WILL BRAZIL JOIN THE SOVEREIGN WEALTH FUND CLUB?

UNCLAS SECTION 01 OF 03 SAO PAULO 000053 SIPDIS SENSITIVE SIPDIS 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 USDOC ALSO FOR 3134/USFCS/OIO DOL FOR ILAB PEREZ-PKOPEZ AND WHOLEY E.O. 12958: N/A TAGS: ECON EFIN EINV BR SUBJECT: WILL BRAZIL JOIN THE SOVEREIGN WEALTH FUND CLUB? REF A: BRASILIA 0036 B: SAO PAULO 1005 C: SAO PAULO 0012 D: SAO PAULO 0768 SENSITIVE BUT UNCLASSIFIED - PLEASE PROTECT ACCCORDINGLY ¶1. (SBU) SUMMARY: In the closing months of 2007, Brazil's Finance Minister Guido Mantega proposed establishing a Sovereign Wealth Fund (SWF) as a vehicle to intervene in foreign exchange markets to curb the appreciation of Brazil's currency. Brazil's controversial plan differs substantially from other nations' funds and sparked a public battle between the Ministry of Finance and the Brazilian Central Bank over the government's commitment to maintain Brazil's floating exchange rate regime. Brazil's Central Bank is unlikely to hand over access to Brazil's sizeable foreign reserves and relinquish control over monetary policy. Furthermore, Brazil is a poor candidate for a SWF because the GOB is not flush with excess revenues from the commodity price boom and does not have a burgeoning fiscal surplus to fund a SWF. Sao Paulo-based financial analysts believe Minister Mantega's plan would amplify any economic crisis following an external shock instead of minimizing the risk. Most are skeptical that the GOB would create a SWF given the timing and global economic turmoil. END SUMMARY. Lack of Coordination and Planning -------------- ¶2. (U) Brazil's Finance Minister Guido Mantega first proposed last October the idea of establishing a Sovereign Wealth Fund (SWF) that would draw on Brazil's foreign reserves of USD 180 billion to fund infrastructure projects in Brazil. That idea sparked a public dispute between Minister Mantega and the Brazilian Central Bank President Henrique Meirelles, who argued that the fund would not be created until foreign reserves could cover Brazil's gross external debt of USD 200 billion. In December, Mantega announced an unorthodox scheme for a SWF in 2008 that would be a tool for the GOB to directly intervene in foreign exchange markets to counter the appreciation of the Brazilian currency. Since 1988, Brazil's Central Bank has exclusively controlled monetary policy (the Central Bank falls under the Ministry of Finance and is therefore not technically independent),and this development would be a significant departure from the GOB's recent economic policies. Although the details are limited, according to Mantega's publicly announced scheme, the SWF would, in theory, be used to invest in offshore assets of Brazilian companies including securities issued by the National Development Bank (BNDES) to boost public infrastructure investment. [Note: Brazil is currently under-executing its public infrastructure budget due to a lack of clear investment guidelines and mechanisms to pursue such activities as public private partnerships,as well as, the GOB's inability to identify good projects and make them viable. End Note.] ¶3. (SBU) In part, these uncertainties reflect a lack of discussion within and among Brazil's ministries and highlight the fact that a unified view among Brazil's key ministries does not exist. A senior adviser to the COPOM (Political Monetary Committee of the Central Bank of Brazil equivalent to the U.S. Board of Governors of the Federal Reserve Bank) told the Treasury Attache that a SWF "is an idea" but that the Ministry of Finance had not prepared a single internal policy paper on this issue (ref A). A senior member of the Central Bank's Department of Economics told Treasury officials that it knows nothing about Mantega's proposal other than what has been reported in the press. Likewise, the Ministry of Foreign Affairs told Treasury officials in December that it has no specific knowledge about a SWF and believes creating such a fund is ill-advised. In a recent meeting with Mission officials, former Finance Minister and GOB insider Antonio Palocci agreed that a SWF is ill-advised, and said that the plan is on hold in light of recent domestic and international economic turbulence. There's No Money SAO PAULO 00000053 002 OF 003 -------------- ¶4. (SBU) One immediate problem in establishing a SWF is that the GOB has not identified the source of funding. Although Brazil's foreign reserve assets are excessive by most measures of reserve adequacy, Central Bank President Meirelles has stated previously to the Treasury Attache that Brazil's large foreign reserve assets have been the single most important factor in preserving Brazil's stability amidst recent global financial market volatility. Given that view, it seems highly unlikely that Brazil's central bank would be willing to use reserves for this purpose. ¶5. (SBU) Brazil's fiscal framework also leaves no room in which to finance a SWF. Ten billion dollars, the initial injection in the Mantega scheme, represent approximately five percent of Brazil's non-interest expenditures. To finance this expenditure from the budget, the Ministry of Finance would be forced to raise revenues, reduce expenditures, or lower its primary surplus target. Given the USD 22 billion hole created by the failure to pass the CPMF (financial transactions tax) in December, Brazil's 2008 fiscal framework is already facing new pressures (ref B and C). Minister Mantega has publicly ruled out any adjustment in Brazil's 2008 primary surplus target which if changed could potentially undermine Brazil's march towards receiving an investment grade sovereign credit rating (ref D). Furthermore, expenditure reductions would be politically difficult in 2008 as municipal elections will be taking place throughout the country, setting the tone for national elections in 2010. Private Sector Opposition -------------- ¶6. (SBU) Brazil's private sector also has been largely opposed to Mantega's idea to create a SWF because Brazil does not fit the typical model country. Mauricio Oreng, from Itau Bank, explained to Econ Specialist that Brazil is not in the same position as nations which, due to their large foreign exchange reserves and fiscal and current account surpluses, have been able to establish SWFs to invest money that would otherwise remain unproductive in short-term instruments. Brazil's foreign debt exceeds its foreign exchange reserves and its current account surplus is approximately 0.7 percent of GDP, not nearly enough to sustain Brazil's economy in the event of a future crisis, he said. Furthermore, Oreng said Brazil is expected to post a current account deficit this year. Oreng opined that Mantega had likely not discussed the proposal with the Central Bank prior to his announcement, but said that the idea had thankfully fallen off the radar screen for now. ¶7. (SBU) ABN Amro noted Mantega's plan for a SWF might incite further appreciation of the Brazilian real by encouraging local companies to issue more securities via the new investment vehicle, in turn increasing the flow of dollars. As a result, in their view, the GOB would therefore undermine its chief goal of limiting the Brazilian currency's appreciation. Tomas Malaga, a senior economist at Itau Bank also noted that Mantega's plan to use the SWF to finance BNDES investments would intensify the impact of external shocks on the Brazilian economy by increasing exposure to Brazilian assets instead of diversifying away from them. He also highlighted a potential financing mismatch because the GOB would conceivably finance BNDES lending abroad through Brazilian banks at higher interest rates than the likely return on investments. Virgilio Castro Cunha, an economist at Merrill Lynch, concurred with Malaga's analysis and opined to Econoff that BNDES had encouraged Mantega's proposal as a way to increase BNDES budget allocations in a less transparent manner. ¶8. (U) Unlike countries that employ SWFs to control excessive government revenues from state-run enterprises, the GOB would need to issue debt to fund the SWF as Brazil's private sector is the primary driver of Brazilian exports. According to an ABN Amro analysis of SWFs, typically countries that established SWFs export a single commodity (oil, gas, minerals, etc.) that brings in SAO PAULO 00000053 003 OF 003 government revenue in the form of royalties, dividends, or taxes. For these countries, higher prices translate directly into improved fiscal performance. ABN Amro's case study showed that SWFs help mitigate the cyclical nature of these revenues as a savings tool for prudent fiscal management. Brazil doesn't have a single commodity that dominates exports nor excessive government revenues directly associated to export performance because Brazil has a diversified export base. Central Bank Opposition Likely -------------- ¶9. (SBU) The Brazilian Central Bank's decision-making body, the National Monetary Council (CMN),is likely to question the idea of a SWF and using reserves to create a wealth fund will require formal approval by the CMN. [Note: The Council includes the Central Bank, Finance Ministry, and Planning Ministry. End Note.] Furthermore, a senior Ministry of Finance official told the Treasury Attache on December 13 that the Finance Ministry was aware that the Central Bank was not enthusiastic about an SWF and might resist if the Ministry of Finance tried to push. Although Minister Mantega could likely persuade Planning Minister Paulo Bernardo to support his plan, Central Bank President Meirelles seems certain to oppose any efforts to spend its reserves. Any perception of political pressure on Meirelles and his board members in this effort would undermine the perceived independence and hard-earned credibility of Brazil's Central Bank. Finance Minister Mantega is thus likely to face strong internal opposition and negative market reaction if he moves too aggressively to create a SWF. Comment -------------- ¶10. (SBU) Support for the GOB's proposal for a Sovereign Wealth Fund is limited. Financial analysts from Sao Paulo's private sector clearly oppose the GOB's unorthodox idea and cite valid concerns about its possible implementation. The GOB also faces an uphill battle to get funding and approval from the Central Bank, suggesting that the GOB may be unable to develop and launch an official proposal over the near-term. For now at least, the GOB is focused on defending the Brazilian economy against the recent global economic turmoil and appears to have shelved the proposal. END COMMENT. WHITE