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P 261846Z JAN 07
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 7952
INFO RUEHRG/AMCONSUL RECIFE 6160
RUEHRI/AMCONSUL RIO DE JANEIRO 3778
RUEHSO/AMCONSUL SAO PAULO 9102
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RUEHAC/AMEMBASSY ASUNCION 5919
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RUEHLP/AMEMBASSY LA PAZ 5136
RUEHCV/AMEMBASSY CARACAS 3592
RUEHBO/AMEMBASSY BOGOTA 4093
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHC/USDOC WASHDC
RHEHNSC/NSC WASHDC

C O N F I D E N T I A L SECTION 01 OF 04 BRASILIA 000149 
 
SIPDIS 
 
SIPDIS 
 
NSC FOR FEARS 
TREASURY FOR OASIA - DAS LEE, J.HOEK 
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 
STATE PASS USTR 
 
E.O. 12958: DECL:01/15/17 
TAGS: ECON EFIN PGOV ETRD PREL EINV BR
SUBJECT: BRAZIL: LULA'S SECOND TERM ECONOMIC GROWTH PACKAGE 
UNDERWHELMING 
 
REF: A) 06 BRASILIA 2490 
     B) BRASILIA 0060 
 C) BRASILIA 0140 
 
Classified by Economic Counselor Bruce Williamson, reasons 1.4 
(b) and (d). 
 
¶1. (SBU) Summary: The GoB announced on January 22 a series of 
measures, the Program to Accelerate Growth (PAC), meant to 
enliven Brazil's current lackadaisical economic growth rates. 
The measures, a combination of targeted tax breaks and new 
public spending, along with the recycling of a few existing 
initiatives, primarily are aimed at boosting investments in 
infrastructure and construction.  A few additional pieces of 
legislation would streamline bureaucracy, particularly in the 
area of environmental permits for large projects, and improve 
the investment climate.  The GoB has spun the PAC as potentially 
pumping Reais 500 billion (USD 235 billion) into the economy 
over the next four years, but the figures are notional and 
depend to a great extent on the implementation of over 21 
individual initiatives requiring congressional approval, as well 
as investment decisions by private actors.  Overall, the package 
reflects the Lula Administration's preference for use of the 
state -- as opposed to the private sector -- as the engine for 
increased economic growth.  Analysts have welcomed the steps as 
useful, but note they are only a modest attempt at addressing 
the fundamental structural distortions that dampen the potential 
growth of the Brazilian economy (refs A and B).  The two most 
urgent issues, tax/fiscal reform and reform of the social 
security system, were not addressed by the PAC, although 
President Lula stated that these issues as well would be dealt 
with separately (in an unspecified time frame).  Ref C reviews 
the PAC's political prospects and impact.  End Summary. 
 
¶2. (SBU) The GoB announced on January 22 its long-awaited 
economic package for Lula's second term.  The unveiling was 
delayed for close to a month after Lula's dissatisfaction with 
the lack of "daring" in the Finance Ministry's initial 
proposals.  The bureaucratic infighting over the package led to 
resignation of the Finance Ministry Treasury Secretary, Carlos 
Kawall, whose more fiscally conservative stance Lula ultimately 
overruled, notably in increasing the minimum wage to Reais 380 
(USD 180) per month.  In the end, the GoB put forward a group of 
twenty-one pieces of legislation -- five of which already had 
been submitted to Congress in years past and have yet to be 
approved -- with the primary purpose of increasing investment in 
infrastructure and construction.  The five bills already under 
Congressional consideration, most of which were aimed at 
improving the investment environment, are: 1) the regulatory 
agencies law; 2) a law to regulate the natural gas market; 3) a 
law to strengthen the competition policy framework; 4) 
legislation to improve social security management and reduce 
fraud; and, 5) a bill to unify the social security and federal 
government tax collections systems ("super-receita").  Seven 
provisional measures (MPs) were issued to enact a series of 
targeted tax breaks.  (Note: MPs are presidential decrees that 
take immediate effect but must nevertheless receive 
congressional ratification within a certain period of time to 
become permanent law.) A further three MPs dealt with the 
minimum wage increase and created rules to try to limit the 
growth of the government's wage bill and create a more 
predictable system for granting future minimum wage increases. 
 
Targeted Tax Breaks, New Spending 
--------------------------------- 
 
¶3. (U) The PAC contained seven MPs that implemented a series of 
tax breaks and spending measures to try to boost infrastructure 
 
BRASILIA 00000149  002 OF 004 
 
 
investment, both private and public, and boost the construction 
industry.  One MP shortens, from 25 years to 24 months, the 
period over which new construction projects can claim already 
existing PIS and COFINS tax credits, injecting an estimated 
Reais 1.15 billion (USD 540 million) into the construction 
sector. Another MP exempts from federal income tax investment 
earnings from new private sector infrastructure investment 
funds.  A related measure creates PIS and COFINS tax exemptions 
on the sales of materials and services used in new 
infrastructure projects such as ports, sanitation, and power 
generation and distribution.  A law to create a more streamlined 
and coordinated system of granting environmental licenses for 
major infrastructure projects, thus addressing a major business 
complaint, complements the infrastructure-related tax breaks. 
 
¶4. (U) New spending on construction and infrastructure also is 
on tap under the PAC.  One MP calls for a Reais 5.2 billion 
hybrid loan/capitalization instrument from the GoB to the 
para-statal bank Caixa Economic Federal (CEF).  The loan draws 
on GoB assets on deposit at the Central Bank, and thus does not 
impact the primary fiscal surplus.  The CEF will on-lend the 
money for low income housing and sanitation projects.  Another 
MP, aimed at increasing resources for low-income housing 
projects, will allow the PAR, a national program which built and 
leased low-income housing, to sell the homes to their occupants 
should they desire.  This would create additional liquidity for 
the PAR fund and allow additional low income housing 
construction. 
 
¶5. (U) The most controversial measure in the PAC is the creation 
of a new governmental infrastructure investment fund financed 
from the profits and "net capital" of the unemployment insurance 
fund (FGTS).  The FGTS, which is funded by payroll taxes, by law 
is the primary source of funding for the Economic and Social 
Development Bank (BNDES).  BNDES profits are returned to the 
fund and build up its capitalization.  Labor groups already have 
challenged the constitutionality of the PAC's plan to use Reais 
5 billion (USD 2.4 billion) from FGTS to finance the new 
government infrastructure fund (ref C). 
 
Fiscal Unease 
------------- 
 
¶6. (SBU) CSFB economist Nilto Calixto pointed out to Emboff in 
January 25 conversation that the PAC made it clear that the GoB 
would reduce its primary surplus in the future.  This could 
theoretically begin to happen in 2007, as the GoB more than 
doubled the size of the Pilot Investment Project (PPI) (from 
Reais 4.3 billion to Reais 11.3 billion -- about USD 5.4 
billion, or 0.5% of GDP).  Under the GoB's budget rules, federal 
investments through the PPI (which require a vetting process to 
ensure they have positive economic returns) are not counted 
against the primary surplus target, so full implementation of 
the PPI would imply a reduction in the primary surplus target 
from 4.25% of GDP to 3.75% of GDP.  Calixto cautioned, however, 
that the GoB's dismal record of budget execution -- including 
under the PPI in 2005 and 2006 -- meant that it was unrealistic 
to expect that the PPI would be fully executed. 
 
¶7. (SBU) The CSFB economist predicted the GoB would actually run 
a primary surplus of close to 4.25% of GDP in 2007, as the 
machinery of public spending would take some time to adjust.  To 
illustrate the point, Calixto noted that the GoB posted a 
primary surplus of about 4.4% of GDP in 2006, despite a 
concerted effort to increase public investments in the run up to 
the elections.  The only category of spending where the GoB had 
over-performed was on salaries and benefits, as the GoB 
increased the minimum wage substantially and gave civil servants 
 
BRASILIA 00000149  003 OF 004 
 
 
significant wage increases.  After 2007, however, Calixto 
expected the primary surplus would begin to fall below the 
current 4.25% of GDP target. 
 
¶8. (SBU) Calixto noted that, given falling interest rates, which 
have significantly reduced the GoB interest bill, there is room 
for the GoB to continue reducing the debt-to-GDP ratio even as 
it runs smaller primary surpluses.  By his calculation, the GoB 
need only run a primary surplus of 2% of GDP in 2007 to keep the 
debt-to-GDP ratio roughly stable at the current 50% of GDP. 
Looser fiscal policy, therefore, need not signal fiscal 
irresponsibility.  The fundamental question is how quickly 
Brazil reduces its stock of debt and borrowing requirement, 
which still soaks up significant amounts of private capital, in 
order to increase the space for private investment.  Through the 
PAC, the GoB is signaling it intends to use the fiscal space to 
finance higher public spending, not facilitate greater private 
investment.  Calixto's study, however, had concluded that the 
benefits of a quicker reduction in debt, which would open the 
doors to greater (and more efficient) private investment, 
exceeded the benefits of higher public spending, even were the 
public spending directed entirely to infrastructure investment. 
 
¶9. (SBU) While key items to extent both constitutional budget 
de-earmarking provisions and a financial transactions tax (CPMF) 
were not included in the PAC -- but likely will be contained in 
separate legislation -- it does incorporate a few measures meant 
to assuage doubts about the GoB's commitment to fiscal 
responsibility raised by other parts of the plan.  In order to 
contain the growth of public spending on salaries and benefits, 
including social security benefits, which constitutionally are 
linked to the minimum wage, the PAC creates rules for future 
adjustments in public sector salaries and the minimum wage.  One 
MP links annual salary increases to inflation plus a real 
adjustment of 1.5% per year.  If implemented, this would likely 
reduce the proportion of public spending going to salaries.  A 
second MP links future minimum wage increases to inflation in 
the previous year plus the rate of real GDP growth in the year 
before that (i.e. t-2).  CSFB's Calixto and prominent fiscal 
expert Raul Velloso both questioned the effectiveness of the 
spending rules, however, arguing that over time such rules tend 
to become floors for future increases, instead of ceilings. 
Another bill, already in Congress, would tighten management of 
the social security system and try to reduce fraud.  A final 
measure, not yet submitted to Congress, would implement a 
constitutional amendment passed in 2003 to reduce the generosity 
of the public sector employees' pension benefits. 
 
Topping up the "MP do Bem" benefits for Electronics 
--------------------------------------------- ------ 
 
¶10. (U) Two MPs will create additional tax breaks meant to 
stimulate research and development for digital television 
products by granting tax exemptions (PIS, IPI, COFINS and CIDE) 
on the sales of digital transmission equipment and investment in 
capital goods and transfers of technology for the development of 
this equipment under a program called PATVD.  A program labeled 
PADIS will create similar tax incentives for semiconductor 
investments. 
 
Former Presidential Candidate Alckmin: Not Far Enough 
--------------------------------------------- -------- 
 
¶11. (SBU) Echoing comments that Sao Paulo state Governor Serra 
made to the press January 25, Geraldo Alckmin, unsuccessful 
candidate of the Brazilian Social Democracy Party (PSDB) for 
president last year, told CG Sao Paulo Poloff on January 23 that 
the PAC is a positive measure and it will help stimulate growth, 
 
BRASILIA 00000149  004 OF 004 
 
 
but it doesn't go far enough.  It will not reduce the tax 
burden, which is the major factor driving the informal economy, 
he said.  There are simply too many obstacles to economic 
growth, such as high interest rates, Alckmin said.  He explained 
that if the government reduces the primary surplus, as it will 
have to increase spending to stimulate growth, this will make 
the task of lowering interest rates both harder and longer.  For 
the past few years, structural reform, which is needed to 
attract investment and stimulate growth, has been stopped, he 
said.  (Note: Alckmin gave us the familiar litany of needed 
reforms: political reform, tax reform, social security reform 
and labor reform, all of which he had proposed to do if elected 
president.  End note.)  The PAC will bring growth to some 
sectors of the economy, but won't affect the macro elements: 
budget, interest rates, and the exchange rate.  He opined that 
when Lula came into office, the Workers Party (PT), provided 
good continuity in macroeconomic policy but got the dosage 
wrong: the high interest rates were appropriate to the FHC era 
because he faced so many international economic crises and slow 
world growth, but the past few years have been a good period for 
the international economy, and Lula didn't make the appropriate 
adjustments to reflect that, Alckmin concluded. 
 
¶12. (C) Comment:  A more "daring" economic program, to borrow 
Lula's term, would have addressed the central economic 
distortions in the Brazilian economy, the solutions to which 
begin with reforming the soon-to-be bankrupt social security 
system, the burdensome tax system and the rigid fiscal 
framework.  While there are measures of incremental merit in the 
PAC, the program that Lula meant to be the economic foundation 
of his second term in office seems to be mostly beside the 
point. 
 
SOBEL