VZCZCXRO8767
RR RUEHRG
DE RUEHSO #0241/01 1141910
ZNR UUUUU ZZH
R 241910Z APR 09
FM AMCONSUL SAO PAULO
TO RUEHC/SECSTATE WASHDC 9125
INFO RUEHBR/AMEMBASSY BRASILIA 0277
RUEHRG/AMCONSUL RECIFE 4352
RUEHRI/AMCONSUL RIO DE JANEIRO 9125
RUEHBU/AMEMBASSY BUENOS AIRES 3477
RUEHAC/AMEMBASSY ASUNCION 3724
RUEHMN/AMEMBASSY MONTEVIDEO 2898
RUEHSG/AMEMBASSY SANTIAGO 2724
RUEHLP/AMEMBASSY LA PAZ 4099
RUCPDOC/USDOC WASHDC 3266
RUEATRS/DEPT OF TREASURY WASHDC
RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 03 SAO PAULO 000241 
 
SIPDIS 
SENSITIVE 
 
STATE PASS USTR FOR KDUCKWORTH 
STATE PASS EXIMBANK 
STATE PASS OPIC FOR DMORONSE, NRIVERA, CMERVENNE 
STATE PASS NSC FOR ROSSELLO 
DEPT OF TREASURY FOR LINDQUIST 
 
E.O. 12958: N/A 
TAGS: ECON EFIN BR
SUBJECT: A NORMAL ECONOMY - BRAZIL AND THE FINANCIAL CRISIS 
 
REF: 08 Sao Paulo 476 
 
SENSITIVE BUT UNCLASSIFIED--PLEASE PROTECT ACCORDINGLY 
 
¶1.  (SBU) Summary:  Although Brazil has experienced a large shock as 
a result of the global economic downturn, it has weathered this 
shock much more effectively than past shocks due to greater economic 
flexibility, large foreign reserves, and a decline in inflation 
pass-through pressures that has made its economy much less 
vulnerable to the risk of exchange rate depreciation.  Brazl's 
current account defcit has widened modestly in recent quarters but 
s not at risk.  Brazil's imports are adjusting rapdly to the 
external shock and its floating exchange rate should help to 
tabilize any future trade imbalances that might emrge.  Brazil's 
current ccount deficit also remains fully financeable via xpected 
FDI inflows. 
 
¶2.  (SBU) Brazil's financial account has suffered a much larger and 
more sudden shock but is also not at significant risk.  The recent 
increase in short-term financial outflos poses little risk because 
inflationary pass-through pressures are now much lower in Brazil 
than in the past.  FDI inflows, moreover, are expected to remain 
strong.  Brazil's large foreign reserves have provided it with a 
critical safety net throughout the crisis.  More broadly, the 
improvement in Brazil's external accounts in recent years has helped 
to provide the Brazilian Central Bank (BCB) with genuine monetary 
independence, and helped make Brazil "a normal economy" for the 
first time in its history.  Unlike past crises, interest rates can 
be used to help Brazil achieve its domestic growth and inflation 
objectives rather than managing its external imbalances.  End 
Summary. 
 
Coping with a Strong External Shock 
----------------------------------- 
 
¶3. (U) The global economic downturn has had a considerable impact on 
Brazil's balance of payments accounts.  Three specific shocks Brazil 
has experienced include a large decline in trade flows, a sharp rise 
in financial outflows, and a large increase in outward profit 
transfers.  Brazil's imports and exports in recent months have 
declined by 40 percent and created significant hardships for 
trade-intensive sectors.  A large and sudden reversal in financial 
outflows occurred in the final quarter of 2008 after more than two 
years of strong inflows.  Outward transfers last year jumped to USD 
34 billion - 50 percent higher than their level in 2007 and more 
than double their level in 2006. 
 
¶4. (U) While the decline in trade flows is due to weak demand 
affecting the entire global economy, remittance and financial 
outflows have been more specific to Brazil.  Remittance outflows 
have been driven by struggling U.S. banks and car makers 
repatriating profits from their Brazilian units (very profitable 
until recently).  Short-term financial outflows have been driven by 
foreign institutional investors liquidating local investments to 
boost their cash positions.  While Brazil's open capital account and 
the depth of its markets are key long-run strengths of its financial 
system, they also make it easy for foreign investors to unwind their 
investments in the short-run and thus may have contributed to the 
recent rise in Brazil's financial outflows. 
 
¶5. (U) Despite these recent difficulties, Brazil's external accounts 
are not at risk.  While trade flows are down sharply, Brazil's trade 
balance maintains a slight surplus.  The pace of remittances is 
expected to moderate significantly this year.  Short-term financial 
outflows have hurt Brazilian equities (where foreign investment is 
most concentrated), but had a more modest impact on debt and credit 
markets given Brazil's limited reliance on foreign borrowing.  FDI 
inflows have fallen from their recent peak levels, but generally 
remain strong.  Most immediately, Brazil's USD 200 billion in 
foreign reserves provide it with a strong cushion against any 
reasonable external shock scenario.  On balance, Brazil's external 
vulnerability indicators have shown a low level of risk throughout 
the crisis and remain far stronger than they were several years ago. 
 
 
 
SAO PAULO 00000241  002 OF 003 
 
 
Brazil's Current Account: A Mild and Gradual Shock 
--------------------------------------------- ----- 
 
¶6. (SBU) Brazil's current account deficit has widened over the past 
year but remains modest in size (approximately -1.7 percent of GDP 
through March) and can be fully financed via FDI inflows (Reftel). 
External deficits in Brazil's two previous crises, by comparison, 
were much higher (-4.8 percent in 1998-99 and -4.6 percent in 
2002-03) and required large-scale IFI financing.  The most immediate 
source of the current account decline has been the increase in 
profit transfers.  Brazil's trade balance has also fallen, but 
remains in surplus (USD 16 billion forecast in 2009) and is not at 
serious risk of deterioration given Brazil's flexible exchange rate 
and strong recent declines in import prices.  The market consensus 
for Brazil's 2009 current account deficit is now -1.0 percent of 
GDP. 
 
¶7. (U) In the short-run, Brazil's trade balance has weakened in part 
because its growth and import demand, while falling sharply, have 
held up better than its key trading partners (U.S., Argentina). 
Over the past quarter, exports to the U.S. have fallen by 50 
percent.  In contrast to past crises, however, Brazil's imports in 
this crisis are adjusting almost as rapidly as its exports helping 
to limit the risk that a large external deficit may open up. 
Brazil's import composition is also holding up well.  Whereas fuel 
imports (largely reflecting cyclical conditions) have fallen by 40 
percent, capital imports (largely reflecting longer-term 
expectations) have fallen by less than 10 percent. 
 
Brazil's Financial Account: A Large and Sudden Shock 
--------------------------------------------- ------- 
 
¶8. (U) Brazil's financial account, in contrast, has suffered a large 
and abrupt shock.  After USD 54 billion in net financial inflows 
received during the first three quarters of 2008 (and USD 89 billion 
in 2007), Brazil suffered USD 21 billion in net outflows in the last 
quarter of 2008.  Outflows were concentrated within Brazil's 
portfolio accounts - most immediately, among its equities.  In 
contrast, FDI inflows remain strong.  Even in the final quarter of 
2008, Brazil received USD 14 billion in FDI inflows - more than 
twice FDI inflows received in the last quarter of 2007.  The BCB 
expects FDI inflows to be USD 22 billion this year. 
 
¶9. (U) Despite the recent reversal in its financial flows, Brazil's 
financial account is not at risk.  One reason is the modest size of 
its external funding needs (approximately USD 60 billion in 2009) 
and large foreign reserve assets.  A second reason is that financial 
outflows have been externally driven, have not reflected a rise in 
"Brazil risk," and thus may rebound quickly once global conditions 
ease.  January-February data indicate that net financial inflows 
have again turned positive.  The third and most important reason is 
the fact that Brazil can now tolerate a much greater degree of 
exchange rate depreciation without generating strong pass-through 
pressures.  Since mid-2008, the Brazilian currency has depreciated 
by 22 percent in real effective terms.  Whereas currency 
depreciation on this scale would have previously risked an 
inflationary spiral, inflation expectations today remain 
well-anchored and have fallen by nearly 100 points (to 4.2 percent) 
over the past two quarters. 
 
¶10. (U) The decline in exchange rate pass-through has provided the 
BCB with much greater room to lower rates and stimulate domestic 
demand.  In previous crises, rates were tightened sharply (amidst 
rapidly slowing growth) to help limit inflation, imports, capital 
outflows, and re-establish Brazil's external balance.  In this 
crisis, in contrast, rates should fall by roughly 300 points. 
Brazil's benchmark rate is now lower than at any time in over two 
decades. 
 
Foreign Reserves:  A Critical Safety Net 
---------------------------------------- 
 
¶11. (U) Large foreign reserves have been critical in assuring 
Brazil's stability throughout the crisis.  At the outset of the 
crisis, Brazil had USD 205 billion in reserves.  In 2007 alone, 
 
SAO PAULO 00000241  003 OF 003 
 
 
reserves grew by nearly USD 100 billion as financial inflows rose 
sharply.  At that time, BCB president Meirelles was criticized for 
excessive reserve accumulation.  By mid-2007, Brazil's reserves were 
well above normal reserve adequacy benchmarks (e.g., three to four 
months import coverage, 100 percent short-term debt, 10 to 20 
percent of broad money).  As of end-2008, Brazil's foreign reserves 
remained equivalent to 14 months of imports, 400 percent of total 
short-term external debt, and 40 percent of broad money. 
 
¶12. (U) Brazil's large reserve stockpile has provided it with a 
strong safety net against severe external stress.  When global 
markets panicked last September, the BCB sold large amounts of 
dollars without any risk of running down its reserves.  The BCB 
could (and did) credibly claim it could meet any amount of local 
dollar demand.  Brazil's foreign reserves now exceed its total 
external debt and its projected external financing needs through at 
least mid-2011. 
 
Comment: Brazil as a "Normal Economy" 
------------------------------------ 
 
¶13. (SBU) Despite a large and sudden shock, Brazil's external 
accounts remain in excellent condition.  While the current account 
deficit has recently grown, its size remains modest. Brazil's trade 
patterns are also adjusting well to the price and demand shocks 
faced in recent quarters.  Short-term financial outflows have risen 
sharply, but pose little risk given Brazil's low funding needs and 
limited inflation risk that exchange rate depreciation now presents. 
 Brazil's foreign reserves have provided an invaluable safety net 
throughout the crisis - ensuring Brazil's external repayment 
capacity and also helping to maintain confidence amidst difficult 
market conditions. 
 
¶14. (SBU) The improvement in Brazil's balance of payments accounts 
has brought it two benefits:  First, stronger external accounts have 
reduced Brazil's risk premium, contributed to its investment grade 
rating, and enhanced its ability to attract foreign capital.  While 
Brazil's banks are not dependent on foreign finance, the increase in 
foreign capital inflows (in the pre-crisis period) did help to 
catalyze other parts of Brazil's markets that should recover when 
the crisis subsides, for example, Brazil's IPO market, merger and 
acquisition activity, and alternative assets.  The second benefit is 
increased space for counter-cyclical monetary policy.  The BCB can 
now adjust rates in response to domestic rather than external 
conditions.  For the first time in its recent history, Brazil has 
effectively achieved monetary independence, which some claim makes 
Brazil a "normal economy."  End Comment. 
 
¶15.  (U) This cable was drafted in conjunction with the U.S. 
Treasury Financial Attache in Sao Paulo and coordinated/cleared by 
Embassy Brasilia. 
 
WHITE