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 000417 
 
SIPDIS 
 
SENSITIVE 
 
NSC FOR BREIER, RENIGAR 
TREASURY FOR OASIA - DAS LEE AND FPARODI 
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D 
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOS LON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV EINV BR
SUBJECT: BRAZIL - STRONG 2005 MACROECONOMIC SCENARIO 
 
REF: A) 04 BRASILIA 2711 
 
     B) 04 BRASILIA 3115 
     C) BRASILIA 210 
 
¶1.   (SBU) Summary:  Brazil enters 2005 in a position of 
relative macroeconomic strength.  GDP growth, debt ratios, 
the trade balance and external accounts are all favorable or 
moving favorably.  In conversations with industry and 
government economists, all were hard pressed to name a 
single economic factor or set of factors that could spoil 
what looks to be a good 2005 for Brazil.  Credible GDP 
growth forecasts range from 3.5% to 4.3%, with consumption 
reviving, helping to drive growth.  The GoB does face some 
challenges, including how high interest rates must go to 
reduce inflation more quickly.  Debt, while falling as a 
percent of GDP, remains high and is the key remaining source 
of vulnerability.  The GoB easily surpassed its 4.5% of GDP 
primary surplus target in 2004, registering a primary 
surplus of 4.61% of GDP.  While there is little doubt the 
GoB will attain its 4.25% of GDP primary surplus for 2005, 
revenue growth should not be as strong this year.  Post 
believes the GoB will graduate from its IMF program when it 
expires in March.  Some analysts cited abrupt changes in 
U.S. interest rates or sharp swings in the value of the 
dollar, affected by the U.S. current account and budget 
deficits, as their biggest fears for 2005.  End Summary. 
 
Continued Growth Momentum 
------------------------- 
 
¶2.   (U) Brazil enters the first quarter of 2005 with strong 
growth momentum, the product of 2004's best-in-a-decade 
yearly GDP growth of 5%.  The GoB has recognized this robust 
growth level by revising upward in late 2004 its GDP growth 
estimate for 2005 budgeting purposes from 4% to 4.36%. 
Despite this, there is still some divergence: the Central 
Bank has, to date, maintained its growth forecast at 4%; a 
Rio de Janeiro-based economist at Icatu Securities predicted 
3-3.5% growth; Brazilian institute of Economic Studies 
economist Paulo Levy predicted 3.8%; and, an optimistic Rio 
de Janeiro Federation of Industries economist said 4.5%. 
(Comment:  the divergence seems to be attributable to 
differences in the inflation outlook and its subsequent 
impact on SELIC rate hikes and the impact of the Real's 
appreciation.  End Comment.)  There are signs of some 
cooling.  While 2004 industrial production, for example, 
attained its highest growth levels in eighteen years, 
(8.3%), it grew a relatively modest 0.6% in December.  In 
recent conversations with economists in government, industry 
and the IMF, all were hard pressed to name a risk or set of 
risks that could spoil the outlook for 2005.  Some analysts 
cited persistent inflation, the U.S. current account and 
budget deficits, which have devalued the dollar, and U.S. 
interest rates as the main risks to growth in 2005. 
 
¶3.   (U) While 2004 GDP growth was overwhelmingly led by 
exports (up 32%) and investment (7.7% growth in the twelve 
months through September 2004), private consumption should 
revive in 2005, helping drive growth.  The recovery of 
employment over the course of 2004 -- down from over 13% in 
April 2004 to 9.6% in December -- should increase wages and, 
ultimately, consumption.  Real incomes did, in fact, halt 
their decade-long slide in 2004 and showed some modest 
growth in the last quarter.  They may grow one to two 
percent this year.  An initial sign that this consumption- 
led growth scenario may be underway was the 4% growth in 
production of consumables and semi-durables in the fourth 
quarter of 2004, strongly outpacing overall industrial 
production growth during the period.  Consumables production 
in particular has been highly correlated with changes in 
real income. 
Inflation Falling, But Slowly 
------------------------------ 
 
¶4.   (SBU) The Central Bank would like to take advantage of 
the moment to slay Brazil's traditional inflation dragon 
once and for all.  Central Bank President Meirelles has 
emphasized to USG officials, including to the Ambassador on 
December 8 (ref B), his view that the Brazilian economy 
retains a significant inflationary bias.  Meirelles argued 
that this legacy of Brazil's hyper-inflationary past, when 
businesses tried to earn money by raising prices faster than 
wages could adjust, was still alive.  Such inflationary 
behavior, he said, must be wrung out of the system.  This 
view appears to be a strong motivating factor behind the 
Central Bank's current round of interest rate increases, 
which have taken the basic short term interest rate (SELIC) 
from 16% in September to 18.25% today (the market expecting 
a further 0.5% increase when the Monetary Policy Committee 
meets February 15-16 and some predict further increases in 
the coming months).  Despite the 2.25 percentage point 
increase in the SELIC, inflation expectations for the year 
remain at 5.7%, well above the 5.1% target.  This slowness 
in adjusting may simply be a reflection that much of the 
inflationary pressure, such as steel price hikes and high 
oil prices, has been coming from the supply-side of the 
equation, rather than the demand side that Central Bank 
policy instruments affect more directly. 
 
¶5.  (SBU) The interest rate increases have been roundly 
unpopular.  The GoB economic team, however, is speaking with 
one voice in defending the policy.  Shortly after the 
January interest rate increase, President Lula echoed 
Meirelles' argument (made in private to the Ambassador) 
criticizing industry for their price hikes, which he argued 
were maintaining inflation expectations well above the 
target for the year.  Industry has since fought back, 
blaming the Central Bank.  Flavio Castelo Branco of the 
National Confederation of Industries (CNI), told Emboff that 
industry believes monetary policy has been too tight, 
fixated on meeting overly ambitious inflation targets. 
Moreover, he argued, high interest rates were contributing 
to the Real's appreciation, ultimately hurting exports. 
 
Debt and Fiscal Policy 
---------------------- 
 
¶5.   (SBU) Strong revenues, falling interest expenditures 
and strong GDP growth have contributed to lowering the GoB's 
net debt-to-GDP ratio, from 57.2% at end-2003 to an 
estimated 51.8% at end-2004.  The GoB continued to make 
significant progress in improving the composition of the 
debt.  Dollar-linked domestic debt, for example, including 
foreign-exchange exposure on related swaps, has fallen to 
9.9% of the total, from well over half two years before.  As 
Brazil's exposure to dollar-linked debt has fallen, the 
current cycle of monetary tightening has highlighted the 
downside of its exposure to SELIC-linked debt (52.5% of the 
total).  New measures lowering taxes on returns from 
investments held longer than a year have created demands for 
longer-term government bonds, according to the head of 
strategic planning in the Finance Ministry's public debt 
department, Anderson Delfino.  This had helped the Ministry 
extend the average maturity of its debt.  Delfino said it 
would take a "perfect storm"-style confluence of events to 
throw off the positive macroeconomic scenario, and in 
particular the improving debt dynamics. 
 
¶6.    (U) The GoB easily surpassed its 4.5% of GDP primary 
surplus target in 2004, registering a primary surplus of 
4.61% of GDP.  There is little doubt the GoB will attain its 
4.25% of GDP surplus for 2005.  While revenue growth should 
not be as strong this year as it was last, the IMF ResRep 
has told us that the fiscal scenario for 2005 looks solid. 
A decision to adjust the income tax brackets for inflation 
creep this year should also contributes to slower revenue 
growth.  Castelo Branco of the CNI bemoaned the overall tax 
burden, but likewise predicts the GoB will meet the fiscal 
target.  An official at the GOB's Institute of Applied 
Economics opined that the GOB would still maintain a surplus 
of around 4.1% of GDP even absent an IMF program, but that 
it would still like a "seal of approval." 
 
Strong External Accounts 
------------------------ 
 
¶7.   (U) Brazil's strong external position makes the current 
growth cycle the most sustainable of any in recent memory. 
While exports would be hard pressed to match the stellar 
growth rates of 2003 and 2004, most current predictions are 
for a trade surplus of about $26 billion in 2005, based on 
exports of a little over $100 billion and imports of about 
$75 billion.  This would anchor the BOP, and allow a current 
account balance of $2.1 billion, or 0.2% of GDP.  Strong 
dollar inflows through the capital account, attracted in 
part by high interest rates, have further strengthened the 
external position.  The Central Bank bought $2.7 billion 
dollars on the spot market in January to shore up reserves. 
The Central Bank denies that its purchases are meant to 
influence the Real's value. 
 
¶8.   (SBU) The 2005 trade surplus should narrow, as the 
appreciating Real drives import growth and reduces export 
growth.  Recovering incomes and consumption growth also 
should spur imports.  The IMF Resident Representative 
pointed out to Emboff that even though the Real had 
appreciated significantly against the dollar, its 
appreciation against the Euro and other leading currencies 
had been much more limited, resulting in a level of real- 
exchange-rate appreciation that was not overly concerning. 
Since less than a quarter of Brazil's exports are to the 
U.S., the appreciation's effect was limited.  CNI's Castelo 
Branco was much less sanguine, worrying that Brazilian 
exports would lose their competitiveness.  He nevertheless 
argued that there had been a structural change in Brazilian 
industry, with large firms in particular energetically 
pursuing export growth.  The most recent data suggests the 
export boom continues, as the January 2005 monthly trade 
surplus of $2.2 billion was significantly above expectations 
despite continued import growth.  Despite the strong 
external accounts, Brazil's overall external debt (public 
and private) of about $200 billion, or twice exports, leaves 
it vulnerable to swings in financial market confidence. 
 
Comment 
------- 
 
¶9.   (SBU) There has been much comment in the press recently 
over whether Brazil should renew its IMF program when it 
expires in March.  While the politics of this are complex, 
we continue believe that the GoB will not seek a new Stand- 
by Agreement, and neither does the macroeconomic scenario 
justify it (ref A).  The GoB would like, however, some sort 
of blessing from the Fund for President Lula's initiative to 
adjust the primary surplus target to allow for greater 
public investment expenditures.  Increasing private 
investment and sustaining healthy growth levels, on the 
other hand, will depend on advancing necessary microeconomic 
and structural reforms (septel).  That said, talk in local 
financial circles of Brazil attaining an investment grade 
credit rating in the 2007/2008 time frame is getting 
stronger all the time. 
 
¶10.  This cable coordinated with Consulates Rio de Janeiro 
and Sao Paulo. 
 
DANILOVICH