BRAZILIAN SOVEREIGN WEALTH FUND BACK IN PLAY

UNCLAS SECTION 01 OF 03 SAO PAULO 000264

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: BRAZILIAN SOVEREIGN WEALTH FUND BACK IN PLAY


SENSITIVE BUT UNCLASSIFIED--PLEASE TREAT ACCORDINGLY

REF: A. Sao Paulo 0053; B. Sao Paulo 0247; C. 07 Sao Paulo 0953; D.
Rio de Janeiro 091


1. (SBU) Summary: The May 13th announcement by Brazil's Finance
Minister seeking to establish a sovereign wealth fund (SWF) for
Brazil has been met with criticism from the financial community and
concerns by the Central Bank. On the heels of this outpouring of
negative press, President Lula asked Finance Minister Mantega to
clarify the proposal before he decides whether to approve and submit
the bill to Congress. Brazil's nebulous proposal for its SWF would
not fit the traditional pattern of protecting against commodity
price swings, but instead serve as a mechanism to sop up excess
foreign currency in the domestic economy. In addition to
potentially reducing the operational autonomy of the Central Bank in
managing monetary policy, the Brazilian economy does not currently
possess the optimal economic fundamentals that make a fund of this
type appropriate. The drive to create this fund as well as the
announced new industrial policy (septel) show a government
increasingly interested in taking an active role in the Brazilian
economy. A strong and largely autonomous Central Bank was key to
Brazil recently obtaining the coveted investment grade rating, and
anything that undermines that institution and increases uncertainty
could have negative repercussions for the entire economy. End
Summary.


2. (SBU) Despite enormous criticism and some incompatibility of
Brazil's current economic conditions with a Sovereign Wealth Fund
(SWF),Brazil's Finance Minister Guido Mantega formally announced a
Brazilian SWF on May 13 after months of behind the scenes
maneuvering. Following the announcement, President Lula delayed
submission to Congress, asking Mantega to clarify his proposal's
objectives. He also indicated that now may not be the right time to
move forward on this proposal. As with the initial plan from
February (Ref A),Brazil's controversial SWF proposal differs
substantially from other nations' funds. Central Bank President
Henrique Meirelles is known to have expressed concerns about a SWF
and has publicly and frequently criticized the idea. One Central
Bank concern was Brazil's foreign reserves, which has now been
addressed as those reserves have now surpassed Brazil's gross
external debt. Although the GOB has not announced the initial size
of the SWF, Mantega suggested it would be between USD 15 and 20
billion. Mantega noted two financing sources, the excess tax
receipts above the 3.8 percent primary surplus target and by issuing
new debt. (Note: In the first quarter, Brazil's primary surplus was
4.5 percent. End Note.) Mantega confirmed that Brazil's foreign
reserves of USD 195 billion would not be touched.


3. (SBU) The GOB would need a majority in both houses of Congress
if this proposal is introduced as a bill. It is more likely to be
introduced as a provisional measure (similar to a presidential
decree),which requires a vote within 120 days or the bill dies.
Special Advisor at the Central Bank Alexandre Pundek informed
Econoff that under Mantega's proposal for the Treasury to manage the
SWF, the GOB would have to change Law 4595 which established
monetary policy under the Central Bank's control. He opined that
any effort to modify that law would likely face international
backlash and as well as congressional opposition. Itau Bank Vice
President Mauricio Oreng told Econoff that he does not think that
Congress would approve the bill and believes opposition congressmen
would question the contradictory role a SWF would play with that of
the Central Bank.

Criticism Widespread
--------------


4. (SBU) Brazil remains a poor candidate for a SWF despite improved
conditions since the GOB first suggested a SWF last October. In
particular, two conditions often considered important for an SWF do
not exist in Brazil: (1) a high level of national saving (Brazil's
national saving rate is only 16 to 17 percent of GDP),and (2) a
current account surplus (Brazil's current account is currently in
deficit and is projected to decline). On the other hand, tax
revenues have reached record levels, Brazil became a net creditor in
February (meaning its foreign reserves are greater than its external

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obligations),and Brazilian debt became investment grade (Ref B) in
April. Pundek told Econoff that Brazil does not have an inflow of
revenues from a state-owned company that exports a major commodity.
He noted that Brazil does not have a current account surplus and
although Petrobras has made two significant oil discoveries (Refs C
and D),the GOB would not see significant revenue flows until the
two fields come online potentially as late as 2015. Pundek noted as
well that Brazil still runs an overall fiscal deficit close to two
percent of GDP and would have to increase its already burdensome
debt profile to fund the SWF at a rate of approximately 12 percent.



5. (SBU) Critics have opposed both of the SWF's official
objectives, which include building up domestic savings to stimulate
economic growth in downturns and funding Brazilian companies abroad.
The National Treasury would manage the SWF's investments in
Brazilian exporters via overseas investments in private debt and
equity. Critics argue that providing financing for the export
sector does not help address Brazil's major export barriers: high
and complex taxes, poor infrastructure, and onerous labor laws.
Likewise, economist Daniel Weeks at Bradesco Bank noted to Econoff
that the Brazilian Development Bank (BNDES) would likely finance
large multinationals that do not need the money. Indeed, CEO Forum
member Jorge Gerdau commented to Commercial Offs that his company
had invested USD eight billion in the U.S. and did not need GOB
funding for exports. Oreng agreed that rather than funding a
vibrant private sector, the GOB should instead be investing in
domestic infrastructure projects that would make Brazil more
competitive. Weeks said the GOB's lack of concrete targets for its
so-called countercyclical policy would leave the SWF available as
another vehicle to hide government spending rather than using excess
revenues to accelerate Brazil's payment of public sector debt.


6. (SBU) Critics condemned the two sources of funding for the SWF
as well. Marcelo Solomon, Chief of Economic Research at Unibanco
told Econoff that the lack of commitment to a higher primary surplus
means the total contribution to the SWF remains uncertain.
Furthermore, without a clear target or a credible signal from the
GOB, he said it would be difficult to estimate the National Treasury
intervention in the spot market. Solomon pointed out that the
absence of a target also implies greater uncertainty in the role
tighter fiscal policy could play on future monetary policy. Weeks
told Econoff that the second funding source was also problematic
because the National Treasury would take some monetary policy
control away from the Central Bank. He said the resulting confusion
between the National Treasury and Central Bank, combined with the
new role for BNDES to finance exporters, are very bad signs.
Finally, a Credit Suisse economist told Econoff that investing
abroad would carry a cost similar to holding foreign reserves; the
SWF assets would potentially earn a lower return than the borrowing
costs.

Politics Perhaps?
--------------


7. (SBU) Brazilian domestic politics helps explain why the GOB
ultimately decided to create a SWF. The GOB can use the SWF to
expand its direct role within the financial system, specifically via
BNDES' purchase of private debt and equity. Mantega can also take
credit for this high profile policy initiative to help overshadow
his reputation as an ineffective and weak Finance Minster within the
international finance community. Finally, Mantega noted that the
SWF is a source of international prestige and helps put Brazil on
par with other countries with SWFs such as China, Russia, and Saudi
Arabia. Indeed, Solomon told Econoff that SWFs have become a status
symbol for emerging market economies to manage their own wealth, but
that a fund of USD 20 billion would be insignificant compared to
others.

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


8. (SBU) The GOB's driving impulse behind the SWF appears to be a
desire among some elements in the GOB to extend and expand the role
of the government in the economy. The GOB would essentially assume
the role of a private bank, determining the conditions for giving

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loans and making financial decisions perhaps best left up to the
market. Many in the financial community see this as harking back to
the 1980s, considered by many the "lost" decade for the Brazilian
economy. What they see as the SWF's worst feature is BNDES' new
role in picking winners and losers in its financing to Brazilian
exporters. Together with the GOB's new industrial policy announced
May 12 that increases the public sector's role in the
economy(septel),the GOB appears to be continuing its internal
struggle between those who support a more open approach and those
whose instincts run toward the statist model. These moves, together
with the recent increased role for state enterprises, suggest that
some key Brazilian policy makers may at heart be strong
interventionists. Ultimately, the SWF would take time to get
through Congress given the backlog in provisional measures, the July
holidays, and the upcoming municipal elections. Given President
Lula's public contradiction of Mantega's statements (a not-uncommon
occurrence),it remains unclear whether or when this proposal would
move forward as the battle between the Central Bank and the Finance
Ministry continues behind the scenes. Strangely, with the unspoken
goal of curbing the appreciation of the currency, the SWF could
instead have the contradictory effect of increasing foreign currency
export earnings and putting more upward pressure on the Brazilian
currency. If this fund does at some point make it through Congress
and is ultimately used as a tool in setting monetary policy, there
could be a significant negative impact to Brazil's economy as
investors may become concerned about an increasing role of
government in the private sector and the lack of autonomy of the
Central Bank. End Comment.


9. (U) This cable has input from, was coordinated with, and cleared
by Embassy Brasilia and coordinated with the US Treasury Financial
Attache in Sao Paulo.

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