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

UNCLAS SECTION 01 OF 04 BRASILIA 002447 
 
SIPDIS 
 
SENSITIVE 
 
TREASURY FOR OASIA - DAS LEE AND FPARODI 
NSC FOR DEMPSEY 
STATE FOR EB/IFD/OMA - MOSS 
STATE PASS FED BOARD OF GOVERNORS FOR ROBITAILLE 
USDOC FOR 3134/USFCS/OIO/EOLSON/DDEVITO 
USDOC FOR 4332/ITA/MAC/WH/OLAC/DMCDOUGALL/ADRISCOLL 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSON/WBASTIAN 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EINV PREL BR
SUBJECT: BRAZIL'S ECONOMIC HIGH POINT REINFORCES LULA'S HAND 
 
REF: A) Brasilia 2221 
 
     B) Brasilia 463 
     C) Sao Paulo 1328 
 
¶1.   (U) Summary:  Brazil is living one of its best economic 
moments in recent memory.  GDP growth has averaged above 6% 
on an annualized basis for the last three quarters.  The 
external accounts remain healthy as exports continue to 
boom; Brazil should run a 1.5% of GDP current account 
surplus this year, its second in a row.  Unemployment, while 
still high, has begun to fall while real incomes are 
beginning to rise after several years of decline. 
Inflationary pressures are building, however, leading the 
Central Bank to raise interest rates (by a quarter point) to 
16.25% on September 15.  The inflationary trajectory already 
has shifted; expected inflation in 2004 is for 7.37%, within 
the plus/minus 2.5 points band around the 5.5% target.  Due 
to these dynamics, the Central Bank on September 23 
announced the revision of its 2005 inflation target from 
4.5% to 5.1%. 
 
¶2.   (U) Strong revenue growth means the GoB is in the 
unfamiliar situation of having the option of tightening 
fiscal policy to take some of the burden off of monetary 
policy, without sacrificing expenditure.  The GoB announced 
on September 22 that it would increase the primary fiscal 
surplus target from 4.25% to 4.5% of GDP.  It hopes that 
formalizing the new target will help limit interest rate 
increases while allowing the GoB to continue to reduce the 
debt-GDP-ratio.  Already the debt-to-GDP ratio has fallen 
from 58.6% in December 2003 and may close out the year at 
about 55%, which would mark the first year-on-year decline 
in the debt-to-GDP ratio in a decade. 
 
¶3.   (SBU) Brazil took advantage of the positive situation 
to tap international markets with an over-subscribed Euro 
750 million eight-year bond, at a spread of 477 basis points 
above the benchmark German Treasury note.  Standard and 
Poor's recognized the progress by upgrading Brazil's credit 
rating to BB-, the same level it had before the 2002 crisis. 
Current low, albeit growing, investment levels mean the 
economy should cool off in the near term from current growth 
rates.  But, the good economic news should strengthen 
President Lula's hand as he implements rigorously orthodox 
economic and fiscal policies and pursues structural reforms 
critical to boosting weak savings and investment to the 
levels necessary for faster economic growth.  The economic 
news may also help candidates from Lula's Workers' Party 
(PT) in the October 3 nationwide municipal elections.  End 
Summary. 
 
The Good News 
------------- 
 
¶4.   (U) The good economic news has been rolling in 
recently, with the Brazilian economy posting its fourth 
consecutive quarter of growth and the third at an annualized 
rate of over 6% (ref A).  Analysts have been busily revising 
upwards their growth projections for the year:  according to 
Central Bank survey data, the market now expects growth of 
4.36% this year, and some respected analysts are predicting 
growth as high as 4.7%.  It is not clear whether the economy 
has begun to cool off since the end of the second quarter. 
One closely-watched leading indicator, sales of packaging 
products, dropped over 4% in August, albeit after a July 
increase of over 5%.  Some analysts suggest this data point 
meant the economy has reached an inflection point and begun 
to trend towards the expected 2005 growth rate of 3.5%.  But 
other indicators from the same time frame, such as steel 
production, show little sign of such a cooling. 
 
¶5.   (U) Employment growth, which had lagged a bit, has now 
begun to pick up markedly.  While unemployment is still high 
and remains a political issue, new GoB data show record 
formal employment creation in January to August (677,900 net 
new jobs).  The recovery is broadening across sectors, with 
consumption spending picking up.  External accounts remain 
very favorable, with export growth leading to a predicted 
trade surplus of $30 billion and an overall current account 
surplus for the year of 1.2% of GDP.  The weakest part of 
the external accounts had been Foreign Direct Investment 
(FDI), but after a recent uptick the Central Bank has 
revised its prediction of total FDI for the year from $13 
billion to $17 billion. 
 
But, Inflationary Pressure Rears its Ugly Head 
--------------------------------------------- - 
 
¶6.   (U) Inflationary expectations, however, also have been 
mounting.  Wholesale price pressures fed by high capacity 
utilization, particularly in the intermediate goods 
industries such as steel, have been feeding through to 
consumer prices.  Workers are beginning to increase wage 
demands (such as the currently-striking bank employees) to 
make up for years of sliding real incomes (ref C). 
Companies are often acceding to union pressure and granting 
wage increases above inflation.  Energy prices also have 
contributed to the mounting inflationary pressures. 
Accumulated inflation in the year through August clocked in 
at 5.14%.  The market consensus as of September 17 was for 
consumer price inflation of 7.37% this year, substantially 
above the official 5.5% target, but still within the band of 
plus or minus 2.5 percentage points. 
 
Balancing Monetary and Fiscal Policies 
-------------------------------------- 
 
¶7.   (U) Given these increasing inflationary pressures, the 
Central Bank on September 15 hiked the basic SELIC interest 
rate by a quarter percent to 16.25%.  Unlike some of the 
previous rate decisions this year, the Central Bank 
telegraphed its intentions well, using the minutes of the 
August monetary policy meeting to lay the groundwork with 
the market for an increase.  Public debate has shifted to 
how quickly and to what degree the Central Bank needs to 
increase interest rates to tamp down emerging inflation. 
The minutes of the September 14-15 Central Bank monetary 
policy meeting make clear that the Bank sees the September 
15 hike as the first in a "process of moderate adjustment" 
of monetary policy, implying further interest rate 
increases.  Increased inflationary expectations have 
actually reduced forward-looking real interest rates by 
about a percentage point since April, when the Central Bank 
last cut the nominal interest rate to 16%.  This process of 
nominal adjustment would reverse some or all of that slide 
in real interest rates. 
 
¶8.   (U) Strong revenue growth this year has given the GoB a 
realistic fiscal policy option to help head off increased 
interest rates.  On September 22 the GoB announced it had 
increased its primary surplus target for 2004 from 4.25% of 
GDP to 4.5% of GDP.  Analysts argue that this should help 
ease the burden on monetary policy in managing inflationary 
expectations, allowing the Central Bank to limit the 
necessary interest rate increases.  Notwithstanding feelings 
by some in President Lula's inner circle (notably Chief of 
Staff Jose Dirceu) that the GoB needed to dedicate part of 
its windfall to social and investment programs, Lula took to 
the airwaves September 23 to justify the decision, arguing 
it was better to pay down debt with the extra revenue than 
simply spend it.  The debt-to-GDP ratio at end-year may be 
as low as 55%, according to some analyses, down 4.6 points 
on the year. 
¶9.   (SBU) One analyst with the Institute for Applied 
Economic Research (IPEA) told Econoff that the GoB really 
had no choice but to exceed the original 4.25% target, since 
revenues are running so far ahead of predictions while 
expenditures are ultimately capped by the 2004 budget law. 
(For example, last year's revisions to COFINS, a social tax 
paid on revenues, have brought in additional percentage 
point of GDP in revenues, according to the IMF ResRep; 
revenues also have been buoyed by the strong GDP growth. 
Note:  The official prediction now is a total federal 
government revenue increase of 1.1% of GDP.)  The IPEA 
economist opined that while the GoB might have considered 
trying to spend more, it would have had to obtain 
Congressional approval for a supplemental budgetary 
authorization.  This, however, would put the GoB in the 
uncomfortable position of acknowledging that the Congress's 
growth and revenue predictions, which the Executive 
criticized in January as inflated during a sometimes 
acrimonious debate over cautionary spending freezes, were in 
fact closer to the mark than the GoB's (Ref B). 
 
¶10.  (U) Looking forward to next year, the Central Bank 
acknowledged in the minutes of its September 14-15 monetary 
policy meeting, published on September 23, that the 
trajectory of inflation has made unrealistic, without a 
sharper monetary response, the achievement of the 2005 
inflation target of 4.5%.  It decided to accommodate 
partially that inflationary inertia and announced a new 2005 
inflation target of 5.1%.  Subsequent to the Central Bank 
decision, the September IPCA-15 (a version of Brazil's 
consumer price index calculated on the 15th of each month, 
one of Brazil's rich heritage of inflation indices) clocked 
in at 0.49%, lower than had been anticipated. 
 
International Markets 
--------------------- 
 
¶11.   (U) The GoB took advantage of a favorable 
international market to launch on September 8 a Euro 750 
million 8-year fixed-rate bond at a spread of 477 basis 
points over the benchmark German treasury note.  The issue 
was oversubscribed, which allowed the GoB to increase the 
amount from Euro 500 million.  The GoB then reopened the 
placement and issued a further Euro 250 million on September 
22, for a total placement of Euro 1 billion.   With this 
bond, the GoB has completed its borrowing program for the 
year on international markets, though some speculate the GoB 
will seek yet another Eurobond placement prior to year's end 
to increase international reserves and/or get a head start 
on 2005 borrowing.  At both the September 8 and September 22 
auctions, spreads were down markedly from the GoB's June and 
July issues, which were launched strategically after May and 
early June financial market turbulence to pave the way for 
private Brazilian borrowers to re-access international 
markets.  Standard and Poor's (S&P) recognized the progress 
by upgrading Brazil's credit rating to BB-, the same level 
it had before the 2002 crisis.  The move by S&P came eight 
days after Moody's had raised its Brazil rating to B1. 
 
Comment 
------- 
 
¶12.  (SBU) The GoB had only the most fleeting of instants to 
sit back and enjoy the positive macroeconomic moment before 
shifting focus to combat new threats.  While inflation is 
not out of hand and remains the lesser concern, investment, 
expected to hit 19% of GDP by end-year, will not bring on- 
stream enough capacity quickly enough to sustain growth at 
the current rates.  Sustaining growth even at more moderate 
rates (3.5% to 4.5% range) will require implementation of 
more of the GoB structural reform agenda, including the 
Public-Private Partnership (PPP) legislation, bankruptcy law 
and reform of the judiciary.  These still are pending 
congressional approval, with the PPP law (slated for a 
Senate vote after the upcoming October municipal elections) 
the closest to passage.  Investors also would like to see a 
lower tax burden and more predictable (and less 
bureaucratic) regulatory environment, items on which it will 
be difficult for the GoB to make substantial progress in the 
short term.  Still, the recession-weary public is beginning 
to breathe a collective sigh of relief.  And, as the old 
adage goes, "nothing succeeds like success."  Both factors 
should give Lula and his macroeconomic guru, FinMin Palocci, 
greater space to pursue their orthodox fiscal and monetary 
policies and the structural reform agenda. 
 
DANILOVICH