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UNCLAS SECTION 01 OF 06 BRASILIA 002562 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
NSC FOR FEARS 
TREASURY FOR OASIA - J.HOEK AND DAS LEE 
STATE PASS USTR FOR CRONIN 
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE 
STATE PASS USAID FOR LAC 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D 
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/SHUPKA 
 
E.O. 12958: N/A 
TAGS: ECON PGOV EFIN PREL SOCI BR
SUBJECT: WHY BRAZIL'S ECONOMY WILL JUST KEEP MUDDLING THROUGH 
 
REF: A) BRASILIA 2490 
 B) BRASILIA 2278 
      C) BRASILIA 2099 
      D) BRASILIA 1151 
 
This cable is Sensitive But Unclassified, please protect 
accordingly. 
 
¶1. (SBU) Summary:  By many measures, Brazil's economy has better 
fundamentals today than it has had at any point over the last three 
decades.  The 1994 "Plano Real" brought previously unknown 
macroeconomic stability to Brazil, defeating its traditional 
inflation nemesis.  Fiscal management has produced solid results: 
the public sector routinely exceeds its primary surplus targets and 
debt levels are falling.  An ongoing export boom underpins continued 
surpluses in Brazil's external accounts.  But Brazilians are glum 
about growth, which has averaged about 2.5% over the last twelve 
years.  Investment levels, currently about 20% of GDP, are simply 
insufficient to support higher growth.  There is no shortage of 
reasons for this, ranging from Brazil's fiscal knot (ref A) to its 
high taxes and onerous tax compliance burden, infamous bureaucracy, 
lack of spending on research and development, infrastructure gap, 
low levels of human capital, questionable priorities in education 
spending, burgeoning social security deficit and burdensome labor 
regulations. 
 
¶2. (SBU) Dealing with these will require a legion of reforms of 
significant scope.  Brazil's political system and societal 
priorities, however, work to water down the ambition of attempts at 
reform.  Society is firmly supportive of low inflation policies and 
fiscal responsibility, but has a knee-jerk reaction to talk of 
(further) privatization.  Meanwhile, Brazil's closet mercantilists 
in industry and the foreign ministry help keep the economy 
relatively closed, limiting the potential to increase productivity 
through greater openness to trade.  Together, these factors mean 
that economic inefficiencies and low productivity growth will keep 
sustainable GDP growth in the 3% to 3.5% range well into the medium 
term.  But neither is Brazil's economy headed for a crisis; it will 
just keep muddling through with middling performance.  End Summary. 
 
Macro vs. Micro 
--------------- 
 
¶3. (SBU) It is worth reflecting on how far Brazil has come in the 
twelve years since the "Plano Real" was introduced in 1994.  The 
plan defeated the hyperinflation of the 1980's and, through 
privatizations, placed much of the economy in private sector hands. 
The current macroeconomic policy mix of a floating exchange rate, 
inflation-targeting monetary policy and high primary fiscal 
surpluses -- necessary to bring down high debt levels -- was 
introduced in 1999 and has consolidated macroeconomic stability. 
Inflation should be less than 3% this year and is expected to be 
only 4% next year.  Public debt levels are high (net debt of about 
50% of GDP and gross debt of 72.1% of GDP) but strong primary 
surpluses have brought the ratio down each year since 2003; in 2005 
Brazil prepaid its IMF debt, and followed that up by paying off its 
Brady bonds and Paris Club debt in 2006, both the legacy of its late 
1980's debt default.  Macroeconomic stability and privatization set 
the stage for the Brazilian companies to be able to take advantage 
of the current surge in world trade growth and the ensuing export 
boom has solidified Brazil's external accounts tremendously. 
Continued current account surpluses have allowed Brazil to pay down 
external debt.  Given lower debt and Central Bank purchases of 
inflowing dollars, Brazil's public sector has become a net creditor 
to the rest of the world.  Moreover, the ghost of hyperinflation 
 
BRASILIA 00002562  002 OF 006 
 
 
past still lingers in Brazil, helping create a clear societal 
consensus in favor of low inflation and fiscal responsibility. 
 
¶4. (SBU) But Brazilians now crave higher economic growth rates. 
These have averaged 2.7% over the four years of the Lula presidency, 
up from 2.2% over the eight years of the Cardoso presidency.  The 
key issues in reaching this goal are productivity growth (how well 
one uses existing capital and labor) and investment levels (to build 
up more capital stock), neither of which has grown enough to create 
the capacity for Brazil's GDP to grow at the 5% level, a figure 
which some politicians are urging be adopted as a growth target.  A 
recent study by the Applied Economic Research Institute (IPEA), an 
independent think-tank attached to the planning ministry, concluded 
that at current investment rates Brazil's capital stock would not 
attain those levels necessary to sustain 5% annual GDP growth until 
¶2017. 
 
¶5. (SBU) The current transition between Lula's first and second 
terms, and the renewal -- to an extent -- of his political mandate, 
has brought sharper political focus to the growth debate in recent 
weeks.  Commentators, policy makers and policy wonks are flogging 
various programs to address this or that perceived limitation on 
growth.  There also is public sparring between the 
"developmentalists" who favor large state-led development models, 
with the more orthodox economists who favor a focus on structural 
and microeconomic reforms as the mechanisms to increase investment. 
 
 
    Table - Savings, Investment and GDP Growth 
    (Percent of GDP) 
 
              Domestic     Gross Fixed 
Year          Savings      Capital Formation   GDP Growth 
----          --------     -----------------   ---------- 
 
 
2001           16.75%          19.47%            1.3% 
2002           18.51%          18.32%            1.9% 
2003           20.38%          17.78%            0.5% 
2004           23.17%          19.58%            4.9% 
2005           22.4%           19.93%            2.3% 
2006           21.6% /1                          2.9% /2 
 
  /1 January through March of 2006 
  /2 Predicted 2006 GDP growth 
 
Fiscal Issues Are the Biggest Problems 
-------------------------------------- 
 
¶6. (SBU) The economic distortions and other structural problems that 
reduce investment levels are legion.  Foremost among these is 
Brazil's fiscal knot, described in detail in ref A.  The need to 
service debt and finance a burgeoning social security deficit within 
the confines of a rigid constitutional earmarking and fiscal 
federalism framework has a three-fold effect:  1) Brazil has a high 
tax burden, approaching 40% of GDP; 2) its financing needs crowd out 
private investment; and, 3) the public sector makes only limited 
investments itself.  The constitutional amendments necessary to 
begin to unravel the knot by reforming the social security system 
and Brazil's fiscal federalism framework require congressional 
super-majorities.  According to published accounts, however, in his 
quest to bring in the leftist PDT party to his governing coalition, 
Lula may have promised to forego ambitious social security reform. 
 
 
 
BRASILIA 00002562  003 OF 006 
 
 
¶7. (SBU) Many businesses find much of Brazil's physical 
infrastructure to be lacking.  During its first term the Lula 
administration, acknowledging the fiscal constraints on government 
investment in infrastructure, touted public-private partnerships 
(PPPs) as the solution to unlocking private investment in marginally 
economical infrastructure projects.  The Congress passed PPP 
legislation in December 2004, but the reality of the bureaucratic 
and substantive hurdles to issuing implementing regulations meant 
that despite the hype, the federal government did not put out for 
bid any PPP projects during Lula's first term.  A few state 
governments have moved with greater alacrity.  The PPP example is 
also a useful illustration of how slowly the Brazilian bureaucracy 
can move.  Turf fights between the ministries, in addition to a lack 
of capacity to quickly hire consultants qualified to evaluate major 
projects, have contributed to the PPPs glacially slow roll-out. 
 
¶8. (SBU) Brazil's infamously high real interest rates also come in 
for criticism as a factor limiting growth levels.  Two key factors 
in this tale of high interest rates are judicial insecurity and the 
distortion of markets in savings and lending through directed credit 
mechanisms and mandatory savings schemes that direct capital to the 
national development bank (BNDES).  The directed credit mechanisms 
require banks to loan a significant percentage of their deposits to 
agriculture at low real interest rates (about 5%).  Workers also 
contribute to the FGTS, a mandatory savings for unemployment scheme, 
which finances the activities of the BNDES.  As both the IMF and 
OECD have pointed out, these measures have the effect of increasing 
interest rates on all other lending as banks charge more on other 
loans to make up for cheap agricultural lending and must pay higher 
rates to compete for the pool of savings.  Moreover, these 
distortions limit the financial intermediation role played by banks, 
which theoretically would route capital to its most efficient 
economic use. 
 
¶9. (SBU) Brazil's judicial system is infamous for the 
unpredictability of its outcomes.  Many analysts complain that 
judges, particularly in the lower courts, take "social equity" into 
account in rendering their decisions, making it difficult for a bank 
to collect on loans or a company to enforce a contract.  A chief 
economist at a major Brazilian Bank told Econoff it could take as 
long as 10 years for his bank to use the judicial system to collect 
on a loan.  The introduction of the concept of binding precedent in 
the 2004 judicial reforms will, over time, help to make the system 
more predictable.  The courts also contribute to a general climate 
of regulatory uncertainty.  Although the regulatory framework in 
many sectors is adequate, according to analysts, unpredictable 
enforcement and changes in the rules, such as Lula's 2004 overhaul 
of the power sector regulatory model, have hurt existing investors. 
 
¶10. (SBU) Most employers find Brazilian labor laws very restrictive, 
creating significant and expensive compliance burdens and limiting 
the flexibility of businesses to work in new ways.  Moreover, 
various payroll levies, such as social security and the FGTS 
unemployment insurance/mandatory savings scheme come close to 
doubling the cost of labor to the employer.  Most economists believe 
reform of the outdated labor laws would help increase economic 
efficiency and make business more competitive.   But labor reform 
would come only at great political cost for Lula, who requires 
support from both the left wing of his own PT and some of the 
smaller leftist parties to obtain congressional majorities. 
 
No Societal Consensus Behind Micro Reforms 
------------------------------------------ 
 
¶11. (SBU) In marked contrast to the consensus supporting low 
 
BRASILIA 00002562  004 OF 006 
 
 
inflation and responsible fiscal policies, many deeper structural 
and microeconomic reforms are manifestly unpopular.  In a telling 
moment in the recent presidential campaign, the Lula campaign 
accused pro-business PSDB party candidate Geraldo Alckmin of 
intending to privatize Brazil's remaining parastatals.  Rather than 
defend the many palpable benefits that successful privatization 
already has brought to Brazil -- most obviously in the 
telecommunications sector, where privatization brought efficient and 
ubiquitous service at lower prices, in sharp contrast to the waiting 
lists and prohibitive pricing that previously prevailed -- the 
Alckmin camp issued denials that it had any intentions of pursuing 
privatization.  Fortunately, parastatals such as Petrobras and 
Eletrobras already have been partially privatized (a fact many 
Brazilians forget) and forced to face competition in their sectors. 
Nor do Brazilian politicians dare to voice the politically sensitive 
but economically sensible idea of reforming the directed credit 
system.  Another force for distortion, the development bank BNDES, 
is almost universally popular among Brazilians despite the 
regressive nature of its financing, which takes money from the 
working class through the mandated payroll savings scheme and uses 
it primarily to finance Brazil's biggest corporations. 
 
Productivity Growth and Innovation 
---------------------------------- 
 
¶12. (SBU) Even with low investment levels, Brazil could sustain 
higher growth rates were productivity growth higher.  Brazil, 
however, spends only 1% of GDP on Research and Development (half the 
OECD average), and most of that is spent by government and 
universities, not the private sector.  An "innovation law" passed in 
December 2004 aimed to improve the situation by promoting 
partnerships between universities and companies to develop 
technology.  Total factor productivity, however, which can be used 
as a proxy for innovation in an economy, has made only marginal (and 
in some cases negative) contributions to Brazilian GDP growth over 
recent years, according to data from the OECD and IPEA.  Another 
well-known obstacle to innovation and R&D in Brazil is spotty 
enforcement of Intellectual Property Rights (IPR).  In a meeting 
with the Ambassador, Petrobras President Gabrielli implied a 
negative opinion of Brazilian IPR protection by emphasizing how 
important it was for Petrobras to obtain approval for its U.S. 
patent application in order to move ahead with investing in 
Brazilian production of H-Bio, a biofuel made by an innovative 
distilling/refining process using a blend of petroleum and 
plant-based oils (such as soybean oil). 
 
¶13. (SBU) Finding adequate human capital is also a challenge for 
businesses in Brazil.  As of 2004, the average Brazilian had 
attended school for 6.6 years and only 57% of students finished 
primary school.  Given constitutional earmarks for education 
spending, the issue is less one of lack of money but of priorities. 
Brazil spends about 4.3% of GDP on education, a level equivalent to 
the OECD average.  But the distribution is troublesome:  Brazil 
spends about as much on primary education per student as Paraguay 
and much less than Mexico, Chile and Argentina.  But it lavishes 
spending at the tertiary level, supporting an expensive system of 
free public universities, entry to which is governed by rigorous 
entry exams.  Access to this system is limited as only the 
better-off can afford the costly preparatory courses that most 
students find necessary to pass the entry exams; those public 
universities serve only 5.1% of the college-age population. 
President Lula has proposed incremental reforms to this system. 
 
Trade -- Ideological Focus 
-------------------------- 
 
BRASILIA 00002562  005 OF 006 
 
 
 
¶15. (SBU) One way to achieve greater productivity is through greater 
competition, including openness to trade.  But the Brazilian economy 
is a relatively closed one, with imports accounting for about 10% of 
GDP as of 2006 (albeit trending upward).  The average applied tariff 
of just over 10%, which is higher than OECD averages, also masks 
higher protection levels for certain sectors, particularly 
manufactures.  Moreover, the foreign ministry's ideologically driven 
focus on furthering south-south cooperation in its trade 
negotiations has not helped Brazil significantly.  A former finance 
ministry Under Secretary pointed out to the Ambassador recently that 
the several trade agreements Brazil (via the Mercosul Customs Union) 
had concluded during President Lula's first term covered countries 
accounting for only 3.6% of Mercosul exports and 1.2% of its 
imports.  But even these tiny figures are overstatements of the 
accords' importance as most of them cover only a small fraction of 
tariff line items -- 10% in the case of the South Africa-Mercosul 
agreement and 5% in the case of the Mercosul-India agreement.  The 
former Under Secretary confided that he was roundly attacked in the 
press by representatives of Brazil's influential Sao Paulo Industry 
Federation (FIESP) after presenting this trade data and argued that 
Brazil needed to pursue trade agreements with its major markets, 
such as the EU and U.S. 
 
Headline reforms vs. smaller measures 
------------------------------------- 
 
¶16. (SBU) Even if prospects are bleak for headline reforms, there is 
much that smaller reforms can accomplish.  For example, some of the 
growth in credit, and particularly the reduction in spreads for 
loans to individuals in recent years, is due to the creation of 
payroll-deduction loans, in which loans repayments are deducted 
directly from the borrowers' salary (or INSS pension payment). 
These loans gave banks greater security and led to more lending to 
individuals at lower cost.  The IMF resrep believes much of this 
lending went to support expansion of small businesses by family 
members of the people who could get such loans.  Another measure, 
the SIMPLES regime, lowered and unified taxes for small businesses 
(i.e. with revenues of up to 1.2 million Reais a year, or about USD 
550,000).  This allowed many small business to move out of 
informality, boosting formal employment (and tax revenue) despite 
the lower tax rates.  Legislation to expand the program by 
increasing the revenue ceiling to 2.4 million Reais is close to 
final congressional passage.  The Lula administration also passed 
targeted tax breaks, along with complementary regulatory 
adjustments, which together have helped spark a construction and 
real estate boom.  But these smaller measures, however effective in 
accomplishing their focused goals, are typical Brazilian 
work-arounds (the culture of the "jeitinho"), and leave untouched 
the fundamental growth-limiting distortions in the Brazilian 
economy. 
 
But little societal ferment 
--------------------------- 
 
¶17. (SBU) Brazil's middling growth rates are simply insufficient to 
lift the masses out of poverty the way many Asian economies have. 
Lula's Bolsa Familia program, however, is now reaching over 11 
million families, helping raise the living standards of the poorest. 
 These income transfer programs do little to help recipients get 
jobs or become less dependent on handouts, but by conditioning the 
transfers on keeping children in school and their vaccinations 
updated, they aim to improve the next generation's prospects and 
break the intra-generational transmission of poverty.  Transfer 
mechanisms such as Bolsa Familia and the income transfer portions of 
 
BRASILIA 00002562  006 OF 006 
 
 
the social security system, which subsidizes pensions for elderly 
rural poor, are in part responsible for the improvement in Brazil's 
GINI coefficient (a measure of inequality) over the last two years. 
Brazil's economy has been creating record numbers of new formal 
sector jobs.  Taken together, these factors take the edge off of 
social ferment that might otherwise result from lower growth levels. 
 
 
¶18. (SBU) Comment:  The political compromises that made possible the 
signal economic achievements of the Real Plan were forced through 
the political system by economic crises: hyperinflation, debt, 
recession and devaluation.  With a sound macroeconomic framework and 
a largely market-based economy in place, however, Brazil today faces 
no serious threat of near term crisis.  Although Lula's re-election 
has to an extent given him a renewed mandate, he has limited 
political capital with which to forge a coalition.  Unfortunately, 
the most significant reforms, particularly in the areas of tax 
reform and fiscal federalism, will require constitutional amendments 
and congressional super-majorities.  Absent the threat of economic 
crisis, Brazilian politicians, reflecting both prevailing societal 
preferences and their own interest in political self preservation, 
will err on the side of moderation in reforms, condemning Brazil to 
lower potential growth path into the medium term. 
 
CHICOLA