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 001682 
 
SIPDIS 
 
SENSITIVE 
 
STATE PASS USTR 
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
SUBJECT: BRAZIL - THE ECONOMICS OF A POLITICAL CRISIS 
 
REF: A) BRASILIA 1456 
     B) BRASILIA  521 
     C) BRASILIA 1631 
     D) BRASILIA 1290 
     E) BRASILIA  682 
     F) BRASILIA 1662 
 
¶1. (SBU) Summary:  Rattled by a mounting scandal over 
alleged Lula administration vote-buying in the Congress, the 
GoB has, among other measures, attempted to shore up support 
among the economic elite by enacting a decree to remove 
certain taxes on capital investments by exporters.  The 
scandal has toppled Lula's powerful Chief of Staff (ref C) 
and will likely hasten the planned departure of Central Bank 
President Henrique Meirelles, currently under investigation 
on unrelated tax charges (ref D).  Financial markets have 
hardly blinked: the GoB placed USD 600 million in Eurobonds 
on June 20 at lower interest rates than it had been able to 
obtain in a February 2005 offering and the Real has resumed 
its pre-scandal appreciation against the dollar.  The GoB 
also is trying to shift the public's focus by proposing a 
dramatic tightening of fiscal policy, which it hopes would 
create space for large reductions in Brazil's unpopular high 
interest rates.  The political scandal, however, makes it 
extremely unlikely that the GoB will be able to obtain 
passage of these fiscal measures, a critical piece of which 
must be approved by a three-fifths majority of Congress. 
The GoB's broader microeconomic reform agenda (ref B) is in 
similarly difficult straits.  Without significant reforms, 
however, expect GDP growth in the election year of 2006 to 
be only marginally better than the modest growth expected 
this year (2.5% to 3.0%).  End Summary. 
 
Central Bank President a Lame Duck 
---------------------------------- 
 
¶2. (SBU) Along with the downfall of President Lula's 
powerful chief of staff Jose Dirceu, the vote-buying scandal 
(ref C) looks likely to hasten the departure of Central Bank 
President Henrique Meirelles.  Meirelles is under 
investigation by the Supreme Court on charges, unrelated to 
the scandal, i.e., that he evaded taxes, engaged in illegal 
money transfers and violated electoral laws in his 2002 
Congressional campaign (ref D).  While Meirelles long had 
been planning to leave the Central Bank by end-August to 
prepare his planned run for governor of Goias state in 2006, 
the vote-buying scandal has made his tenure at the Central 
Bank less tenable.  The leading candidate to replace 
Meirelles, Vice Finance Minister Murilo Portugal, who was 
Brazil's Executive Director at the IMF until April, has a 
sterling reputation as a fiscal and monetary conservative 
and would likely maintain Bank policies along the lines set 
by Meirelles and his team. 
 
¶3. (U) Accordingly, financial markets have been taking the 
political scandal in stride.  After an initial wobble, the 
Real has resumed its trend of appreciation against the 
dollar (ref A), and is close to its three-year high against 
the dollar.  On June 20, the GoB placed a $600 million ten- 
year Eurobond at a spread of a mere 363 basis points over 
U.S. treasuries.  By comparison, the yield on this bond 
offering, 7.73%, was down from the 7.9% yield on Brazil's 
February $1 billion offer, although the spread over U.S. 
treasuries on that offer was 10 basis points lower. 
 
Pork over Payola 
---------------- 
 
¶4. (SBU) The GoB moved quickly after the scandal broke to 
try to shore up its support with industry by speeding up the 
issuance of a Provisional Measure (MP), previously under 
consideration, which creates a grab-bag of goodies for 
several sectors.  (Note: MPs are a form of executive decree 
with immediate force of law, but which nevertheless require 
congressional ratification to become permanent legislation.) 
MP 252, issued by Lula on June 15, enacts a series of 
changes in the tax system to benefit multiple sectors.  The 
"Recap" tax regime would suspend certain taxes on the sales 
and importation of capital goods for firms of which 80 
percent or more of revenues are export-related, while the 
"Repes" provides specific exemptions for software and IT 
exporters.  The MP also makes more flexible a tax credit 
regime applicable to capital investments.  Some Brazilian 
analysts have questioned the WTO-consistency of the tax 
benefits for exporters; see septel for an unofficial 
translation of the relevant provisions. 
 
¶5. (SBU) MP 252 also enacts tax measures to help the 
construction industry, including an income tax exemption on 
the capital gains on the sale of a home if the seller buys a 
new home of equal or greater value within 180 days.  In 
conjunction with several related MPs, MP 252 also seeks to 
create incentives for innovation by doubling tax deductions 
on the amount a firm spends for research and development. 
While Congress has not yet acted on MP 252, given the 
popularity of tax cuts the measure, in some form, is likely 
to be approved. 
 
¶6. (SBU) The Finance Ministry has estimated the cost of MP 
252, in foregone revenues, at 1.5 billion Reals this year 
(approximately $625 million) and 3.3 billion Reals ($1.3 
billion) next year.  Despite the measure's cost, there is 
little risk that the GoB will not meet its primary surplus 
target.  Revenues continue to grow faster than GDP and the 
GoB retains discretion not to spend amounts authorized in 
the budget.  Moreover, IMF Resident Representative Max Alier 
and UN economist Carlos Mussi emphasized to Econoff that, 
even if it wanted to, the GoB would find it hard to try to 
"buy" its way out of the scandal.  Fiscal Responsibility Law 
(LRF) provisions requiring that new spending be matched with 
a funding source are not easily bypassed, Alier argued. 
Mussi observed that, to avoid even the hint of impropriety, 
the knee jerk response of Lula's orthodox-minded economic 
team to a political crisis will be to trend even more 
conservative on spending decisions.  Others within the GoB 
have made much the same point; i.e. with macroeconomic 
stabilization and the resumption of economic growth 
representing the principal achievement to date of the Lula 
administration, the president is loathe to tinker with his 
orthodox macroeconomic policies. 
 
Fiscal Policy to Attack Interest Rates 
-------------------------------------- 
 
¶7. (SBU) To reaffirm its credentials with the market -- and 
attack a principal cause of roundly unpopular high interest 
rates -- the GoB is debating a relatively bold series of 
fiscal measures to tighten fiscal policy.  Principal among 
these is moving, over the course of four to five years, from 
targeting a primary surplus to an overall balanced budget 
(nominal deficit of zero).  The idea, which has some 
traction with fiscally conservative elements in Congress, is 
to create space for dramatic interest rate reductions in the 
medium term by significantly reducing the GoB's borrowing 
requirements.  This would reduce crowding out of credit to 
the private sector and allow interest rates to fall. (Note: 
Many other factors also influence Brazil's infamously high 
real interest rates -- see ref E.) The plan's proponents 
(among them Federal Deputy and former Finance Minister 
Delfim Netto) argue that falling interest rates would have a 
"virtuous circle" effect, and by reducing GoB interest 
costs, further reduce the borrowing requirement. 
 
¶8. (SBU) For the plan to work, the GoB would require greater 
flexibility in prioritizing expenditures and the ability to 
use a greater proportion of revenues for debt service. 
Currently, the vast majority of GoB revenues are subject to 
constitutional earmarks and revenue sharing requirements 
with state and municipal governments.  The GoB would have to 
obtain Congressional support for a constitutional amendment 
enlarging the current de-earmarking measure (or DRU, in its 
Portuguese acronym) from 10% of overall federal revenues to 
20% or 30% of revenues.  Moreover, not all of the mooted 
measures have GoB-wide support.  While supporting a move 
towards a nominal fiscal balance, the Finance Ministry has 
pointed out that a strict target would require volatile 
primary expenditure patterns if the GoB had to act to offset 
sudden interest rate and exchange rate shifts.  For similar 
reasons, in a conversation with Econoff, the IMF's Alier 
also questioned the wisdom of a firm nominal balance target. 
The overall idea of using greater fiscal restraint and 
expenditure flexibility to create room to reduce interest 
rates, however, has found a sympathetic audience among 
politicians and businessmen weary of sky-scraping interest 
rates. 
 
Comment 
------- 
 
¶9. (SBU) A significant part of the GoB's response to the 
political vote-buying scandal has focused on economic 
policy, which is at best a secondary tool in dealing with 
the problem.  Nevertheless, it is to the GoB's credit that 
its proposed reforms to attack (unpopular) high interest 
rates are grounded in orthodox economics.  Moreover, its 
pork-barrel MP will not vitiate its ability to meet its 
primary surplus targets.  But, with a poisoned congressional 
atmosphere, it is difficult to see the GoB obtaining passage 
of any significant legislation to tighten fiscal policy, 
much less getting the three-fifths majority necessary to 
modify constitutional earmarking requirements.  In addition, 
Lula's microeconomic reform agenda (ref B) looks dead, with 
the exception of measures that do not require congressional 
action, such as implementation of already-approved public- 
private partnerships (PPPs).  Without significant reforms, 
however, GDP growth next year should not be much better than 
this year's expected 2.5% to 3.0%.  All of this must weigh 
heavily on the mind of a reelection-minded President, who, 
absent some unexpectedly deft political management, is in 
danger of becoming seriously politically weakened with more 
than a year to go before the 2006 elections. 
 
DANILOVICH