VZCZCXRO1562
RR RUEHRG
DE RUEHSO #0432/01 1411233
ZNR UUUUU ZZH
R 211233Z MAY 07
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 6967
INFO RUEHBR/AMEMBASSY BRASILIA 8101
RHEHNSC/NSC WASHDC
RUCPDOC/USDOC WASHDC 2784
RUEHMN/AMEMBASSY MONTEVIDEO 2340
RUEHBU/AMEMBASSY BUENOS AIRES 2734
RUEHSG/AMEMBASSY SANTIAGO 2049
RUEHLP/AMEMBASSY LA PAZ 3348
RUEHAC/AMEMBASSY ASUNCION 3005
RUEHRG/AMCONSUL RECIFE 3581
RUEHRI/AMCONSUL RIO DE JANEIRO 8078
RUEHFR/AMEMBASSY PARIS 0267
RUEATRS/DEPT OF TREASURY WASHDC
RUEHC/DEPT OF LABOR WASHDC

UNCLAS SECTION 01 OF 04 SAO PAULO 000432 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR WHA/BSC, WHA/EPSC, EB/IFD/OMA 
STATE PASS FEDERAL RESERVE BOARD FOR P.ROBITAILLE 
STATE PASS TO USTR FOR SCRONIN 
STATE PASS EXIMBANK 
STATE PASS OPIC FOR MORONESE, NRIVERA, CMERVENNE 
NSC FOR FEARS 
USDOC FOR 4332/ITA/MAC/WH/OLAC 
USDOC FOR 3134/USFCS/OIO 
DEPT OF TREASURY FOR JHOEK 
PARIS FOR ECON - TOM WHITE 
USAID FOR LAC/AA 
 
E.O. 12958:  N/A 
TAGS: EFIN ECON EINV PGOV BR
SUBJECT: OFFICE OF THE COMPTROLLER OF THE CURRENCY (OCC) MEETS WITH 
CENTRAL BANK AND OTHER BANKING INSTITUTUIONS 
 
 
SENSITIVE BUT UNCLASSIFIED; PLEASE PROTECT ACCORDINGLY 
 
------- 
Summary 
------- 
 
1  (U) The Deputy Comptroller for Global Banking and Financial 
Analysis, Ms. Nancy Wentzler, and two other OCC economists in the 
International Banking and Finance department visited Sao Paulo April 
25-27 for a series of informational meetings with various financial 
sector economists and bankers in Sao Paulo.  They were joined by the 
new regional Treasury Representative in Sao Paulo, William Block, 
and Econoff.  In addition to Central Bank representatives, they met 
with Banco Santander, Banco Itau, Banespa, Citigroup, JP Morgan, 
Lehman Brothers, Maua Investments, Nossa Caixa Bank, and Unibanco. 
 
 
¶2.  (U) The current local mood about Brazil's near and medium-term 
prospects is almost uniformly positive. In contrast to more 
cautiously optimistic views heard during previous meetings here 
(September 2006), current sentiment is much more upbeat.  Most 
growth forecasts have been revised upward in recent months by 50 
basis points (4.0-4.5 percent projected growth in 2007).  Domestic 
demand is improving, trade performance is solid, and net financial 
inflows have accelerated.  Continued foreign exchange appreciation 
(USD 1.90-1.95 from USD 2.00-2.05 at end-April) is forecast for 
¶2007.  Brazil's Emerging Markets Bond Index (EMBI) spread is only 
20-30 basis points above Mexico's despite Brazil's being two notches 
below investment grade (upgraded since this visit by Fitch and S&P). 
 Falling interest rates have supported credit growth, capacity 
utilization, and increased fiscal policy space.  A financial crisis 
- domestic or external - in the next 3-5 years is difficult to 
imagine.  End Summary. 
 
------------------------------- 
SOURCES OF BRAZIL'S IMPROVEMENT 
------------------------------- 
 
Disinflation 
 
¶3.  (U) In the view of virtually all market participants, 
disinflation has been the most important factor contributing to the 
improvement in Brazil's performance in recent years.  Low and stable 
inflation is now perceived to be a largely permanent feature of 
Brazil's economy and, as one analyst stated, "has made Brazil a 
normal country for the first time in its history."  Stable inflation 
expectations have reduced Brazil's country risk premium and cost of 
capital, allowed investors to project cash flows over much longer 
time horizons (5-10 years), reduced dead-weight loss associated with 
unstable prices, and helped extend Brazil's term structure out to 
more than 10 years in BRL denominated instruments. Brazil's central 
bank is the most respected economic institution in the country. 
 
Reserve Accumulation 
 
¶4.  (U) The pace of reserve growth accelerated sharply in the first 
quarter of 2007.  The current stock of reserves (around USD 120 
billion at end-April, and subsequently higher by an additional USD 
5-10 billion) has helped eliminate net public external debt and 
significantly reduced Brazil's exchange rate vulnerability.  Most 
analysts believe considerable room remains to build reserves further 
in 2007-08.  Few if any concerns were expressed about the potential 
costs of continued reserve growth - for example, the quasi-fiscal 
costs of rising sterilization (offset in part by falling interest 
rates) or rising inflation (offset by stable inflation expectations 
and rising real money demand).  The quality of recent financial 
 
SAO PAULO 00000432  002 OF 004 
 
 
inflows is seen as high, with net foreign direct investment inflows 
(in part resulting from rising IPO activity) comprising a large 
share of inflows.  High local yields and stable foreign exchange 
expectations have encouraged global carry-trade inflows.  The 
private banking system maintains a net long position in Brazilian 
currency. 
 
Rising Private Sector Productivity 
 
¶5.  (U) Although productivity figures are scarce and subject to 
significant standard error, the consensus view is that Brazil's 
private sector is experiencing rapid productivity and investment 
growth despite high bureaucratic costs and weak business climate 
indicators.  In contrast to most other Latin American countries (for 
example, Mexico), Brazil's private sector is seen as highly dynamic 
and globally competitive. Growth sectors include energy, 
agri-business, construction, and financial services.  With key 
micro-level reforms, Brazil's private sector is poised for rapid and 
sustained growth. 
 
Banking System Strength 
 
 
¶6.  (U) Bank balance sheets are strong (average 16 percent 
capitalization, legal minimum of 11 percent), and banks should 
experience rapid growth in coming years (real estate, medium-sized 
commercial lending).  Credit growth (consumer and commercial 
lending) has expanded rapidly (Citibank has doubled its employees in 
its consumer lending department in the past 12 months). Many 
analysts noted growth opportunities in housing finance (now only 1.5 
percent of GDP), though legal reforms (for example, implementation 
of a recent bankruptcy law) are needed first to catalyze lending. 
Payroll lending to public sector employees (monthly income serves as 
underlying collateral) has risen sharply.  A small enterprise loan 
market exists but is hobbled by high delinquency (average 1.5 
percent default rate per month) and the absence of adequate credit 
rating information. Local derivative markets are adequate for most 
hedging purposes, with swaps available at reasonable cost and 
duration.  The quality of bank supervision is reported to be high. 
Implementation of Basel II will begin in 2008. 
 
Low Political Risk 
 
¶7.  (SBU) Political risk is low and fears of Latin-style populism in 
Brazil have largely disappeared.  Most Brazilians view Venezuela and 
Bolivia as risks, not benefits, for Brazil and want to avoid 
alignment with both countries.  The parameters of economic policy 
debate in Brazil have narrowed considerably in recent years.  Even 
among bankers, Lula is well regarded - not because of what he has 
accomplished but because of what he has avoided, which is inflation. 
 One banker stated that Lula "is the most pragmatic person in the 
world, and doesn't have an ideological bone in his body."  Another 
stated that Lula will be recorded as one of Brazil's greatest 
presidents because he has "discredited populism in Brazil."  At the 
same time, all analysts agreed that prospects for economic reform 
are non-existent under Lula, and are looking to 2010 as the next 
reform window. 
 
------------------------- 
CHALLENGES AND PRIORITIES 
------------------------- 
 
Poor Fiscal Performance 
 
¶8.  (SBU) Despite continued strong headline numbers, Brazil's fiscal 
framework and the underlying quality of its fiscal performance are 
 
SAO PAULO 00000432  003 OF 004 
 
 
seen as weak.  Problems most commonly cited were: (a) poor quality 
of public sector expenditures and the lack of social returns earned 
on public spending; (b) high tax rates (around 35 percent average 
rate) and complexity, which increase evasion and add to economy-wide 
dead weight loss; and (c) continued growth in expenditure 
indexation. Unwinding indexation, especially with pensions, is 
essential but will be politically difficult.  Because of low public 
sector expenditure quality, Brazilian firms and individuals must 
absorb many additional health and educational costs, effectively 
increasing the tax rate. Modest tax reform is seen as possible 
before 2010.  Pension reform, however, will require more time. 
 
Financial Sector Reforms 
 
¶9.  (U) Despite a reasonably robust and healthy banking system, 
problems most frequently cited included: (a) a large financial 
sector bureaucracy that imposes high red-tape costs, (b) the absence 
of securitized and syndicated loan markets (for example, an MBS 
market barely exists), and c) weak and costly foreclosure procedures 
that contribute to high loan-deposit spreads.  Until loan recovery 
rates improve, unsecuritized lending is unlikely to grow.  The 
average monthly interest rate for small-sized enterprise lending is 
reportedly 5-7 percent. 
 
Costly Labor Markets 
 
¶10.  (SBU) The high cost of firing employees is seen as a 
significant barrier.  One analyst stated that it is "virtually 
impossible to fire anybody in Brazil."  High costs discourage future 
employment growth, decrease labor market mobility, reduce resources 
available for capital spending, and push a large number of employees 
into the informal sector (around 35 percent of GDP).  There are no 
expectations of labor market reform under Lula. 
 
Energy Sector 
 
¶11.  (U) Several analysts noted emerging weaknesses in Brazil's 
energy infrastructure and rising vulnerability to an energy shock. 
Brazil remains highly dependent on rainfall to generate electricity. 
 Brazil's government is responding by increasing capacity, though 
too slowly.  Private investment is discouraged both by formal 
barriers and by a rigid retail price regime.  Even absent a shock, a 
supply-demand imbalance is expected to emerge by 2010 and become a 
growing supply-side constraint. 
 
------------------------------ 
ISSUES FOR FURTHER EXPLORATION 
------------------------------ 
 
Intensity of Bank Competition 
 
¶12.  (U) Although most analysts believe Brazilian banks do compete 
against each other, a consistent view was not provided about why 
abnormally high profits in the sector (recent annual 
Return-on-Equities of 30 percent) are not increasing existing 
competition or attracting new entrants.  Brazil's banking system is 
fairly concentrated; 5-6 banks hold two-thirds of deposits and many 
banks have quasi-monopolistic holds in some lending markets.  Some 
believe the lack of competition is due to regulatory barriers (for 
example, the time and paperwork involved when consumers try to 
transfer accounts to different banks, which reduces bank 
competition), while others believe that further capital market 
deepening is needed to increase the level of competition banks face. 
 
 
Economic Openness 
 
SAO PAULO 00000432  004 OF 004 
 
 
 
¶13.  (U) Views also differed on the extent to which Brazil is 
externally open.  While formal trade barriers have fallen, informal 
barriers remain high. A recently established "IPOD Index" (akin to 
the Big Mac index of The Economist news magazine, measuring relative 
prices of non-tradables across countries) that attempts to proxy the 
international price of tradable goods reportedly showed that Brazil 
has the highest IPOD costs of any country in the world, thus 
suggesting a lack of openness. 
 
Reducing Real Interest Rates 
 
¶14.  (U) Some analysts believe that further reductions in real rates 
(currently around 8.5 percent) are needed for higher growth. Others, 
however, believe that lower rates, while beneficial, will have a 
smaller impact on growth.  One reason cited is that Brazil is 
already thought to be growing at or near its full employment level 
(i.e., reducing the output effects and increasing the price effects 
of further monetary stimulus). Some analysts also noted that lower 
rates may further diminish Lula's political incentive to enact 
reforms by providing him with further breathing room with fiscal 
policy. 
 
Central Bank Foreign Exchange Intervention 
 
¶15.  (U) Most analysts believe recent central bank reserve growth is 
motivated by its interest in increasing precautionary reserves. 
However, at least one major bank (Unibanco) stated that intervention 
is being driven primarily by a need to prevent excessive currency 
appreciation and pre-empt export-industry political pressures. 
 
Benefits of Investment Grade Status 
 
¶16.  (U) Views also differed on the expected benefits of investment 
grade status. Some analysts believe this will be an important 
milestone and will generate important spinoff benefits (for example, 
further investment from institutional investors). Others noted that 
Brazil's external, dollar-denominated debt is already trading close 
to investment grade spreads and do not foresee significant 
additional benefits. As a result of Brazil's recent GDP revision and 
reduced debt ratios, investment grade status is now expected by the 
end of 2009 rather than 2010. 
 
¶17. (U) This cable was coordinated with Embassy Brasilia. 
 
MCMULLEN