits of biofuels, future demand
for biofuels exports could wind up being somewhat flatter than is
currently envisioned. While not catastrophic for Brazil, this

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development is likely to hinder Brazil's ethanol industry from
realizing the full growth, scale, and global stature to which Brazil
aspires. END COMMENT.


8. (U) This cable was written in conjunction with the Treasury
Attache and was coordinated and cleared by the Embassy in Brasilia.

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