VZCZCXRO1243
RR RUEHRG
DE RUEHSO #0005/01 0071055
ZNR UUUUU ZZH
R 071055Z JAN 09
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 8830
INFO RUEHBR/AMEMBASSY BRASILIA 9986
RUEHRG/AMCONSUL RECIFE 4270
RUEHRI/AMCONSUL RIO DE JANEIRO 8968
RUEHBU/AMEMBASSY BUENOS AIRES 3366
RUEHAC/AMEMBASSY ASUNCION 3613
RUEHMN/AMEMBASSY MONTEVIDEO 2827
RUEHSG/AMEMBASSY SANTIAGO 2613
RUEHLP/AMEMBASSY LA PAZ 4022
RUCPDOC/USDOC WASHDC 3237
RUEATRS/DEPT OF TREASURY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 04 SAO PAULO 000005 
 
SIPDIS 
SENSITIVE 
 
STATE PASS USTR FOR KDUCKWORTH 
STATE PASS EXIMBANK 
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE 
DEPT OF TREASURY FOR JHOEK, BONEILL 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EINV ETRD BR
SUBJECT: BRAZILIAN CURRENCY DEPRECIATION: AFFECTING THE ECONOMY? 
 
REF: A. Sao Paulo 0476; B. Sao Paulo 0680; C. Sao Paulo 0522; D. 
Brasilia 1427 
 
SENSITIVE BUT UNCLASSIFIED--PLEASE PROTECT ACCORDINGLY 
 
¶1.  (U) Summary:  Brazil's currency depreciated by more than 40 
percent against the USD since the global financial crisis hit 
Brazil.  The depreciation has less to do with Brazil's economic 
fundamentals and more with global risk aversion and the rush to U.S. 
Dollars.  The strength of the Brazilian economy, coupled with 
Brazil's status as a net creditor, has mitigated the short-term 
macroeconomic implications; however, the Brazilian private sector is 
struggling to plan future investments in the absence of any exchange 
rate stability.  The current conditions are very different than 
Brazil's last two currency crises of 1999 and 2002 when the causes 
were more endogenous to the Brazilian economy.  The Brazilian 
Central Bank (BCB) has used its international reserve holdings much 
more frequently than in past years, but financial interlocutors 
believe the Bank has employed them in a more conservative manner 
than many in the private sector would like.  The BCB has been more 
preoccupied with guaranteeing the supply of USD in foreign exchange 
markets than stabilizing the exchange rate; injecting USD 60 billion 
for export financing, spot market sales and repos, financing 
external debt, and covering foreign exchange derivative positions. 
Financial contacts do not see any change in the trend of the BCB's 
actions over the near-term.  The BCB has a challenging year and 
several tough decisions ahead.  End Summary. 
 
Macro Picture Not So Bad 
------------------------ 
 
¶2.  (SBU) Between September 1 and December 31, Brazil's currency the 
Real (BRL) was the most volatile currency in the world, depreciating 
against the U.S. Dollar by approximately 43 percent.  The main 
causes of the rapid depreciation have been the massive outflows of 
portfolio investments and the global demand for USD amid global risk 
aversion.  Although the long-term impacts remain undetermined, this 
time around, Brazil's stronger macroeconomic fundamentals have 
mitigated some of the short-term effects.  Brazil's foreign reserve 
position, USD 207 billion, including USD 150 billion in U.S. 
Treasury bills, improves as the BRL depreciates relative to the USD 
and has helped the BCB maintain its reserves despite heavy USD 
intervention in foreign exchange markets.  Likewise, Brazil's 
position as a net external creditor as of January 2008 means that 
depreciation has a net positive effect on its net debt to GDP ratio 
because its USD reserves are greater than outstanding debt. 
Unibanco economists estimated that a 10 percent depreciation of the 
BRL translated to a decline in the public-sector net external debt 
to GDP ratio by approximately one percent.  Brazil's net debt to GDP 
indicator declined by approximately five percentage points since 
September to 34.9 percent of GDP in December, which would have been 
38.7 percent without the depreciation effect. 
 
¶3.  (SBU) While external debt has become less costly, the 
depreciation has contributed to an increase in internal government 
debt by USD 424 million.  Currency depreciation makes imports 
relatively more expensive, while exports become cheaper worldwide. 
This time, however, slumping global demand for Brazilian exports and 
the freefall of commodity prices are likely to mean exports will not 
rebound as quickly.  The Center for External Trade Studies 
Foundation (FUNCEX) estimated a 16 percent decline in the total 
value of exports for 2009; however, they expect a slight rebound in 
total volume of about five percent after sluggish growth of less 
than two percent in 2008 (Ref A).  FUNCEX expects a slow-down of 
import volumes for 2009, estimating growth at six percent, following 
annual growth in 2008 of almost 20 percent.  Finally, dividends and 
profits remittances are already showing a decline because of the 
exchange rate and lower asset prices, which should lessen the 
current account deficit (Ref A). 
 
¶4.  (SBU) Concerns over increases in inflation due to the BRL 
depreciation appear at this time to be overblown.  Unibanco 
econometric models show that a 10 percent depreciation in the 
currency leads to a two percent increase in Brazil's inflation rate. 
 Despite this, the BCB's fourth quarter inflation report stated that 
inflation was less of a risk now than earlier in 2008, and in fact 
 
SAO PAULO 00000005  002 OF 004 
 
 
recent reports indicate a slight deflationary pressure in the 
economy.  In its report, the BCB said that inflation is less of a 
concern for two central reasons:  1) strong domestic demand, one of 
the main drivers for consumer price inflation in 2008, has 
contracted sharply due to the global financial crisis; and 2) 
inflation indices have retreated in tandem with the decline of 
commodity prices (a 45 percent decline in USD prices for commodities 
since July).  Because of the BRL depreciation, prices in BRL for 
Brazilian export commodities and imported goods have both been 
fairly stable because the BRL price for those goods remains 
unchanged at the new lower exchange rate. 
 
Private Sector Very Concerned 
----------------------------- 
 
¶5.  (SBU) Most of the immediate and long-term concerns center on how 
the exchange rate volatility will affect the private sector and 
investment decisions.  Greater price uncertainty due to exchange 
rate volatility makes it difficult to plan future investments. 
Indeed, many companies had sizeable foreign exchange derivatives 
positions to hedge against the BRL appreciation in the first half of 
2008 that have resulted in significant losses for several big 
companies.  So far, three prominent Brazilian firms, Votorantim 
(manufacturing, financing, new business), Aracruz (pulp), and Sadia 
(meat packing), have reported losses of approximately USD 2.5 
billion, but some estimates are as high as USD 20 billion in 
exposure across the Brazilian private sector (Ref D). 
 
¶6.  (SBU) Roberto Giannetti da Fonseca, Director of Foreign Affairs 
at the Federation of Industries of Sao Paulo, said that it has been 
very difficult for the manufacturing sector to live without a 
reference exchange rate.  Giannetti da Fonseca pointed to the daily 
trade volume decline as evidence that businessmen are unable to 
accurately plan for the future.  In August, before the financial 
crisis, the average daily trade volume was USD 1.772 billion, while 
the average over the first 10 days of December was USD 1.395 billion 
(Refs B and C).  According to Itau, business confidence is one of 
the best indicators of GDP growth for the coming quarter.  The 
Fundacao Getulio Vargas (FGV) business confidence index declined by 
11 percent from November to December to a 10-year low (October 1998 
during the Russian crisis).  The same survey showed capacity 
utilization down four percentage points from November and the 
indicator for future production was the lowest since January 1991. 
Indeed, Brazil's Institute for Statistics announced that November's 
industrial production was down 5.2 percent from October, the largest 
drop in 13 years. 
 
Not the Same as Last Two Adjustments 
------------------------------------ 
 
¶7.  (SBU) The recent depreciation of the BRL is very different than 
Brazil's last two foreign exchange shocks in 1999 and 2002.  The 
drivers for the 2008 depreciation are exogenous to the local 
economy, while earlier crises led to much deeper economic problems 
due to local variables.  The current crisis is beyond the reach of 
domestic policies to curb the currency depreciation.  Likewise, the 
current decline has occurred amid very different balance of payments 
financing conditions.  Prior to 2003, foreign direct investment 
stock hovered around USD 150 billion, but was close to USD 600 
billion when the crisis struck Brazil last year.  Net external 
portfolio stock also soared from USD 20 billion at the end of 2003 
and had reached USD 225 billion at the end of August 2008. 
 
¶8.  (SBU) Brazil's position as a net external creditor with its 
buildup of foreign reserves is another obvious improvement over 
previous crises.  Because of this cushion, the BCB has been much 
more active in foreign exchange markets than in previous crises. 
The daily average consolidated intervention in the month of October 
surpassed more than threefold the largest monthly intervention 
during the 2002 crisis.  From September to December, BNP Paribas 
estimated that the BCB injected approximately USD 70 billion into 
the Brazilian foreign exchange markets and to finance private sector 
external debt.  One negative difference is the large foreign 
exchange derivatives positions that many Brazilian exporters held on 
their balance sheets, which elevated fears that the Brazilian 
banking industry could be affected. 
 
SAO PAULO 00000005  003 OF 004 
 
 
 
What to Expect for 2009? 
------------------------ 
 
¶9.  (SBU) The short answer is that no one really knows where the 
exchange rate will go in 2009.  Market consensus in the last week of 
December for the 2009 exchange rate was R$ 2.25; however, the market 
has built in greater depreciation of the BRL into its 2009 estimates 
on a near weekly basis since September.  Hitoshi Castro, head of 
Commercial Banking for Banco Fator told Econoffs that he believed 
the exchange rate would fluctuate between R$ 2.35 to R$ 2.65, but 
could spike as high as R$ 3.0.  His rationale was that the downside 
risks of greater profit remittances, toxic derivatives (Castro 
thinks that 30 percent are still unaccounted for), the automotive 
industry crisis with some 250,000 cars in current inventories, and 
the high demand for forward foreign exchange contracts all imply 
greater depreciation of the BRL.  Castro postured that an exchange 
rate of R$ 2.5 reduces the likelihood that Brazilians would pull 
deposits out of Brazil and that businesses in Brazil would limit 
repatriation of remittances, both good reasons for the BCB's current 
stance. 
 
More BCB Intervention? 
---------------------- 
 
¶10.  (SBU) The shortage of USD in the market has been a bigger 
concern for the BCB, and both the BCB and the GOB have pursued many 
measures to increase the USD liquidity in the Brazilian market (Ref 
D).  Of the USD 70 billion the BCB injected from September through 
the end of 2008, the BCB used only USD 10 billion for spot market 
interventions to stabilize the BRL.  Itau Securities noted that the 
BCB's primary actions have been USD credit lines for Brazilian 
exporters due to the shortage of USD in the market.  Mauricio Oreng 
from Itau underscored that the BCB's actions do not suggest its 
behavior would change in 2009.  Rather, he believes the BCB will 
continue its cautious management of reserves and limit the 
deterioration in quality of Brazil's reserve composition.  Given 
market uncertainties for the duration of the crisis, he does not 
expect the BCB to react too quickly.  In order to keep the 
reserves-to-imports ratio at a comfortable level, Oreng expected the 
BCB to limit its intervention to USD 65 billion.  Likewise, Castro 
does not expect the BCB to use its reserves to control the exchange 
rate, but on occasion the BCB could heavily intervene if the 
exchange rate hovered at R$ 3.0.  Castro instead insisted that the 
BCB exploits its high reserve level to keep currency speculators at 
bay.  (Comment: Castro explained that the stronger the reserve 
position, the greater the threat the BCB can make that it would 
intervene when it would hit speculators hardest.  Specifically, he 
noted that the BCB could flood the market when movement is 
particularly low, which would have a sizeable effect on the exchange 
rate.  This should keep currency traders from over-enthusiastic 
speculation.  End Comment.) 
 
Comment 
------- 
 
¶11.  (SBU) Over the medium term, Brazil's exchange rate is not 
likely to fall below R$ 2.0.  The BCB has several tough choices 
ahead including the difficult decision of balancing the potential, 
if minimal, pressure of depreciation in consumer prices while 
maintaining positive economic growth by easing interest rates. 
Another consideration is how much the BCB intervenes in foreign 
currency markets to maintain the exchange rate.  In the first part 
of 2008, the BCB faced intense pressure from exporters as the BRL 
appreciated and is now again facing harsh criticism from the 
domestic private sector to keep the exchange rate stable.  Given 
that the sources of the BRL movement are mostly due to external 
forces, the BCB has a tough task ahead if it decides to intervene in 
an effort to limit exchange rate volatility.  The exchange rate has 
proved an amazing, if unanticipated, hedge against the financial 
crisis.  While uncertainties remain over the GOB's fiscal policy for 
2009, the BCB, through its reserves policy, should remain a 
stabilizing force for fiscal policy.  End Comment. 
 
¶12.  (U) This cable was cleared by Embassy Brasilia and with the 
U.S. Treasury Financial Attache in Sao Paulo. 
 
SAO PAULO 00000005  004 OF 004 
 
 
 
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