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### Viewing cable 05BRASILIA682, BRAZIL'S STEELY MONETARY POLICY

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
05BRASILIA682 | 2005-03-11 19:30 | 2011-07-11 00:00 | UNCLASSIFIED//FOR OFFICIAL USE ONLY | Embassy Brasilia

`

    This record is a partial extract of the original cable. The full text of the original cable is not available.

` `

    UNCLAS SECTION 01 OF 03 BRASILIA 000682

    SIPDIS

    SENSITIVE

    NSC FOR BREIER, RENIGAR
    TREASURY FOR OASIA - DAS LEE AND FPARODI
    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/DDEVITO/DANDERSON/EOL SON

    E.O. 12958: N/A
    TAGS: ECON EFIN ETRD PGOV EIND BR
    SUBJECT: BRAZIL'S STEELY MONETARY POLICY

    REF: A) 04 BRASILIA 3115
         B) 04 BRASILIA 3100
         C) BRASILIA 417
         D) SAO PAULO 193

    This cable is Sensitive but Unclassified, please protect
    accordingly.

    ¶1.   (SBU) The GoB published a decree March 4 reducing to
    zero the import tariff on fifteen different categories of
    steel.  The measure is temporary and does not represent a
    general liberalization, but rather is aimed at containing
    inflationary pressures driven by price increases in steel
    and other major industrial inputs.  Dealing with these
    inflationary pressures has proven difficult for the GoB,
    despite the Central Bank's elevation of interest rates to
    18.75%, in a cycle of monetary tightening beginning in
    September 2004.  Despite the monetary tightening, and a
    concurrent 10% appreciation of the Real, inflationary
    expectations have hardly budged.  This may be in part
    because current inflationary pressures, concentrated on
    the supply side, differ from previous episodes.  The small
    percentage of credit in the economy, much of which is
    directed to certain sectors or loaned at fixed rates by
    the development bank, limits the influence of Central Bank
    interest rate changes on the course of the overall
    economy.  The episode highlights the need for financial
    market reform and broader, permanent import liberalization
    to increase competition in the economy.  End Summary.

    Inflationary (and Political) Bias
    ---------------------------------

    ¶2.   (SBU) In December 8, 2004 conversation (ref A),
    Central Bank President Meirelles complained to the
    Ambassador about the inflationary bias in the Brazilian
    economy, and specifically about steel prices.  Meirelles
    argued that this bias was a legacy of Brazil's hyper-
    inflationary past, when businesses tried to earn money by
    raising prices faster than wages could adjust.  In
    January, President Lula echoed Meirelles' argument (made
    in private to the Ambassador), when he publicly criticized
    industry for increasing prices, blaming them for keeping
    inflationary expectations alive and forcing the Central
    Bank to raise interest rates higher than it would
    otherwise need.  It was during that attack that Lula first
    publicly threatened to liberalize imports to restrain
    price increases.  (Note: Brazil, while a major steel
    exporter, has imported between USD 456 million and USD 550
    million worth of steel products annually over the last few
    years.  End note.)

    What has Inflation Been Doing?
    ------------------------------

    ¶3.   (SBU) After spiking in 2002 due to the effects of
    currency devaluation, recently Brazilian inflation has
    been under control.  The consumer price index (IPCA)
    peaked in 2002 at 12.5%, falling to 9.3% in 2003 and 7.6%
    in 2004.  While not high in historical terms, this
    inflation has reacted stubbornly to Central Bank interest
    rate hikes meant to bring inflationary expectations in
    line with the 5.1% target for 2005.  The Central Bank has
    raised its benchmark interest rate on overnight borrowing
    (the SELIC) by 2.75 percentage points, from 16% in
    September 2004 to the current 18.75%.  Private sector
    inflationary expectations for 2005 (measured by Central
    Bank surveys of financial institutions that run their own
    forecasting models), however, have hovered in a band of
    about 5.7% to 5.95% during the period of adjustment.  The
    Central Bank, for its part, has declined to revise upward
    its target, perhaps fearing -- as the local IMF ResRep
    recently confided to Emboffs -- that it needs to get
    inflation as low as possible this year as 2006 is an
    election year.
    Is This Inflation Different?
    ----------------------------
    ¶4.   (U) The interest rate hikes in particular have been
    profoundly unpopular, and rekindled debate about the
    effectiveness of Brazil's inflation targeting regime and
    monetary policy tools (i.e. targeting inflation using the
    SELIC benchmark interest rate).  Even some supporters of
    the inflation targeting regime and the GoB's orthodox
    policy line have begun to debate what lies behind the
    current inflationary stickiness and whether the SELIC is
    the right tool for achieving the target.  For example,
    former Central Bank President Gustavo Franco has argued
    that recent inflationary pressure has been characterized
    by small supply shocks (such as the steel price increases
    that sparked Lula's and Meirelles' ire), the costs of
    dealing with exchange rate volatility and the high cost of
    credit itself.

    Limits of Current Monetary Policy Tools
    ---------------------------------------

    ¶5.    (U) In addition to the nature of the current
    inflationary pressures, several structural elements in the
    financial system tend to limit the effectiveness of
    Central Bank interest rate changes on overall economic
    activity.  First, credit as a percent of the economy is
    low, at 26.3% of GDP in January 2005.  This is down over
    ten percentage points over the last decade, albeit on a
    recent upward trend.  Many businesses, particularly those
    that do not have access to lower interest rate foreign
    currency loans, tend to self-finance investment out of
    retained earnings.

    ¶6.   (U) The amount of credit directly influenced by the
    SELIC is further reduced by the existence of "directed
    credit," which, according to Central Bank data, makes up
    about 36% of all credit.  Over half of all directed credit
    is long term financing granted by the National Development
    Bank (BNDES) at a GoB-set rate (the TJLP, currently
    9.75%), which does not reflect changes in market interest
    rates.  The remainder of directed credit consists of
    agricultural credits (30%) and housing credits.  These
    latter two categories of credit have below-market floating
    interest rates that track the overall direction of market
    interest rates.  These directed credits are among the
    villains that account for Brazil's infamously high lending
    spreads.

    ¶7.   (U) Other, likely less significant factors limiting
    the effectiveness of monetary policy are the effects of
    recent microeconomic reforms designed to enhance access to
    credit, including the 2003 creation of payroll-deduction
    loans.  While payroll-deduction loans work to increase the
    aggregate amount of credit -- which, all things being
    equal, would tend to make interest rate targeting more
    effective -- like BNDES lending, these particular loans
    have commanded far lower interest rates than normal
    personal loans.  A similar measure that would use social
    security pension benefits to secure loan repayments is
    under implementation.  Franco further pointed out that
    Brazilian consumers, in particular, have become so inured
    to scandalous interest rates that a change of only a
    couple points has very limited impact on consumption
    decisions.  Taken together, these factors reduce the
    impact that the price of overnight credit, embodied in the
    SELIC, has on much of the economy.

    Need More Competition
    ---------------------
    ¶8.   (U) One factor that the public debate has not focused
    on is the existence of cartels in many sectors of the
    economy, making prices stickier (ref D).  While the GoB is
    cognizant of the existence of such, and domestic air
    carriers (traditionally one of the economy's high tariff
    sectors) have recently launched a price war, the
    government's plans to improve competition policy and anti-
    monopoly efforts are longer term (septel).  Thus the
    decision to liberalize steel imports, in an attempt to
    boost competition and reduce prices in a more relevant
    timeframe.  Industry reaction has been mixed, with car
    manufacturers and other steel consumers welcoming the
    opportunity to negotiate with foreign suppliers as
    leverage in price negotiations with domestic steel
    suppliers, while the steel industry predictably has
    dissented.

    Comment
    -------

    ¶9.   (SBU) Despite the debate over the effectiveness of
    the SELIC and, secondarily, the inflation-targeting regime
    itself, the GoB does not intend to abandon either.
    Moreover, attitudes in the financial markets may be
    catching up those in the Central Bank.  The IMF Resident
    Representative observed to Econoffs March 8 that over the
    last month financial market participants have begun
    revising their views that the Central Bank would be forced
    to abandon the 5.1% inflation target for the year as
    unrealistic.  That said, the episode highlights the
    importance of further microeconomic reform of the
    financial system, particularly to eliminate directed
    credits and to make BNDES interest rates more closely
    reflect monetary policy objectives.  While some financial
    system reforms, such as measures enhancing access to
    credit, may work against the effectiveness of the SELIC in
    the short term, over the medium and longer term they
    should help create a more rational financial system, and
    one that ultimately will respond more readily to smaller
    interest rate changes by the Central Bank.  Import
    liberalization, however welcome, will not contribute much
    towards that goal until it becomes broader-based and is
    made permanent.

    DANILOVICH

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