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RUEHC/USDOC WASHDC
RHEHNSC/NSC WASHDC

C O N F I D E N T I A L SECTION 01 OF 03 BRASILIA 000961 
 
SIPDIS 
 
SIPDIS 
 
NSC FOR CRONIN 
TREASURY FOR OASIA - DAS LEE, DDOUGLAS 
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/SHUPKA 
STATE PASS USAID FOR LAC 
 
E.O. DECL:05/16/2016 
TAGS: ECON EFIN PGOV PREL BR
SUBJECT: BRAZIL - CENTRAL BANK RESOLUTE IN FACE OF INTEREST RATE 
FLAK FROM FINANCE MINISTER 
 
REF: A) BRASILIA 0665 
      B) BRASILIA 0790 
      C) BRASILIA 0888 and previous 
 
Classified by Economic Counselor Bruce Williamson, reasons 1.4 
(b) and (d). 
 
¶1. (C) Summary:  Over the weekend of May 6-7, newly-appointed 
Finance Minister Guido Mantega made statements to the press 
which appeared to condition positive relations between the 
Finance Ministry and the Central Bank (BCB)on continued CB 
interest rate reductions.  The Bank's Monetary Policy Director, 
Rodrigo Azevedo, told Emboff that the CB was confident of its 
direct line to President Lula and is not allowing political 
pressure to play a part in interest rate decisions.  Another 
Bank official stated to us that the CB no longer pays any 
attention to Mantega's "artless" declarations.  While the 
markets have taken all this in stride and appear to have 
discounted occasional Mantega outbursts on interest rates as 
inconsequential, there is a more serious subtext here, involving 
the debate over policies to be pursued in a potential second 
Lula administration.  While Lula is unlikely to meddle much with 
the broad outlines of macroeconomic policy were he to win a 
second mandate, his ability to pursue substantial microeconomic 
reform, particularly to address urgent fiscal and tax reforms, 
is in doubt.  Under this scenario, look for the Brazilian 
economy to continue simply muddling through.  End Summary. 
 
¶2. (U) Over the weekend of May 6-7, Finance Minister Mantega, 
who has been in the job for about a month-and-a-half, made 
remarks to the press suggesting that the tenor of his 
relationship with the Central Bank would depend on continued 
decisions by the BCB to reduce the overnight benchmark rate (the 
SELIC), which currently stands at 15.75%.  The BCB has reduced 
rates in each of its meetings since September 2005, when the 
SELIC stood at 19.75%, in response to falling inflation 
expectations.  Most analysts expect the cycle of monetary 
loosening to continue.  According to a May 12 Central Bank 
survey, financial market institutions expect the SELIC to be 
lowered to 14% by the end of 2006.  (Note: Given market 
inflation expectations of 4.5% for 2007, this would still mean a 
forward-looking real interest rate of almost 10%.) 
 
¶3. (C) During his first couple of weeks on the job, Mantega was 
careful to minimize his previous criticisms of BCB interest rate 
policy, made while in his prior positions as Planning Minister 
and then as President of the National Development Bank (BNDES) 
(Ref A).   More recently, however, he has made some remarks that 
Central Bank Investor Relations Department Head Pedro Fachada 
termed "artless."  In a joint television interview with Bank 
Monetary Policy Director Rodrigo Azevedo, Mantega stated the 
only problem with Brazil's economy right now was the appreciated 
exchange rate, a statement which Fachada said had led to 
elicited pointed questioning on what Brazil's future exchange 
rate policy might be.  This was followed by Mantega's May 6-7 
pronouncement, which appeared to premise good institutional 
relations between the Finance Ministry and BCB on continued rate 
hikes.  Bank President Meirelles, who at the time was in Basel 
for Bank for International Settlements (BIS) meetings, 
reportedly stated that the Central Bank listens to the Finance 
Minister but makes its interest rate decisions based on 
technical criteria, not political ones. 
 
Does Mantega's Mouthing-Off Matter? 
----------------------------------- 
 
¶4. (C) Azevedo told Econoff May 9 that the Central Bank is 
confident of its new, direct line to President Lula.  Even 
 
BRASILIA 00000961  002 OF 003 
 
 
though the Bank "heard" Mantega's statements, monetary policy 
decisions, he affirmed, would continue to be made on technical 
grounds.  Fachada was dismissive of Mantega in a later 
conversation with Econoff, stating that the Bank was, 
essentially, ignoring Mantega.  What Mantega says about exchange 
rates and monetary policy, Fachada declared, is no longer 
relevant.  The nominations of the two new Central Bank directors 
(both reputable economists) were moving forward without 
political interference; they should have confirmation hearings 
soon, according to Fachada.  IMF Resident Representative Max 
Alier stated to Econoff May 16 that Mantega was simply a 
caretaker in the portfolio, and would not be allowed to affect 
BCB policy decisions. 
 
¶5. (C) UN Economist Carlos Mussi reinforced these points in a 
May 10 meeting, noting that Meirelles has become a de facto 
cabinet minister, reporting directly to the President. 
Moreover, since Meirelles is expected to leave at the end of the 
year when the new administration takes office, Mussi stated, he 
has little to lose in asserting forcefully the BCB's 
independence.  Financial markets, moreover, have hardly batted 
an eye, with the Real remaining strong and measures of Brazil 
risk fluctuating little.  Mussi argued that the stage is set for 
interest rate and exchange rate policy to continue as they have 
through the elections.  On the fiscal side, the GoB would be 
practicing more expansionary fiscal policy on the margin as 
Mantega would ensure the GoB did not over-perform the 4.25% of 
GDP primary surplus target, according to Mussi.  Mantega, 
however, is not politically strong enough to lower the 4.25% 
target, as perhaps he and other PT cadre would like, Mussi 
argued. 
 
But longer Term is a Question Mark 
---------------------------------- 
 
¶5. (C) But the public jockeying back and forth has raised 
questions about economic policy in a second Lula term.  In 
Mussi's evaluation, Mantega either fails to understand or does 
not really care about the importance of reducing the debt-to-GDP 
ratio.  He noted that Former Finance Minister Palocci had been 
able to manage the natural tensions of Lula's "Popular 
Orthodoxy" economic policies, i.e., orthodox macroeconomic 
policies combined with increased spending on social programs. 
Lula and Palocci had been aided by a benign inflationary 
environment as well, Mussi stated, which allowed freer spending. 
 Without Palocci, however, and with only de facto Central Bank 
independence, Mussi was concerned that there were no candidates 
to step in and play the role of advocate for sound orthodox 
policies in a potential Lula second term.  Meanwhile, other 
analysts have expressed misgivings to Post about Mantega's 
economic instincts should a crisis occur. 
 
¶6. (C) There are several "structural" problems which may create 
rougher sledding ahead for Lula's second term, according to 
Mussi.  First is the potential shortfall in power generation 
capacity foreseen for the 2009/2010 time frame (this could 
happen earlier if a gas cutoff or shortage results from the 
current impasse with Bolivia - ref B.)  Second, Mussi is worried 
that agricultural producers, whose earnings have been squeezed 
by the appreciated exchange rate, might increase acreage devoted 
to cash crops at the expense of production of low-margin staple 
foods.  This would create inflationary pressure on food prices. 
Next, Mussi pointed out, continued exchange rate appreciation 
could well trigger a consumption boom, fed by ballooning 
imports.  Finally, on the fiscal side, revenue growth is falling 
off while obligatory expenditures, fed in particular by the 
government's wage bill and the social security deficit, have 
been growing apace. Lula, Mussi stated, would require sound 
 
BRASILIA 00000961  003 OF 003 
 
 
economic advice to deal with these problems but it was unclear 
who would provide such unfiltered counsel. 
 
¶7. (C) Although Lula already is openly campaigning for 
re-election despite not having officially declared his 
candidacy, his stump speech does not address the critical need 
for microeconomic reforms.  No one knows, Mussi stated, what his 
proposal for tackling the social security deficit is, or what he 
plans to do about the byzantine and burdensome tax system and 
the interlocking fiscal reforms necessary to reform the 
budgetary straitjacket imposed by constitutional earmarks and 
revenue sharing requirements (ref C).  The IMF's Alier pointed 
out that the end-2007 expiration of the temporary de-earmarking 
legislation (the DRU, which exempts 20% of federal revenues from 
the constitutional earmarks and revenue sharing requirements), 
along with the expiration of the financial transactions tax 
(CPMF), would force fiscal issues to the center of public 
debate. (Note: without the DRU, the federal government would not 
have the cash to meet its debt-service obligations.)  During a 
second mandate, however, Lula is expected to have less political 
capital and a weaker congressional base, thus reducing his 
capacity to use the opportunity presented by the expiration of 
these measures to push more extensive reforms through Congress. 
Mussi suggested that in the absence of leadership on reforms 
from the federal government, reform-minded state governments, 
depending on the outcome of the gubernatorial races in several 
key states -- especially Sao Paulo -- might become a force 
pushing for fiscal/budgetary reform.  Separately, Alier was 
dismissive of the idea that the state governments could lead 
reform efforts. 
 
¶8. (C) Comment:  Although the Central Bank is confident of its 
independence from Finance Minister Mantega and can be expected 
to continue to pursue an apolitical monetary policy, Mantega's 
recent statements exacerbate the questions about the coherence 
of economic policy to be pursued in a possible second Lula 
administration.  Lula understands the importance of Central Bank 
independence and likely would maintain the current arrangements, 
i.e. de facto BCB policy-making independence and a line of 
authority directly to himself.  Nor do we expect any radical 
departures on fiscal policy, which would face significant 
institutional resistance from the finance and planning ministry 
senior technical staff and legal hurdles imposed by the fiscal 
responsibility law.  But maintaining the status quo on the broad 
outlines of macroeconomic policy is insufficient to move Brazil 
to the higher growth rates necessary to addressing entrenched 
poverty and economic disparities between regions and social 
classes. 
 
¶9. (C) Comment Continued: Progress on microeconomic and 
structural reforms, which could contribute to increasing 
potential growth rates, is a much more difficult question.  We 
do not expect action to grant formal Central Bank independence, 
even though the Mantega case has highlighted its importance. 
And while it's too early to foresee the coalition politics of 
the next Congress, at this point it's hard to imagine Lula being 
strong enough in his second term to push through broad-based 
fiscal, tax and labor market reform, arguably the highest 
priorities for any incoming administration.  That is not to say 
that Lula would be hamstrung, as the GoB could implement less 
comprehensive measures, such as the 2004 payroll-deduction loan 
program which successfully reduced lending spreads and sparked 
credit growth.  Barring strong pressure for reforms from 
unexpected quarters, such as reformist state governments, the 
Brazilian economy under any Lula II administration looks likely 
to continue simply muddling through. 
 
CHICOLA