VZCZCXRO3786
PP RUEHRG
DE RUEHBR #1336/01 1971443
ZNR UUUUU ZZH
P 161443Z JUL 07
FM AMEMBASSY BRASILIA
TO RUEHC/SECSTATE WASHDC PRIORITY 9515
INFO RUEHBR/AMEMBASSY BRASILIA
RUEHRI/AMCONSUL RIO DE JANEIRO 4772
RUEHSO/AMCONSUL SAO PAULO 0377
RUEHRG/AMCONSUL RECIFE 6943
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHAC/AMEMBASSY ASUNCION 6214
RUEHBU/AMEMBASSY BUENOS AIRES 4913
RUEHSG/AMEMBASSY SANTIAGO 6359

UNCLAS SECTION 01 OF 03 BRASILIA 001336 
 
SIPDIS 
 
SENSITIVE 
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STATE PASS USTR FOR CRONIN 
STATE PASS FEDERAL RESERVE BOARD FOR P.ROBITAILLE 
TREASURY FOR OASIA - J.HOEK 
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.0. 12958: N/A 
TAGS: ECON EFIN PGOV BR
SUBJECT: BRAZIL: July 11, 2007, meeting between U.S. Treasury 
Secretary Paulson and Central Bank President Meirelles 
 
 
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¶1. (SBU) Summary:  In their July 11 Brasilia meeting, Central Bank 
President Henrique Meirelles told Secretary Paulson that Brazil 
appears to have overcome the extreme economic and financial 
volatility it experienced in the past, and that Brazil's medium-term 
growth and inflation outlook is positive.  The recent improvement in 
Brazil's economic performance is partly attributable to favorable 
global economic growth, but is also attributable to Brazil's strong 
fiscal and monetary policy performance as well as the reduction in 
its external financial vulnerabilities.  The strong appreciation of 
the Brazilian real that has occurred in recent months reflects the 
improvement in Brazil's economic fundamentals in addition to recent 
credit rating agency upgrades of Brazil's sovereign debt. End 
Summary. 
 
¶2. (SBU) Meirelles opened the meeting by providing an overview of 
Brazil's economic history over the past decade and also its current 
economic outlook. Meirelles stated that Brazil has historically 
suffered from "stop-and-go," boom-and-bust economic cycles largely 
as a result of three factors: (1) erratic balance of payments 
performance, (2) poor fiscal policy and resulting pressures for 
monetary financing from the central bank that led to high and 
volatile inflation, and (3) the extensive use of controls and 
regulations rather than price and market mechanisms to allocate 
economic resources, which increased the size of Brazil's public 
sector and slowed private sector development in Brazil. 
 
¶3. (SBU) Meirelles stated that the adoption of the Plano Real in 
1994 was an important, but incomplete, step in Brazil's transition 
toward economic stabilization. The Plano Real successfully ended 
Brazil's hyperinflation. However, it did not address underlying 
problems in Brazil's fiscal and balance of payments performance. 
Largely as a result of Brazil's poor fiscal performance after 1994, 
it suffered crises in 1998-99 and again in 2002. Meirelles stated 
that it was only after all three factors came together in 2003-04 - 
lower inflation, improved fiscal policy, and stronger trade 
performance - did Brazil's economic performance begin to improve 
measurably. Provided these factors continue, Brazil's growth should 
be much more sustainable in the future than it has been in the past. 
 
 
¶4. (SBU) Although Meirelles attributed some of Brazil's improved 
performance in recent years to favorable global economic conditions, 
he stated that Brazil has successfully leveraged benign global 
conditions to implement reforms and improve public and private 
sector balance sheets (for example, eliminating net external public 
sector debt). Brazil's Central Bank is currently forecasting 4.7% 
growth for calendar year 2007 (slightly higher than most private 
sector forecasts). Personal consumption spending is expanding by 8% 
(annualized), and investment is growing even more rapidly (rate not 
specified). In contrast to Brazil's previous growth cycles, net 
exports are now negative net contributors to Brazil's growth. 
Inflation over the next three years is forecast to be in line with 
the central bank's annual target (4.5%). 
 
¶5. (SBU) Meirelles stated that Brazil's improved macroeconomic 
outlook has had positive spillover effects on private sector 
investment. Low and stable inflation has helped to reduce risk 
premia and allowed private sector investors to project cash flows 
over much longer time horizons, supporting faster growth in 
investment spending. Domestic credit is currently expanding by 20% 
(annualized). Brazil's domestic credit-to-GDP ratio has climbed from 
21% in 2002 to 32% in 2007. 
 
¶6. (SBU) Meirelles stated that the strong appreciation of the 
Brazilian real (from 3.8/USD in 2002 to 1.89/USD at present) has 
forced a "painful but necessary restructuring process on some 
industries," and that currency appreciation has been an important 
catalyst for some Brazilian industries to significantly improve 
their global competitiveness. 
 
¶7. (SBU) Secretary Paulson provided an overview of the global and 
the U.S. economic outlook. He stated that he has never observed such 
favorable global economic conditions as currently exist and that the 
global economy is now "awash in cash." He stated that he is not 
predicting a crisis, but that he also believes such favorable global 
 
BRASILIA 00001336  002 OF 003 
 
 
conditions will not persist indefinitely. He reported that growth 
prospects in many regions, especially in East Asia, remain strong. 
 
¶8. (SBU) Discussing the U.S. economy, Secretary Paulson stated that 
the outlook appears strong, that most sectors of the economy are in 
good shape, and that the U.S. economy appears flexible and resilient 
to most potential shocks it could experience. He stated that the 
U.S. fiscal deficit (currently forecast for FY 2007 to be equivalent 
to 1.5% of GDP) has surprised many people on the upside due to 
stronger-than-expected revenue growth. Revenues are currently 18.4% 
of GDP - consistent with the long-term U.S. historical average. 
Secretary Paulson stated that key factor for continued U.S. growth 
 
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is to ensure that inflation does not rise, which would force the 
Federal Reserve to tighten monetary policy quickly and in a way that 
might harm confidence and private sector spending. 
 
¶9. (SBU) Secretary Paulson stated that difficulties in the sub-prime 
housing market were fairly predictable as a result of the extended 
liquidity buildup in U.S. real estate and the aggressiveness of U.S. 
lenders. He stated that he believes that conditions in the sub-prime 
market have probably bottomed out, but that the effects in this 
market may persist for some time as banks work through these 
non-performing loans. He said that sub-prime is a controversial 
political issue in the U.S., but he believes the economic impact of 
sub-prime housing market difficulties on the U.S. macroeconomy will 
be limited. 
 
¶10. (SBU) Discussing exchange rates, Secretary Paulson noted the 
importance of allowing exchange rates to be market-determined. 
Although he believes a strong dollar is in the U.S. national 
economic interest, he also believes market forces should determine 
foreign exchange rates and does not support efforts by some 
countries - notably China - to manage their exchange rates in a 
rigid manner. He noted that it would be helpful if Brazilian 
officials communicated this message in their discussions with 
China's leaders. 
 
¶11. (SBU) In response to a question asked by Paulo Vieira da Cunha 
(Director of International Affairs) about the potential risk posed 
by global hedge funds, Secretary Paulson stated that hedge funds 
have provided many important benefits to the global economy but that 
he is concerned about possible risks they might create due to their 
extensive use of financial leverage. Secretary Paulson currently 
chairs an inter-agency working group (Treasury, Federal Reserve, the 
Securities and Exchange Commission, and the Commodities Futures 
Trading Commission) that is examining potential systemic risks that 
might emanate from hedge funds. He stated that he believes imposing 
new regulations to limit hedge fund risk is likely to be 
ineffective, and instead prefers an alternative approach that 
emphasizes the importance of improved transparency, greater 
disclosure, and the implementation of best financial practices by 
hedge funds. 
 
¶12. (SBU) Secretary Paulson stated that he does not believe global 
current account imbalances are likely to be resolved through 
exchange rate movements. Although currency adjustments can be 
helpful in correcting external imbalances, the deeper and more 
important source of these imbalances lie in structural factors at 
work within larger economies.  In particular, Secretary Paulson 
noted the high degree of precautionary saving that exists in China 
due to the lack of adequate social insurance mechanisms and the 
shallow capital markets there that force many firms to finance 
investment spending via retained earnings rather than through 
external borrowing. 
 
¶13. (SBU) In response to a question about U.S. fiscal performance 
asked by Mario Mesquita (Director of Economic Policy), Secretary 
Paulson stated that the key fiscal challenge the U.S. faces is 
medium-term rather than short-term. Recent short-term U.S. fiscal 
performance has exceeded most forecasts. However, the U.S. has not 
effectively addressed medium-term challenges it faces in reforming 
health care and social security spending. He stated that these 
problems are not analytically difficult, but that building a 
political consensus on the reforms needed to ensure the long-term 
solvency of these programs has proven difficult. 
 
BRASILIA 00001336  003 OF 003 
 
 
 
Sobel