This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 08 BRASILIA 000450 
 
SIPDIS 
 
NSC FOR SHANNON, DEMPSEY, CRUZ 
TREASURY FOR OASIA/SEGAL 
EXIMBANK FOR DIRECTOR FOLEY 
FED BOARD OF GOVERNORS FOR ROBATAILLE 
USDA FOR U/S PENN, FAS/FAA/TERPSTRA 
USDOC FOR 4322/ITA/IEP/WH/OLAC-SC 
SOUTHCOM FOR POLAD 
 
SENSITIVE 
 
E.O. 12958: N/A 
TAGS: EFIN ECON EINV ETRD PREL PGOV SOCI BR
SUBJECT: BRAZIL'S PUBLIC-DEBT VULNERABILITY LESSENS, FOR NOW 
 
REF: (A) 03 BRASILIA 3682, (B) 03 BRASILIA 3911 
 
SUMMARY 
------- 
 
¶1.    (U) Brazil's nominal net public debt and debt/GDP 
ratio both continued to rise in 2003, but there are grounds 
for guarded hope that the debt burden is not now the 
imminent threat it has been in recent years.  The debt/GDP 
ratio (58.2% end-December) is far down from its brief late- 
2002 spike of 64% and is forecast to decline year-on-year in 
2004 -- a first since 1993.  The GoB has worked well to 
reduce the debt's exchange-rate vulnerability:  foreign 
public debt grew fractionally in 2003, but the dollar-linked 
component of domestic debt was steeply down, to 10% of the 
total (20.5%, including swap exposure) from end-2002's 20.3% 
(53.5%, including swap exposure).  The Real's appreciation 
since late 2002 from almost four to under three per USD has 
in itself greatly eased service of the debt's foreign- 
currency component.  And Brazil's soaring exports have added 
a new shock-absorber against sudden depreciation of the Real 
and consequent surges in dollar-linked debt. 
 
¶2.   (U) Eighty percent of the total debt is domestic, i.e., 
denominated in Reals.  Half of that 80% is tied to the 
Central Bank's benchmark SELIC interest rate.  Thus, the 
SELIC's drop from 26.5 to 16.5% since June 2003, if 
continued, means future-year savings in interest payments of 
1.5-3.0% of GDP, as the GoB replaces or retires old debt 
issued at high SELIC rates.  In a "virtuous-circle" effect, 
the return of market confidence during Lula's first year has 
allowed the GoB to improve the composition of its 
securitized debt by issuing more fixed-rate paper, as well 
as (since August) lengthening maturities.  GoB optimists 
speak of cutting debt-service costs enough to achieve 
nominal/nominal balanced budgets by 2008, paving the way for 
debt/GDP to decline to the low 40% range within the decade. 
 
¶3.   (SBU) Yet Brazil's public debt remains far too close 
for comfort to a macroeconomic knife's edge.  The Lula 
government's hard-won primary surplus of 4.32% of GDP in 
2003 still covered less than half of the interest payment 
(9.49%) on its debt stock.  The overall nominal debt and 
debt ratio each thus still grew by around three percent. 
(The Real's appreciation partly counteracted the nominal- 
deficit effect, by shrinking the valuation in Reals of 
foreign-exchange-linked debt.)  For 2004, the GoB itself 
projects only a modest reduction in the ratio, to 57.3% -- 
even assuming 3.5% GDP growth.  Domestic and/or external 
shocks could reverse recent positive trends.  Meanwhile, the 
huge costs of debt-service sap the GoB's ability to make 
investments needed for growth, without which the debt burden 
will become more intractable.  Bottom line:  Lula's team in 
its first year made more progress in managing the public 
debt than even they might have dreamed possible -- but the 
debt worry looks sure to remain, hovering like a ghost over 
his entire term.  END SUMMARY. 
 
Scope and Structure 
------------------- 
 
¶4. (U) Brazil's net public-sector debt rose in 2003 from 881 
to 913 billion Reals (from 55.5 to 58.2% of year-end GDP). 
Converted at the then-exchange-rate of Reals 2.89 per USD, 
the end-2003 total amounted to $316.1 billion.  That dollar 
figure may mislead, however.  Net public foreign debt 
constituted just USD 64.6 billion, or 20.4% of the total. 
The other four-fifths was domestic and denominated in Reals. 
Thus, the GoB can finance itself almost entirely on the 
local market.  About 90% of new debt issued is domestic; 
recent modest external issues have involved simply rolling 
over foreign-exchange debt.  The domestic debt admittedly 
includes foreign-exchange exposure of about USD 55.8 billion 
in the form of domestic securities tied to the exchange rate 
or currency swaps issued in parallel with those securities. 
The total foreign-exchange-rate exposure of Brazil's public 
debt thus amounts to roughly USD 121 billion, 30.4% of the 
total (40.9% including swaps). 
 
¶5. (U) FOREIGN-DEBT NOTE:  The GoB (and IMF-approved) figure 
for Brazil's foreign public-debt total is net/net of 
official gross/gross reserves.  The latter at end-2003 were 
below USD 60 billion, of which over USD 38 billion 
represented IMF loans.  Net reserves then were under 20 
billion, a small fraction of their average since the early 
1980s.  The GoB has since increased its net reserves by over 
two billion dollars via open-market purchases, an ongoing 
process.   END NOTE. 
 
                           ------- 
                           Table 1 
                           ------- 
 
        Brazil's Consolidated Net Public Sector Debt 
            (1998-2003, End-Year), Billion Reals 
 
              1998    1999    2000    2001    2002    2003 
 
Net Debt     385.9   516.6   563.2   660.8   881.1    913.1 
(% of GDP)    41.7    48.7    48.7    52.6    55.5     58.2 
 
Foreign 1/    57.2   108.8   111.3   130.8   226.8    186.4 
(in dollars)  47.3    60.8    57.0    56.4    64.2     64.6 
(% of GDP)     6.2    10.3     9.6    10.4    14.3     11.9 
 
Net Domestic 328.7   407.8   451.8   530.0   654.3    726.7 
(% of GDP)    35.5    38.4    39.1    42.2    41.2     46.3 
 
-1/ Net of Central Bank foreign exchange-denominated assets 
including gross reserves; converted at contemporary exchange- 
rate. 
 
Sources: Central Bank and Finance Ministry. 
 
 
                           ------- 
                           Table 2 
                           ------- 
 
               Breakdown of Public-Sector Debt 
                      Billions of Reals 
                        December 2003 
 
NET PUBLIC SECTOR DEBT               913.1 
 
Gross Debt                              1,344.6 
 - Federal Government                     940.0 
 - Central Bank                           312.4 
 - State Governments                       21.9 
 - Municipal Governments               5.2 
 - Federal para-statals               51.2 
 - State para-statals                      13.9 
 - Municipal para-statals                   0.3 
 
Assets netted out                        -431.5 
 - Federal Government               -203.3 
     (primarily domestic assets of the Workers' Guarantee 
     Fund, assets of similar domestic funds and renegotiated 
     state debts to federal government) 
 - Central Bank                          -161.5 
    (primarily international reserves) 
 - State Governments                      -11.3 
 - Municipal Governments                   -2.5 
 - Federal para-statals              -52.6 
     (includes foreign exchange deposits, renegotiated debt, 
     other credits) 
  - State para-statals                -0.3 
  - municipal para-statals                 -0.1 
 
Source: Central Bank 
 
¶6.  NOTE:  To avoid confusion amongst specialist followers 
of Brazilian finances, it should be noted that Brazil's net 
public domestic debt ("divida liquida") is not the same as 
its Federal Domestic Securitized Debt (FDSD -- "divida 
mobiliaria").  The latter includes some GoB paper which does 
not reflect net debt, e.g., extra issuances to sterilize the 
CB's open-market purchases of dollars to boost reserves, or 
other monetary-policy operations.  FDSD thus is sometimes 
greater, sometimes less, than net domestic debt, as a 
comparison of Table 1 above with Table 3 displays. 
 
                           ------- 
                           Table 3 
                           ------- 
 
          Federal Domestic Securitized Debt 
            (1998-2003), Billion Reals 
 
              1998    1999    2000    2001    2002    2003 
 
Stock        323.9   414.4   510.7   624.1   623.2    731.4 
 -(% of GDP)  35.0    39.1    44.2    49.7    39.2     46.1 
 
Source: Central Bank and Finance Ministry 
 
How Did We Get Here? 
-------------------- 
 
¶7. (U) Multiple dynamics raised Brazil's federal debt/GDP 
level from 1994's 30% to the current 58+%.  The key drivers 
have been: a) high nominal deficits (and, before 1998, 
primary deficits), generated fundamentally by the high 
interest rates to which successive GoBs have resorted to 
stabilize the currency and fight inflation in the face of 
various shocks; b) centralization of state, municipal and 
other liabilities at the federal level after the mid-1990s; 
c) currency devaluation since 1998; and d) stubbornly low 
GDP growth. 
 
High, Interest-Driven Deficits 
------------------------------ 
 
¶8. (U) Before the 1997-99 emerging-market financial crisis, 
the GoB ran not just nominal but primary consolidated budget 
deficits.  The Cardoso government of that era maintained an 
overvalued exchange rate by means of high interest rates. 
When forced to float the Real in 1999, it raised interest 
rates still further to control inflation.  These factors 
help explain how interest costs of what was initially a 
relatively modest stock of debt have for years been so high. 
 
¶9. (U) The years since 1998 have seen primary-budget 
surpluses of 3.2% of GDP or better.  However, in those same 
years debt service has grown to 7-9% of GDP in interest 
payments alone.  This tremendous expense soaks up as much as 
a quarter of government revenues (federal and state.)  It 
has been the primary agent behind Brazil's fiscal deficits 
since the Plano Real in 1994.  To illustrate:  the Lula 
government's hard-won 4.32% of GDP primary surplus covered 
less than half its interest expenditures (9.49% of GDP) in 
¶2003.  Result: a nominal deficit of 5.16% of GDP.  Table 4 
illustrates the impact of debt service on Brazil's fiscal 
accounts over the last half-decade. 
 
                           ------ 
                           TABLE 4 
                           ------- 
           Interest Payments Drive Fiscal Deficits 
          (In Billions of Reals and Percent of GDP) 
 
Year         1998    1999    2000    2001    2002     2003 
 
-Nominal 
Interest    68.3    87.4    78.0    86.4    114.0    145.2 
-% GDP       7.5     9.0     7.1     7.2      8.6      9.5 
(accrual basis) 
 
-Primary 
 Surplus     0.1    31.1    38.2    43.7     52.4     66.2 
-Pct of GDP  0.0     3.2     3.5     3.6      4.0      4.3 
 
-Nominal 
 Deficit    68.2    56.3    39.8    42.7     61.6     79.0 
-Pct of GDP  7.5     5.8     3.6     3.6      4.6     5.16 
 
Source: Ministry of Finance and Central Bank 
 
¶10. (SBU) NOTE:  Unibanco's chief economist once lamented to 
Econoff that his former employer, the World Bank, had ever 
convinced the IMF to fix primary surpluses instead of actual 
deficits as program benchmarks.  This policy, he said, masks 
the extent of a country's fiscal problems.  In Brazil's 
case, even the current 4.3% of GDP primary surplus is not 
enough to bring down the debt-to-GDP ratio, he argued.  END 
NOTE. 
 
"Skeletons" 
----------- 
 
¶11. (U) The Cardoso administration's responsible process 
through the late-1990s of acknowledging bad state, municipal 
and parastatal debt, plus some other liabilities, has also 
driven up the official GoB debt level.  Much of these debts, 
commonly referred to as "skeletons", have been centralized 
in the federal government.  "Skeletons" added an officially 
estimated 8.62% of GDP to the stock of federal public debt 
in the eight years to December 2003.  Pessimists opine that 
more skeletons remain to be unearthed, perhaps another 5-8% 
of GDP, but this upper figure seems increasingly unlikely. 
 
Currency Depreciation 
--------------------- 
 
¶12. (U) Since 1998, the dominant factor in worsening the 
debt/GDP ratio has been the exchange rate.  This was 
reflected by the jump in the ratio after the GoB was forced 
to float the Real in early 1999.  From 41.7% in 1998, the 
ratio leapt to 48.7% at the end of 1999.  (The particularly 
high interest rates briefly imposed in 1999 were also a 
factor, but those rates themselves stemmed from the need to 
staunch capital flight and inflationary effects arising from 
the devaluation.)  The Real's renewed plunge from April into 
October 2002 -- combined with the effects of high interest 
rates employed to combat inflation and restore market 
confidence during the presidential campaign -- likewise took 
a toll, causing the brief spike at 64%. 
 
¶13. (U) A CSFB study gave as the rule-of-thumb for the 
second half of 2002 (with the Real in the 3.50-4.0/dollar 
zone) that a 10% currency devaluation translated to a 2 
percent rise in Brazil's debt/GDP.  At its worst, in 
November 2002, it meant a 3.4% increase.  This effect was 
not mainly due to Brazil's relatively modest foreign public 
debt.  Rather, it was driven by the then-burgeoning level of 
the dollar-linked portion of domestic public debt.  That, in 
turn, was generated by the GoB's practice, adopted out of 
necessity, of holding down interest rates on its new debt by 
increasing issuance of dollar-linked instruments.  As part 
of this process, starting in April 2002 the Central Bank 
also began issuing dozens of billions of dollars' worth of 
swaps in parallel with new Treasury SELIC issuances.  (IMF 
rules forbid Treasury from selling swaps or other 
derivatives.) 
 
¶14. (U) Lula's GOB has assiduously reduced this exposure to 
exchange-rate volatility.  As market confidence in his 
financial team has grown, the latter has been able to 
retire, rather than roll over, massive portions of dollar- 
linked debt coming due, replacing them with non-dollar- 
linked debt.  In 2003, it retired from the market over $20 
billion in dollar-linked debt and debt-related swaps.  By 
year's-end, the dollar-linked part of the domestic debt had 
halved, from 20.3 to 10.0%, year-on-year.  Including swaps, 
the drop was from 33.5 to 20.5%.  The process has 
accelerated since, with a total of $7.6 billion more in 
dollar-denominated debt retired in the first two months of 
2004, according to the latest GoB figures. 
 
                           ------- 
                           Table 5 
                           ------- 
 
            COMPOSITION OF DOMESTIC FEDERAL DEBT 
 
                      End-2002     Sept.'03   End-2003 
                      --------     --------   -------- 
 
Fixed-interest            1.5%       6.9%          9.5% 
Floating-interest        42.4%      48.9%         46.5% 
Inflation linked          9.2%       9.8%         10.3% 
Total Dollar and 
 Dollar-linked        45.8%      33.0%         32.4% 
 Others                   1.6%       1.4%          1.4% 
 
Source:  Central Bank and Finance Ministry 
 
FLOATING INTEREST RATE EXPOSURE 
------------------------------- 
 
¶15. (U) As the debt's foreign-exchange component has shrunk, 
its interest-rate component has grown.  Half the domestic 
debt is floating-rate, linked to the Central Bank's discount 
(SELIC) rate.  To illustrate the potential downside of this 
factor: the Central Bank's interest-rate hikes in response 
to the crisis of confidence in 2002 increased average 
interest on Brazil's domestic public securitized debt to a 
peak of 31.7% in November 2002. 
 
¶16. (U) The GoB has begun to turn the tide in this area, as 
seen in Table 6.  New financial-market confidence has 
allowed it to reduce interest rates, increase issues of 
fixed-rate debt (from under two to over twelve percent of 
the total, year-on-year by end-2003) and, beginning in 
August 2003, also to lengthen maturities.  By December 2003, 
the SELIC had dropped to 16.5% from 26.5% in mid-2003, and 
the average interest rate on domestic debt was down to 
around 22%.  This, to be sure, still left the real rate well 
in the double-digit range.  As for foreign-debt service:  by 
January 2004, the GoB was able to launch a 30-year Eurobond 
with a spread of 377 basis points above U.S. Treasuries -- 
quite remarkable after the spreads of 24% above U.S. 
Treasuries little more than a year before. 
 
                           ------- 
                           TABLE 6 
                           ------- 
 
  DOMESTIC SECURITIZED FEDERAL DEBT INDICATORS/1 
 
                      End 2002  Sept 03    Dec 03 
 
Ave. maturity 
       (months)        33.20       31.20     31.34 
- fixed rate            3.06        6.64      6.50 
- SELIC linked       21.83      22.38     22.74 
- Dollar linked         35.47      40.82     40.51 
- inflation link        79.18      75.29     77.88 
 
Duration (months)       20.0        15.2 
Percent maturing within one year 
 (total)                38.9        32.1      33.4 
- fixed rate            96.8        86.9      85.9 
- SELIC linked          48.8        30.9      28.9 
- Dollar linked         31.1        33.5      42.7 
- inflation link         1.3         1.7       1.4 
 
Average Interest Rate 
- w/swap exposure    20.9           18.6 
- w/out swaps        29.1           21.2 
 
Exchange-Rate Exposure (Billions of Reals) 
- Dollar-linked       139.47         83.24    78.67 
- Swaps                91.10       103.37     82.72 
- Total               230.57        186.62   161.39 
 
1/ Federal domestic debt in the form of securities 
   held by the public 
 
Source: Ministry of Finance and Central Bank 
 
GDP:  The Stagnant Variable 
--------------------------- 
 
¶17. (U) The final variable in the debt/GDP equation is GDP 
itself.  Brazil's anemic growth over the last several years 
has exacerbated the ratio's increase.  Growth in 2004 is 
widely forecast to recover to 3.5%.  But even if that 
scenario is borne out, along with market expectations of 
relative exchange-rate stability (3.1-3.2 Reals/$) plus a 
further decline in the SELIC interest rate to 13.5% at end- 
year, private-sector specialists calculate debt/GDP at end- 
2004 will still be 58%.  The GoB itself forecasts just a 
modest fall, to 57.2%. 
 
¶18. (U) After 2004, projections of declining debt/GDP levels 
depend critically on sustained growth rates of at least 3.5 
to 4%.  Indeed, the public debt will only be payable to the 
extent that Brazil solves its longer-term growth problem. 
That solution, in turn, hinges on the raft of microeconomic 
reforms necessary to increase economic efficiency and 
promote investment (Ref A.) 
 
¶19. (U) Meanwhile, Brazil's debt level in itself stymies 
longer-term growth.  Most GoB borrowing is to roll over 
maturing debt and to pay current fiscal deficits.  Public 
investment has dried up, squeezed both by debt service and 
constitutional spending earmarks which leave only about 9% 
of the federal budget as discretionary spending. 
 
COMMENT 
------- 
 
¶20. (SBU) Financial-market enthusiasm for Brazil debt-paper 
seems ready for the long-haul.  Certainly Brazil has come a 
good way from the "vicious circle" near-panic induced by the 
presidential campaign of 2002, with that period's plummeting 
exchange rate, interest-rate hikes, and extreme difficulty 
in debt-rollover.  But, for all the debt-management skill 
and progress of Lula's first year, Brazil's public-debt 
profile could quite easily again fall prey to negative turns 
of market mood if, e.g., local interest-rate or global risk- 
capital trends take a bad turn, and/or domestic growth in 
the real economy continues not to materialize. 
 
¶21. (SBU) Beyond keeping its fingers crossed against 
external and domestic shocks, the GoB can now best improve 
its debt sustainability by enacting structural and 
microeconomic reforms to attract investment and boost 
growth.  Unfortunately, the early results of its efforts to 
reform the tax, pension and regulatory systems have been 
economically underwhelming, however politically resolute. 
The phantoms of doubt about Brazil's debt have withdrawn to 
the wings for now, but will surely hang around, ready again 
to haunt the GoB, through Lula's term. 
 
HRINAK