VZCZCXRO4179
PP RUEHRG
DE RUEHBR #0366/01 0521958
ZNR UUUUU ZZH
P 211958Z FEB 06
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 4596
INFO RUEHRG/AMCONSUL RECIFE 4370
RUEHRI/AMCONSUL RIO DE JANEIRO 1575
RUEHSO/AMCONSUL SAO PAULO 6424
RUEHAC/AMEMBASSY ASUNCION 5247
RUEHBU/AMEMBASSY BUENOS AIRES 3813
RUEHMN/AMEMBASSY MONTEVIDEO 6073
RUEHSG/AMEMBASSY SANTIAGO 5359
RUEHCV/AMEMBASSY CARACAS 3142
RUEHME/AMEMBASSY MEXICO 1931
RUEHQT/AMEMBASSY QUITO 1741
RUEHPE/AMEMBASSY LIMA 2870
RUEHLP/AMEMBASSY LA PAZ 4393
RUEHBO/AMEMBASSY BOGOTA 3623
RHEHNSC/NSC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC

UNCLAS SECTION 01 OF 04 BRASILIA 000366 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
NSC FOR CRONIN 
TREASURY FOR OASIA - DAS LEE, 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 
STATE PASS USAID FOR LAC 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EINV PGOV BR
SUBJECT: BRAZIL - THE EVER-RISING REAL AND OTHER MACROECONOMIC 
TIDBITS 
 
REF: A) 05 BRASILIA 3207 
 B) 05 BRASILIA 3306 
 C) BRASILIA 0327 
 
¶1. (SBU) Summary:  The torrent of dollars entering Brazil, fueled 
primarily by the trade surplus (over $44 billion in 2005) but also 
by FDI and portfolio investment flows, has created both 
opportunities and challenges for Brazilian macroeconomic policy 
management.  GoB and private debtors are making use of the strong 
Real, which is trading at its most appreciated level since 2001, to 
pay down external or dollar-linked debt.  As of February 9, the GoB 
had repurchased US$2.3 billion of its dollar-denominated external 
bonds.  Investor perceptions of Brazil risk are at record lows 
despite the uncertainties associated with presidential elections in 
October.  Taking advantage of this situation, the GoB has moved to 
improve its debt profile further by cutting taxes on foreign 
portfolio investment in domestically issued GoB bonds.  Industry, on 
the other hand, is complaining loudly that the strong Real is 
cutting into export competitiveness and profits.  They are behind a 
bill introduced in Congress which would liberalize the rules for 
foreign exchange transactions, eliminating a requirement that all 
revenues from exports be converted into Reais (ref C).  More 
generally, the exchange rate and monetary policy already are shaping 
up to be an important point of the economic policy debate in this 
election year.  End Summary. 
 
The Real is Real Strong 
----------------------- 
 
¶2. (SBU) Strong dollar inflows continue to move the Brazilian Real 
to record (medium-term) levels.  On February 20, the Real traded at 
around 2.11 to the dollar, its most appreciated level (in nominal 
terms) since 2001.  Underpinning this performance are strong trade 
and current account balances, the latter reaching US$14.1 billion or 
1.4% of GDP in 2005.  Foreign Direct Investment (FDI) brought in 
another US$15.2 billion or 1.9% of 2005 GDP, reinforced by a further 
US$6.6 billion in net portfolio investment inflows, the latter 
attracted in part by high real interest rates.  (While in September 
2005 the Central Bank began to lower nominal interest rates from 
their recent peak of 19.75%, market analysts expect that the 
benchmark SELIC rate will only reach 15% by year's end -- which 
would translate into a still high real interest rate of about 10%, 
given inflation expectations of about 4.5% for 2006.) 
 
¶3. (SBU) The Central Bank continues to purchase dollars in both the 
spot and futures markets to build up reserves, which stood at 
US$57.27 billion on February 20 (even after the December prepayment 
of US$17 billion to the IMF).  Separately, the Finance Ministry has 
pre-purchased US$9 billion to service external debt payments through 
June 2006.  While a convenient device to brake the Real's upward 
momentum, these GoB dollar purchases were never intended to be 
full-scale interventions in the currency market and have slowed the 
Real's appreciation only marginally and temporarily.  Moreover, the 
Central Bank expects further appreciation, according to a recent 
study -- the contents of which were shared with Econoffs by a Trade 
Ministry contact -- which posits that the Real/Dollar exchange rate 
will drop below 2 to 1 in the coming weeks/months.  According to 
that document, the Central Bank did not plan to intervene in the 
market to prevent this.  Separately, one ex-Finance Ministry 
official has predicted publicly that after breaching the R$2 barrier 
in March, the Real will drift towards the R$1.90 level -- the next 
psychological support point. 
 
Debt Buy Back(s), Brazil Risk to Record Lows 
-------------------------------------------- 
 
¶4. (U) The GoB is taking advantage of the strong Real to improve its 
debt profile in several ways.  Along with the December 2005 IMF 
 
BRASILIA 00000366  002 OF 004 
 
 
pre-payment, the GoB has announced a prepayment of its rescheduled 
Paris Club debt (ref B) and revealed that it had repurchased on 
secondary markets US$2.3 billion of its international bonds.  A 
Finance Ministry press statement suggested that the GoB might 
repurchase as much as US$20 billion, including all of its Brady bond 
debt maturing over the 2006-2010 period.  The GoB already has 
eliminated its exposure to dollar-linked domestic debt, removing a 
vulnerability that plagued Lula's macroeconomic team during the 2002 
financial market crisis of confidence.  These moves to improve the 
debt profile are part of the Finance Ministry's campaign to obtain 
an investment grade credit rating, a goal which would substantially 
reduce the GoB's financing costs. 
 
¶5. (U) Reflecting the positive external scenario and debt profile 
improvements, investor perceptions of Brazil risk have fallen. 
Brazil's EMBI+ index, which measures these perceptions, hit an 
all-time low of 226 on February 10, 2006. 
 
Tax Cuts for Foreign Portfolio Investment 
----------------------------------------- 
 
¶6. (U) On February 15, 2006, the GoB issued Provisional Measure (MP) 
281 exempting foreign investment in government securities (and in 
venture capital funds) from Brazilian income tax.  (Note: MPs are a 
peculiar form of executive decree with immediate force of law, but 
which nevertheless must be ratified by Congress to become 
permanent.)  Brazilian Treasury Secretary Joaquim Levy, the primary 
force behind the MP, said the principal goal of the measure is to 
increase the demand for domestically-issued Real-denominated 
government bonds by reducing transactions costs for foreigners.  To 
date, the GoB has been able to obtain better terms (i.e. longer 
maturity, fixed interest rates) on its overseas issuances, including 
its Real-denominated bonds launched in the fourth quarter of 2005. 
The GoB hopes increased demand will help improve the profile of its 
domestic debt.  As noted above, while it has eliminated its 
dollar-indexed domestic debt from its portfolio (much of which was 
replaced with debt linked to the SELIC), the GoB has made only 
incremental progress in moving away from SELIC-linked bonds, which 
still make up about half of its portfolio of domestically-issued 
securities. 
 
¶7. (U) Meanwhile, the sensitivity of the GOB's stock of domestic 
debt stock to variations in the benchmark SELIC overnight rate has 
complicated fiscal and monetary policy-making as last year's series 
of Central Bank interest rate hikes have had a big impact on the 
GoB's fiscal accounts.  This increased reliance on SELIC-linked debt 
meant that 2005 interest expenditures were up significantly (by over 
1% of GDP) from 2004 due to the Central Bank's cycle of monetary 
tightening in 2005.  The GoB hopes an influx of foreign portfolio 
investment will help overcome the apparent reluctance of domestic 
investors in government bonds to move to inflation-indexed or fixed 
rate issues.  By limiting the tax exemption to bonds which are not 
pledged in repurchase agreements, MP 281 aims to mitigate the risk 
of the tax rollback creating additional opportunities for 
speculators to bet against the Real during a financial crisis. 
Neither does the exemption apply to investment from countries 
without income tax (i.e. offshore tax havens) nor those where income 
is taxed at a rate of less than 20%. 
 
¶8. (U) Whether the tax cut will indeed attract substantial inflows 
of new foreign portfolio investment, as the GoB hopes, is another 
story.  The February 17 "Folha de Sao Paulo" reported that among 
Wall Street analysts the reaction to this move was mixed.  One 
analysts was quoted as saying that all MP 281 does is to eliminate 
Brazilian taxes for investors from those countries, like the U.S., 
which do not have a double-taxation treaty with Brazil.  Another 
pointed out that as Argentina and Mexico already have adopted 
similar measures, Brazil was merely keeping pace with these two 
 
BRASILIA 00000366  003 OF 004 
 
 
countries. 
 
Industry Unhappy -- Dutch Disease? 
---------------------------------- 
 
¶9. (SBU) The same influx of foreign portfolio investment that the 
GoB hopes to attract with MP 281 worries industry groups, which 
already were unhappy with the appreciated Real and prevailing high 
interest rates.  They have criticized the new tax exemption, noting 
that it increases the risk of currency appreciation.  They argue 
that further strengthening of the Real, which many expect to occur, 
will continue to cut into export competitiveness and profit margins. 
 Some local economists worry that the exchange rate is affecting 
investment decisions at the margins by reducing the expected 
profitability of new investments in tradable goods -- thus 
negatively impacting future economic growth.  Raul Velloso, an 
economist with links to the opposition PSDB party, suggested to 
Econoff that the China-driven growth in commodity exports was 
creating a Dutch disease-like effect with respect to Brazilian 
industrial production, both of manufactured exports and 
import-competing products.  Though manufactured exports nevertheless 
grew strongly in 2005, he argued they could not continue to do so, 
given the unfavorable exchange rate.  One potential early sign of 
these effects is that, according to one study, many small and medium 
businesses stopped exporting in 2005 even as large companies 
(Motorola, Nokia, Volvo, Siemens, Alstom, Samsung) with greater 
management and financial capabilities boosted their exports strongly 
(all by over 100%). 
 
¶10. (U) Industry is sponsoring its own legislative changes, working 
through congressional allies to introduce a bill to liberalize the 
foreign exchange regime (ref C).  The bill would remove requirements 
that exporters convert all their foreign currency export proceeds 
into Reais, allowing them instead to hold domestic foreign-currency 
denominated bank accounts.  This would, they hope, both reduce 
transaction costs and relieve some of the appreciation pressure on 
the Real. 
 
¶11. (SBU) Comment:  While the Real's vigor is in many senses a "rich 
man's problem," reflecting the underlying strengths of the Brazilian 
economy, it is shaping up to be a divisive political issue in this 
presidential election year, marking the boundary between Brazil's 
more economically interventionist-minded candidates and those who 
advocate a hands-off exchange rate policy approximating the status 
quo.  Finance Minister Palocci has been notable for his absence from 
the current controversy over the strength of the Real, letting Levy 
be the public face of the ministry in making the case for the tax 
exemption to skeptical industry groups.  After months of 
scandal-dodging and continued rumors about his exit from the 
ministry to run for Congress and/or manage Lula's campaign, 
Palocci's reticence may simply indicate a desire to adopt a lower 
profile for a while. 
 
¶12. (SBU) However, the issue that will receive the most focus among 
the press and the candidates is the high prevailing interest rates. 
Everyone is in favor of a faster reduction in interest rates -- 
except, of course, the GoB economic team (i.e. Central Bank Chief 
Meirelles and FinMin Palocci).  The common refrain is that a 
speedier pace of rate cuts would help on the exchange rate side by 
slowing the appreciation of the real.  Still, Meirelles and Palocci 
resist this for fear of reawakening the Brazilian economy's 
traditional nemesis: inflation.  While decisions on the path forward 
will be difficult, in many ways Brazil is fortunate to face such a 
choice.  Economic success has now provided the country with greater 
freedom to choose among available fiscal and monetary policy tools. 
The next government's macro-economic team may find, though, that 
greater freedom to choose necessarily brings along with it greater 
freedom to make mistakes. 
 
BRASILIA 00000366  004 OF 004 
 
 
 
LINEHAN