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

UNCLAS SECTION 01 OF 03 BRASILIA 000682 
 
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 ETRD PGOV EIND BR
SUBJECT: BRAZIL'S STEELY MONETARY POLICY 
 
REF: A) 04 BRASILIA 3115 
     B) 04 BRASILIA 3100 
     C) BRASILIA 417 
     D) SAO PAULO 193 
 
This cable is Sensitive but Unclassified, please protect 
accordingly. 
 
¶1.   (SBU) The GoB published a decree March 4 reducing to 
zero the import tariff on fifteen different categories of 
steel.  The measure is temporary and does not represent a 
general liberalization, but rather is aimed at containing 
inflationary pressures driven by price increases in steel 
and other major industrial inputs.  Dealing with these 
inflationary pressures has proven difficult for the GoB, 
despite the Central Bank's elevation of interest rates to 
18.75%, in a cycle of monetary tightening beginning in 
September 2004.  Despite the monetary tightening, and a 
concurrent 10% appreciation of the Real, inflationary 
expectations have hardly budged.  This may be in part 
because current inflationary pressures, concentrated on 
the supply side, differ from previous episodes.  The small 
percentage of credit in the economy, much of which is 
directed to certain sectors or loaned at fixed rates by 
the development bank, limits the influence of Central Bank 
interest rate changes on the course of the overall 
economy.  The episode highlights the need for financial 
market reform and broader, permanent import liberalization 
to increase competition in the economy.  End Summary. 
 
Inflationary (and Political) Bias 
--------------------------------- 
 
¶2.   (SBU) In December 8, 2004 conversation (ref A), 
Central Bank President Meirelles complained to the 
Ambassador about the inflationary bias in the Brazilian 
economy, and specifically about steel prices.  Meirelles 
argued that this bias was a legacy of Brazil's hyper- 
inflationary past, when businesses tried to earn money by 
raising prices faster than wages could adjust.  In 
January, President Lula echoed Meirelles' argument (made 
in private to the Ambassador), when he publicly criticized 
industry for increasing prices, blaming them for keeping 
inflationary expectations alive and forcing the Central 
Bank to raise interest rates higher than it would 
otherwise need.  It was during that attack that Lula first 
publicly threatened to liberalize imports to restrain 
price increases.  (Note: Brazil, while a major steel 
exporter, has imported between USD 456 million and USD 550 
million worth of steel products annually over the last few 
years.  End note.) 
 
What has Inflation Been Doing? 
------------------------------ 
 
¶3.   (SBU) After spiking in 2002 due to the effects of 
currency devaluation, recently Brazilian inflation has 
been under control.  The consumer price index (IPCA) 
peaked in 2002 at 12.5%, falling to 9.3% in 2003 and 7.6% 
in 2004.  While not high in historical terms, this 
inflation has reacted stubbornly to Central Bank interest 
rate hikes meant to bring inflationary expectations in 
line with the 5.1% target for 2005.  The Central Bank has 
raised its benchmark interest rate on overnight borrowing 
(the SELIC) by 2.75 percentage points, from 16% in 
September 2004 to the current 18.75%.  Private sector 
inflationary expectations for 2005 (measured by Central 
Bank surveys of financial institutions that run their own 
forecasting models), however, have hovered in a band of 
about 5.7% to 5.95% during the period of adjustment.  The 
Central Bank, for its part, has declined to revise upward 
its target, perhaps fearing -- as the local IMF ResRep 
recently confided to Emboffs -- that it needs to get 
inflation as low as possible this year as 2006 is an 
election year. 
Is This Inflation Different? 
---------------------------- 
¶4.   (U) The interest rate hikes in particular have been 
profoundly unpopular, and rekindled debate about the 
effectiveness of Brazil's inflation targeting regime and 
monetary policy tools (i.e. targeting inflation using the 
SELIC benchmark interest rate).  Even some supporters of 
the inflation targeting regime and the GoB's orthodox 
policy line have begun to debate what lies behind the 
current inflationary stickiness and whether the SELIC is 
the right tool for achieving the target.  For example, 
former Central Bank President Gustavo Franco has argued 
that recent inflationary pressure has been characterized 
by small supply shocks (such as the steel price increases 
that sparked Lula's and Meirelles' ire), the costs of 
dealing with exchange rate volatility and the high cost of 
credit itself. 
 
Limits of Current Monetary Policy Tools 
--------------------------------------- 
 
¶5.    (U) In addition to the nature of the current 
inflationary pressures, several structural elements in the 
financial system tend to limit the effectiveness of 
Central Bank interest rate changes on overall economic 
activity.  First, credit as a percent of the economy is 
low, at 26.3% of GDP in January 2005.  This is down over 
ten percentage points over the last decade, albeit on a 
recent upward trend.  Many businesses, particularly those 
that do not have access to lower interest rate foreign 
currency loans, tend to self-finance investment out of 
retained earnings. 
 
¶6.   (U) The amount of credit directly influenced by the 
SELIC is further reduced by the existence of "directed 
credit," which, according to Central Bank data, makes up 
about 36% of all credit.  Over half of all directed credit 
is long term financing granted by the National Development 
Bank (BNDES) at a GoB-set rate (the TJLP, currently 
9.75%), which does not reflect changes in market interest 
rates.  The remainder of directed credit consists of 
agricultural credits (30%) and housing credits.  These 
latter two categories of credit have below-market floating 
interest rates that track the overall direction of market 
interest rates.  These directed credits are among the 
villains that account for Brazil's infamously high lending 
spreads. 
 
¶7.   (U) Other, likely less significant factors limiting 
the effectiveness of monetary policy are the effects of 
recent microeconomic reforms designed to enhance access to 
credit, including the 2003 creation of payroll-deduction 
loans.  While payroll-deduction loans work to increase the 
aggregate amount of credit -- which, all things being 
equal, would tend to make interest rate targeting more 
effective -- like BNDES lending, these particular loans 
have commanded far lower interest rates than normal 
personal loans.  A similar measure that would use social 
security pension benefits to secure loan repayments is 
under implementation.  Franco further pointed out that 
Brazilian consumers, in particular, have become so inured 
to scandalous interest rates that a change of only a 
couple points has very limited impact on consumption 
decisions.  Taken together, these factors reduce the 
impact that the price of overnight credit, embodied in the 
SELIC, has on much of the economy. 
 
Need More Competition 
--------------------- 
¶8.   (U) One factor that the public debate has not focused 
on is the existence of cartels in many sectors of the 
economy, making prices stickier (ref D).  While the GoB is 
cognizant of the existence of such, and domestic air 
carriers (traditionally one of the economy's high tariff 
sectors) have recently launched a price war, the 
government's plans to improve competition policy and anti- 
monopoly efforts are longer term (septel).  Thus the 
decision to liberalize steel imports, in an attempt to 
boost competition and reduce prices in a more relevant 
timeframe.  Industry reaction has been mixed, with car 
manufacturers and other steel consumers welcoming the 
opportunity to negotiate with foreign suppliers as 
leverage in price negotiations with domestic steel 
suppliers, while the steel industry predictably has 
dissented. 
 
Comment 
------- 
 
¶9.   (SBU) Despite the debate over the effectiveness of 
the SELIC and, secondarily, the inflation-targeting regime 
itself, the GoB does not intend to abandon either. 
Moreover, attitudes in the financial markets may be 
catching up those in the Central Bank.  The IMF Resident 
Representative observed to Econoffs March 8 that over the 
last month financial market participants have begun 
revising their views that the Central Bank would be forced 
to abandon the 5.1% inflation target for the year as 
unrealistic.  That said, the episode highlights the 
importance of further microeconomic reform of the 
financial system, particularly to eliminate directed 
credits and to make BNDES interest rates more closely 
reflect monetary policy objectives.  While some financial 
system reforms, such as measures enhancing access to 
credit, may work against the effectiveness of the SELIC in 
the short term, over the medium and longer term they 
should help create a more rational financial system, and 
one that ultimately will respond more readily to smaller 
interest rate changes by the Central Bank.  Import 
liberalization, however welcome, will not contribute much 
towards that goal until it becomes broader-based and is 
made permanent. 
 
DANILOVICH