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 000521 
 
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/EOL SON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV EINV BR
SUBJECT: BRAZIL - THE MICROECONOMIC REFORM AGENDA 
 
REF: A) 04 BRASILIA 3115 
     B) BRASILIA 043 
     C) BRASILIA 210 
     D) BRASILIA 417 
     E) BRASILIA 447 
     F) BRASILIA 387 
     G) BRASILIA 024 
 
¶1.   (SBU) Summary:  In contrast to Brazil's recent 
outstanding macroeconomic performance, its progress on the 
microeconomic and structural reforms necessary to sustain 
healthy growth levels has been mixed.  The GoB has a well- 
articulated reform agenda and continues to push key 
measures through Congress.  It obtained congressional 
approval in the closing moments of 2004 for laws allowing 
for the creation of public-private partnerships (PPPs) in 
infrastructure investment, reform of the bankruptcy code, 
an innovation incentives law and judicial reform (ref B). 
President Lula, however, has named only four reform 
priorities for 2005: a second round of tax reform to unify 
state-level VAT tax rates; labor union reform; reform of 
the University system; and, regulation/implementation of 
the PPPs.  While not singled out as a priority by Lula, 
many other reforms, including Central Bank autonomy and a 
framework law to govern regulatory agencies (ref E), 
remain on the agenda.  The surprise defeat of Lula's 
candidate in elections for Speaker of the Chamber of 
Deputies (ref F) may complicate relations with the 
Congress and contribute to the slimmed down set of 
presidential reform priorities for the year. 
Nevertheless, the GoB views reform as a long-term process 
in which it is important not to lose momentum and will 
look for alternate ways to advance more technical level 
measures.  End summary. 
 
¶2.   (SBU) It is a matter of gospel among the GoB economic 
team that Brazil needs to sustain healthy growth levels 
for some time to begin to make an impact on entrenched 
poverty and its skewed income distribution.  What the 
sustainable rate of economic growth is, however, remains 
much debated.  Central Bank Chairman Meirelles put the 
rate at 3% to 3.5% in a December conversation with the 
Ambassador (ref A).  More optimistic analysts put the 
number closer to 4%.  But, all recognize there is a need 
for continued reform to boost productivity and, thereby, 
the sustainable growth rate.  The GoB's microeconomic 
reform agenda aims to, among other things, improve the 
functioning of credit markets, promote long terms savings, 
reduce bureaucratic hurdles for businesses, cut payroll 
taxes and decrease judicial uncertainty.   While pieces of 
this well articulated agenda have already been 
implemented, one contact, Mauricio Mendonca of the 
National Confederation of Industries (CNI), observed to us 
that political realities have frequently reduced the 
ambition of GoB's reform proposals and delayed their 
passage. 
 
Recent Reforms: PPP, Bankruptcy Law and Judicial Reform 
--------------------------------------------- ---------- 
 
¶3.   (SBU) The Lula administration championed PPPs as the 
centerpiece to its plans to increase infrastructure 
investment.  The idea is to make marginally profitable 
commercial investments in infrastructure, which 
nevertheless have a high societal return, more attractive. 
This can be accomplished by, among other things, 
guaranteeing a minimum return, providing an operating 
subsidy or fronting part of the initial investment, 
including through contributions in kind.  The law was 
approved December 22, 2004 and the GoB hopes to issue 
implementing regulations and launch the first projects for 
bids in late 2005.  Some observers (including some within 
the GoB - ref A) have argued that the GoB has 
overemphasized PPPs and should instead focus on projects 
that would be profitable as straight concession contracts. 
In any event, implementing regulations remain to be 
elaborated.  The business community, according to 
Mendonca, believes the Congress improved the PPP 
legislation that the GoB submitted, but nevertheless feels 
it had taken unduly long to do so, delaying implementation 
for the sake of marginal improvements. 
 
¶4.   (U) The Congress passed on December 13 a major 
overhaul of the bankruptcy code.  Modeled on Chapter 11 of 
the U.S. bankruptcy statutes, the law makes it possible 
for companies in financial straits to negotiate 
restructuring arrangements with their creditors outside of 
the courtroom.  Resorting to bankruptcy under the previous 
code was, effectively, a death sentence.  The new code 
gives higher priority to commercial creditors and limits 
labor claims, all of which should enhance creditors' 
ability to recover their money.  The reform ultimately may 
have a significant impact on Brazil's infamously high 
lending spreads (on average about 24 percentage points 
above the benchmark SELIC rate for businesses and 45 
points for individuals), but it remains to be seen how the 
code holds up in the court system. 
 
¶5.   (U) Another frequently cited culprit for high lending 
spreads in Brazil is the uncertainty that individual 
judges will enforce creditor claims.  The judicial reform 
enacted in December 2004 should, over time, begin to 
improve the situation.  Key among the several improvements 
enacted is the concept of binding precedent (ref G). 
Decisions by appeals courts or the Supreme Court will be 
binding on lower courts in future cases where the same 
point of law is in question and when the case was decided 
by a super-majority of the judges.  In addition to 
reducing uncertainty, this should help reduce the workload 
on the overburdened courts. 
 
¶6.   (U) Variously billed as an innovation law and an 
industrial policy law, Law 10.973 of December 2, 2004 
enacts a series of measures to spur investment in research 
and development.  These measures include, among other 
things, authorizing financial markets to create technology 
mutual funds, allowing private enterprises to fund 
university research, and creation public-private 
technology incubators.  A separate law (11.080 of December 
30, 2004) creates an agency to manage the GoB's industrial 
policy. 
 
¶7.   (U) Along with these headline measures, the GoB 
enacted multiple lower profile reforms, including: 
reduction of taxes on long term investments, measures to 
improve mortgage market functioning, a program to finance 
capital equipment modernization and reduction of a 
financial transactions tax on life insurance. 
 
On the Agenda for 2005 
---------------------- 
 
¶8.   (SBU) President Lula announced on February 15 his 
four priority reforms for 2005, including: a second round 
of tax reform to unify state-level VAT tax rates; labor 
union reform; reform of the University system; and, 
regulation/implementation of the PPPs.  Only the first 
three of these would require congressional action. 
 
-- The tax reform would unify the state-level ICMS tax, a 
VAT with rules and rates that currently vary from state to 
state.  ICMS unification, along with a national-level VAT, 
formed part of Lula's original 2003 tax reform package, 
but its consideration was postponed as part of a political 
compromise. 
 
-- Labor-union reform, as currently envisioned, would 
revamp the rules for labor union activities but would not 
modify Brazil's rigid workplace rules, which firms 
complain is a major disincentive to hiring.  Broader labor 
reform would be postponed until next year (i.e. after the 
October 2006 election). 
 
--  The university reform measures aim to increase access 
by Afro-Brazilian students to federal universities through 
quota systems and grant certain poor students free 
education at private universities. 
 
¶9.   (SBU) Lula's list of priorities did not include a 
number of other reform measures currently pending in 
Congress.  These include Central Bank independence, the 
regulatory agency law (ref E), the second tranche of 
judicial reform (ref G), a law allowing expanding use of 
mediation to resolve legal disputes, a micro-credit 
program, simplified labor and tax requirements for very 
small businesses and legislation to refine rules against 
anti-competitive practices in financial markets.  The 
Finance Ministry also has a long list of other reform 
proposals that have no yet made it to Congress.  These 
include reducing payroll taxes, reform of the tax system 
for small and medium-sized enterprises, creation of a 
positive credit reference database, liberalization of the 
market for reinsurance and creation of a national value 
added tax (envisioned for 2007).  The Secretary of 
Economic Policy at the Finance Ministry, Marcos Lisboa, 
has emphasized to us on multiple occasions the importance 
he places on maintaining reform momentum in what he views 
as a long-term reform process.  The Finance Ministry 
accordingly has moved forward with alternate lower-profile 
and more technical measures, such as the tax rate changes 
to promote long-term savings -- enacted via decree in mid- 
2004 -- at points when Congressional action has been slow. 
 
Business Priorities 
------------------- 
 
¶10.  (SBU) CNI's Mendonca told Emboff February 23 that 
industry's top priorities are labor reform and a 
comprehensive tax reform.  He lamented that labor reform 
appears to be off the agenda for this year.  While he 
expected the Congress to unify the ICMS tax, Mendonca 
dismissed this as an isolated effort, far short of the 
overhaul that industry believes the tax system requires. 
Mendonca argued that the current system, which 
consistently taxes production and investment, must move to 
one that taxes consumption and profits.  While there might 
be consensus that the tax system is broken, Mendonca said, 
Brazil's high debt service creates a "fiscal 
straightjacket" that makes overhaul of the tax system a 
risk to revenues that Brazil can little afford.  This 
means that major tax system changes would likely have to 
be postponed until debt service levels have been reduced. 
Mendonca nevertheless argued that Brazil was moving 
methodically and steadily, albeit slowly, in the right 
direction, having sustained a process of continual reforms 
for a decade through three administrations and two very 
different presidents. 
 
Comment 
------- 
 
¶11.  (SBU) The surprise election of dark horse candidate 
Severino Cavalcanti as Speaker of the House of Deputies 
appears to have reduced the ambition of the GoB's 2005 
reform agenda.  Lula's four priorities, only three of 
which require congressional action, slimmed down what had 
been expected.  Lula notably made no mention of Central 
Bank independence, a measure Cavalcanti has said he 
opposes, but which the Finance Ministry was pushing as a 
priority for the year.  While much can change quickly in 
the world of Brazil's congressional politics, 2005 looks 
to be a slow one for Brazil's microeconomic reform agenda. 
That said, we expect the Finance Ministry to find ways to 
push lower-profile technical measures and maintain 
positive reform momentum. 
 
DANILOVICH