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 003207 
 
SIPDIS 
 
SENSITIVE 
 
NSC FOR CRONIN 
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 - ECONOMY CONTRACTS, CRITICISM EXPANDS 
 
REF: A) BRASILIA 3150 
 
     B) BRASILIA 3092 
     C) BRASILIA 3043 
 
¶1. (SBU) Summary:  Brazil's economy contracted 1.2% in the 
third quarter of 2005, falling further than even the 
pessimists had predicted.  Growth expectations for the year, 
therefore, are being downgraded to the 2.3% to 2.7% range. 
The unexpectedly abrupt fall in GDP has intensified 
criticism of the Central Bank from across the political 
spectrum.  Prominent orthodox economists have joined the 
chorus of disapproval, arguing that the Central Bank was 
over-zealous in its monetary tightening earlier in 2005. 
While there is a palpable sense of disappointment here that 
Brazil will not repeat its strong 2004 GDP growth 
performance (4.9%), the new growth projections are not far 
below the 3% level that most analysts believe is Brazil's 
maximum sustainable (and non-inflationary) level of growth 
in the medium term absent significant reforms to increase 
productivity.  Moreover, growth in 2006 has a good chance of 
being stronger as current interest rate cuts spark a 
positive credit cycle and the GoB places greater emphasis on 
spending.  The lack of any progress on President Lula's 
microeconomic reform agenda in Congress and a clear downward 
trend in investments, however, suggest there is little hope 
for sustaining faster growth rates.  End Summary. 
 
¶2. (U) Brazil's economy contracted 1.2% in the third quarter 
of 2005, according to recently released GoB data.  Parsing 
the numbers, the quarterly growth data (see table below) 
show, on the demand side, declines in investment and 
government consumption.  The supply side saw sharp drops in 
agriculture (-3.4%) and industrial output (-1.2%), while 
services showed no movement (0% growth).  While overall 
export growth continued to be strong in spite of the 
appreciation of the Real, there is some evidence that price- 
sensitive agricultural exports, such as bulk grains, were 
damaged by the exchange rate; it also has contributed to a 
fall in planted area for the upcoming crop.  Along with 
exports, the only bright spot in the third quarter numbers 
was personal consumption, which grew 0.8%.  Private sector 
analysts now are predicting overall GDP growth for 2005 will 
be between 2.5% and 2.7%; the latest Central Bank poll of 
market expectations shows an average predicted growth of 
2.66%.  Meanwhile, a Planning Ministry think-tank (IPEA) has 
issued an even lower growth estimate of 2.3% for the year. 
 
 
                        Brazilian GDP 
            Percent Growth - Seasonally Adjusted 
 
 
                 Annual/1       Quarterly Growth/2 
               2003   2004    4Q04   1Q05    2Q05   3Q05 
 
Total GDP      0.5     4.9     0.8    0.2     1.1   -1.2 
 
Supply Side 
 - Agriculture 5.0     5.3     0.8    0.4     1.7   -3.4 
 - Industry   -1.0     6.2     0.9   -0.8     1.4   -1.2 
 - Services   -0.1     3.3     0.6   -0.2     1.2    0.0 
 
Demand Side 
 - Consumption 
   (Private)  -3.3     4.1     1.1   -0.2     0.9    0.8 
 - Govt.       0.6     0.1     0.5    0.3     0.9   -0.4 
 - Investment -6.6    10.9    -2.8   -3.1     4.7   -0.9 
 - Exports    14.2    18.0     4.4    2.8     2.6    1.8 
 - Imports    -1.9    14.3     3.6    2.5     1.9    1.4 
 
     /1 Percent Change on Previous Year 
     /2 Percent Change on Previous Quarter, Preliminary 
     Source: Statistical and Geographic Institute (IBGE) 
 
 
Chorus of Disapproval 
--------------------- 
 
¶3. (SBU) The negative growth result has intensified 
criticism of the Central Bank from across the political 
spectrum.  While not questioning the basic thrust of 
monetary policy, several prominent orthodox economists, 
among them former Central Bank President Arminio Fraga and 
former director Sergio Werlang, have criticized the extent 
of the Central Bank's interest rate hikes.  These saw the 
benchmark SELIC overnight rate jump to 19.75% and real 
interest rates reach about 13%, a level local economists 
claim are the highest of any major economy in the world. 
The Central Bank's monetary policy committee (COPOM) will 
almost certainly cut the SELIC target rate by 50 basis 
points at its December 13-14 meeting, to 18%, continuing its 
current cycle of monetary easing, which began in September. 
Some Central Bank directors have lashed out at the Brazilian 
Statistical and Geographic Institute (IBGE), questioning 
(with some justification) the reliability of the IBGE 
estimates.  Lula and Palocci both have publicly backed the 
Central Bank and its continued independence to set interest 
rates. 
 
Role of the Weak Dollar/Strong Real 
----------------------------------- 
 
¶4. (U) The strengthening Real, which in recent months has 
consistently traded at relatively appreciated levels against 
the dollar (a band between 2.15 and 2.3 Reals per dollar), 
may be beginning to affect price-sensitive agricultural 
exports.  There is anecdotal evidence that the strong Real 
is affecting investment decisions at the margins.  One 
recent prominent example was a decision by Arcelor, reported 
in the press on November 29, to cancel a joint venture 
project with Brazilian mining giant CVRD to build a steel 
plant in the state of Maranhao due to the strong Real, which 
reduced the expected competitiveness of the plant's export- 
destined production.  China's Baosteel, according to the 
press, also cited the appreciated Real when it called off 
its plans to construct a steel plant in the northeast. 
While these are only anecdotal data points, the fall in 
investments (-0.9%) in the third quarter IBGE data was the 
third such contraction in the last four quarters and 
suggests that investment is on a clear downward trend.  This 
raises concerns about the foundations for future growth. 
 
Will 2006 Be Better? 
-------------------- 
 
¶5. (SBU) Not all the data was negative.  Carlos Mussi, an 
economist with the United Nations Economic Commission for 
Latin America and the Caribbean, pointed out in a December 2 
meeting with Econoff that private consumption had posted 
good growth for the second consecutive quarter.  This 
consumption is being fueled in part by continued access to 
credit at lower interest rates available under new payroll 
deduction loans, which give banks greater assurance of being 
repaid.  He argued that falling interest rates, when 
combined with stable employment and higher personal incomes, 
have created the conditions for a positive credit cycle that 
could sustain increased personal consumption, laying the 
foundation for stronger growth in 2006.  This scenario gains 
credibility in light of a November poll which found consumer 
confidence to be at its highest level in recent years. 
 
¶6. (SBU) Growth in 2006 also should benefit from a fiscal 
stimulus over the next six to eight months.  Lula Chief of 
Staff Dilma Rousseff has led a political charge to force the 
Finance Ministry to spend (rather than save) any revenues 
above the primary surplus target, reportedly set informally 
by Lula and Palocci at between 4.6% and 4.7% of GDP 
(somewhat higher than the formal 4.25% of GDP target 
included in the budget).  The GoB was running a primary 
surplus well ahead of this level (at least 5.1% of GDP in 
the first nine months of 2005), cushioned by better than 
expected tax revenues, which creates room for substantial 
end-of-year spending without endangering overall fiscal 
restraint.  There also will be pressure to obligate as much 
money as possible during the first six months of the 2006 
election year, after which point election-related limits on 
signing large new contracts go into effect until after the 
October 2006 election.  The extent to which significantly 
increased expenditures on investment projects is possible is 
debatable, however, as the GOB's administrative capacity to 
spend is severely handicapped by its dysfunctional 
bureaucracy.  While it is true that Palocci has been stingy 
in handing out funding to the ministries, many agencies have 
proven unable to spend a significant portion of the public 
investment monies they have received. 
 
¶7. (SBU) Comment: Lula's more forceful recent backing of his 
finance minister and efforts to plaster over differences 
within his administration on fiscal policy mitigate the 
concern that Palocci might be forced out in a policy 
disagreement, despite the poor third quarter GDP result. 
While December 6 statements by Lula to the effect that there 
will be "adjustments" in GOB macroeconomic policy on the 
surface sound ominous, in the end it will be the ultra- 
orthodox Ministry of Finance and Central Bank that implement 
any adjustment (likely in the manner they see fit).  Palocci 
nevertheless remains vulnerable should evidence emerge to 
support the many allegations of wrongdoing made against him 
(refs B and C), as this would likely would lead to his 
departure.  Specifically, his upcoming mid-December 
appearance before the congressional committee investigating 
illegal bingo operations could prove particularly difficult. 
To date, his previous two congressional appearances have 
been softball affairs in front of the upper and lower house 
economic committees. 
 
¶8.  (SBU) Even political survival, however, may be cold 
comfort for Palocci should the economy continue to perform 
as poorly as it did last quarter.  And, while there is clear 
potential for 2006 to be a better year for Brazilian 
economic growth than 2005 now looks to be, the falling 
investment trend and death of Lula's microeconomic reform 
agenda exacerbate concerns about the sustainability of 
robust growth levels.  Look for continued middling economic 
performance from Brazil into the medium term. 
 
LINEHAN