BRAZIL MOSTLY INSULATED FROM U.S. SLOWDOWN

UNCLAS SECTION 01 OF 03 SAO PAULO 000236

SIPDIS
SENSITIVE

STATE PASS USTR FOR KDUCKWORTH
STATE PASS EXIMBANK
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE
DEPT OF TREASURY FOR JHOEK, BONEILL

E.O. 12958: N/A
TAGS: ECON EFIN EINV ETRD BR
SUBJECT: BRAZIL MOSTLY INSULATED FROM U.S. SLOWDOWN


SENSITIVE BUT UNCLASSIFIED--PLEAE TREAT ACCORDINGLY

REF: A. 07 Sao Paulo 086

B. Sao Paulo 227

C. Sao Paulo 130


1. (SBU) ummary: Brazil is more insulated from any U.S. drien
worldwide economic slowdown than other emergin market countries.
Its domestic economy fuels ecnomic growth, Brazilian banks have
plenty of captal to lend, and Brazil is increasingly integrated
into world markets. Similarly, the Brazilian stck exchange
outperformed its emerging market peers, nearly doubling the gains of
the next best emeging market performer. At a time when
international markets are more risk averse, Brazil received the
coveted investment grade foreign currency sovereign credit rating
from Standard and Poor's. However, Brazil is not immune. There are
some signs that access to international credit lines is more limited
than before, and the impact of a U.S. slowdown on other countries,
particularly on China, may have a measurable impact on Brazil. End
Summary.

Lots of Padding
--------------


2. (SBU) Brazil's financial system is strong and has demonstrated a
resiliency to the U.S. economic downturn that would not have been
possible ten years ago. The Brazilian banking system is extremely
well-capitalized. Indeed, Itau Securities CEO Roberto Nishikawa
told Econoff that Brazilian banks have enough capital to avoid a
similar credit crisis even with domestic credit expansion to a
record level on the order of 40 percent of GDP this year. (Note:
Henrique Meirelles, President of the Central Bank stated to Econoff
on April 11 that he expected the credit growth to decrease from over
20 percent per year to approximately 10 to 15 percent growth in

2008. End Note.) Brazil's public sector has nearly retired its
dollar-denominated debt, which was a source of trouble in earlier
financial crises. Brazil in February became a net creditor,
indicating that Brazil now holds more in reserves than it owes.


3. (SBU) Brazil's two stock exchanges, the Bovespa and the
Commodities and Futures Exchange, merged to form the world's third
largest stock exchange (ref A). The Bovespa outperformed its 15
emerging market peers between August 2007, when the U.S. sub-prime
crisis first unraveled, and April of this year. (Note: The
Brazilian index Ibovespa gained 19 percent, beating out Russia which
had 11 percent, and India and Mexico with six percent. The primary
Chinese index has dropped 26 percent since August. End Note.)


4. (U) Brazil is now increasingly integrated into world markets,
exporting a diverse range of products to hundreds of countries
worldwide. For example, the GOB's export destinations by region in
2007 showed a balanced distribution between the four principal
regions: the European Union (25 percent),Latin America and the
Caribbean (22 percent),the U.S. (15 percent),and Asia (15
percent). Similarly, Brazilian exports span consumer goods,
manufactured products, and agricultural products, and no one
commodity dominates exports. Among Brazil's exports are several
commodities including sugar, soy products, coffee, meats, and metals
that have seen record prices in recent years. According to Sergio
Werlang, Director of Credit at Banco Itau, commodity
producer-countries are less vulnerable to an economic downturn as
long as demand for commodities stays strong. Brazil will be less
affected by the U.S. downturn because it should continue to prosper
from high commodity prices.


5. (SBU) Even with soaring commodity prices, domestic demand drives
the Brazilian economy, growing by 6.85 percentage points in 2007.
By contrast, the external sector negatively contributed to GDP
growth and drove overall GDP growth down to 5.4 percent last year.
Director of Economic Research at Bradesco Bank, Octavio de Barros,
told Econoffs that Bradesco expected about five percent GDP growth
this year regardless of international conditions due to Brazil's
strong domestic demand. He identified credit expansion (27 percent
last year),real wage growth (two percent from March 2007 to March
2008),and the predictability of a stable economy when making
investment decisions as keys driving this growth.

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On the Margins?
--------------


6. (SBU) For the most part, the Brazilian financial system does not
depend on external financing. Barros told Econoff that for
approximately 70 percent of private investments last year, companies
used their own resources, while 11 percent used domestic commercial
banks and only two percent relied on external financing for their
investments. Despite Brazil's independence, however, there are a
few areas on the margins where less international credit
availability, primarily from U.S. banks, may affect investments in
Brazil. Carlos Bentancourt, CEO of Bracor Investments, told Econoff
that the Bear Stearns collapse immediately hit the Brazilian credit
market as banks cut international lines of credit. Betancourt
noted, however, that he had not seen any change in Brazil's
fundamentals that would merit a credit crunch. He pointed instead
to contagion caused by the banks, likely to result in decreasing
leverage and a move towards less risky debt. Press reports have
also listed tightened international credit lines among the factors
for the failures of a few large projects.

Inflation Bigger Concern
--------------


7. (U) Brazilian officials are more concerned about food price
inflation than a global economic slowdown (ref B). Despite single
digit inflation numbers over the last five years, the Central Bank
took a forceful stand in April by raising interest rates by 0.5
percentage points amid fears that inflation would surpass the target
of 4.5 percent. 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.

Investment on Track
--------------


8. (U) Despite the adjustment in monetary policy and a real
interest rate of 7.1 percent (among the highest in the world),
Barros told Econoff that Bradesco thinks interest rate hikes
probably will not significantly alter the private sector's
investment decisions. Barros highlighted Bradesco's proprietary
survey that queries 1,600 Brazilian companies whether interest rate
hikes would affect their investment decisions. Approximately 60
percent of companies said that a one percent increase over the
course of the year would not affect their investment decisions, and
only 17 percent said it would moderately or heavily affect their
decisions. With a two percent hike, 50 percent said it would not
affect their decision and 27 percent said that it would. By
comparison, the survey showed that 67 percent of respondents said
that the global market turbulence and an eventual U.S. recession
would not affect their investments over the next six months, and
only five percent said it would have a marked impact on their
middle-term horizon.


9. (U) On April 30, Standard and Poor's upgraded Brazil's sovereign
credit rating to investment grade (septel). The upgrade opens the
doors for further investment in Brazil, especially to funds limited
to investment grade assets, and is likely to mitigate any investment
slowdown because of interest rate hikes. Foreign direct investment
(FDI) in Brazil last year was USD 34.6 billion and is at record
levels already this year. According to the UN, Brazil ranks fifth
among the most attractive countries for FDI, behind only China,
India, the U.S., and Russia.

The China Factor
--------------


10. (U) While trade with the U.S. is declining, Brazilian trade
flows with emerging markets are up from 35 percent of exports 20
years ago to 55 percent today, according to Octavio de Barros.
Brazil's second largest trading partner, China, is a primary driver
of this trend toward emerging markets. Brazilian exports to China
last year were up 28 percent from 2006 and imports from China were

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up were up 57 percent (ref C). Barros stated that Brazil's main
risk of a global economic slowdown would be a secondary slowdown in
China. Barros underscored, however, that Bradesco does not expect
any deceleration because they believe domestic demand will continue
to drive the Chinese economy. Barros pointed to several large
infrastructure projects the Chinese government has planned,
including building mass transit in all cities over one million
people, which should drive demand especially for Brazilian
commodities such as iron ore. Sergio Werlang told Econoff that Itau
believes China is the key to determining whether there will be any
measurable impact in Brazil from the U.S. downturn. He stated that
the Chinese economy is larger every day and that Chinese growth is
responsible for maintaining commodity prices. For these reasons,
financial analysts in Sao Paulo have not ratcheted down their GDP
growth forecasts for 2008. Merrill Lynch's forecast, for example,
showed growth only slightly down from 4.6 percent to 4.5 percent
after the April interest rate hike.

Comment
--------------


11. (SBU) Brazil's performance amid worldwide fears of a U.S.
slowdown has been robust. Indeed, Standard and Poor's awarded
Brazil with an investment grade sovereign credit rating for its good
behavior. However, despite its resilience against a slowdown,
Brazil is not invulnerable. Brazil's bigger challenge will be
achieving higher potential GDP growth above five percent and keeping
inflation at bay. End Comment.


12. (U) This cable has been cleared by Embassy Brasilia and
coordinated with the US Treasury Financial Attache in Sao Paulo.

WHITE