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### Viewing cable 05BRASILIA3207, BRAZIL - ECONOMY CONTRACTS, CRITICISM EXPANDS

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
05BRASILIA3207 | 2005-12-08 11:03 | 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 003207

    SIPDIS

    SENSITIVE

    NSC FOR CRONIN
    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 - ECONOMY CONTRACTS, CRITICISM EXPANDS

    REF: A) BRASILIA 3150

         B) BRASILIA 3092
         C) BRASILIA 3043

    ¶1. (SBU) Summary:  Brazil's economy contracted 1.2% in the
    third quarter of 2005, falling further than even the
    pessimists had predicted.  Growth expectations for the year,
    therefore, are being downgraded to the 2.3% to 2.7% range.
    The unexpectedly abrupt fall in GDP has intensified
    criticism of the Central Bank from across the political
    spectrum.  Prominent orthodox economists have joined the
    chorus of disapproval, arguing that the Central Bank was
    over-zealous in its monetary tightening earlier in 2005.
    While there is a palpable sense of disappointment here that
    Brazil will not repeat its strong 2004 GDP growth
    performance (4.9%), the new growth projections are not far
    below the 3% level that most analysts believe is Brazil's
    maximum sustainable (and non-inflationary) level of growth
    in the medium term absent significant reforms to increase
    productivity.  Moreover, growth in 2006 has a good chance of
    being stronger as current interest rate cuts spark a
    positive credit cycle and the GoB places greater emphasis on
    spending.  The lack of any progress on President Lula's
    microeconomic reform agenda in Congress and a clear downward
    trend in investments, however, suggest there is little hope
    for sustaining faster growth rates.  End Summary.

    ¶2. (U) Brazil's economy contracted 1.2% in the third quarter
    of 2005, according to recently released GoB data.  Parsing
    the numbers, the quarterly growth data (see table below)
    show, on the demand side, declines in investment and
    government consumption.  The supply side saw sharp drops in
    agriculture (-3.4%) and industrial output (-1.2%), while
    services showed no movement (0% growth).  While overall
    export growth continued to be strong in spite of the
    appreciation of the Real, there is some evidence that price-
    sensitive agricultural exports, such as bulk grains, were
    damaged by the exchange rate; it also has contributed to a
    fall in planted area for the upcoming crop.  Along with
    exports, the only bright spot in the third quarter numbers
    was personal consumption, which grew 0.8%.  Private sector
    analysts now are predicting overall GDP growth for 2005 will
    be between 2.5% and 2.7%; the latest Central Bank poll of
    market expectations shows an average predicted growth of
    2.66%.  Meanwhile, a Planning Ministry think-tank (IPEA) has
    issued an even lower growth estimate of 2.3% for the year.

                            Brazilian GDP
                Percent Growth - Seasonally Adjusted

                     Annual/1       Quarterly Growth/2
                   2003   2004    4Q04   1Q05    2Q05   3Q05

    Total GDP      0.5     4.9     0.8    0.2     1.1   -1.2

    Supply Side
     - Agriculture 5.0     5.3     0.8    0.4     1.7   -3.4
     - Industry   -1.0     6.2     0.9   -0.8     1.4   -1.2
     - Services   -0.1     3.3     0.6   -0.2     1.2    0.0

    Demand Side
     - Consumption
       (Private)  -3.3     4.1     1.1   -0.2     0.9    0.8
     - Govt.       0.6     0.1     0.5    0.3     0.9   -0.4
     - Investment -6.6    10.9    -2.8   -3.1     4.7   -0.9
     - Exports    14.2    18.0     4.4    2.8     2.6    1.8
     - Imports    -1.9    14.3     3.6    2.5     1.9    1.4

         /1 Percent Change on Previous Year
         /2 Percent Change on Previous Quarter, Preliminary
         Source: Statistical and Geographic Institute (IBGE)

    Chorus of Disapproval
    ---------------------

    ¶3. (SBU) The negative growth result has intensified
    criticism of the Central Bank from across the political
    spectrum.  While not questioning the basic thrust of
    monetary policy, several prominent orthodox economists,
    among them former Central Bank President Arminio Fraga and
    former director Sergio Werlang, have criticized the extent
    of the Central Bank's interest rate hikes.  These saw the
    benchmark SELIC overnight rate jump to 19.75% and real
    interest rates reach about 13%, a level local economists
    claim are the highest of any major economy in the world.
    The Central Bank's monetary policy committee (COPOM) will
    almost certainly cut the SELIC target rate by 50 basis
    points at its December 13-14 meeting, to 18%, continuing its
    current cycle of monetary easing, which began in September.
    Some Central Bank directors have lashed out at the Brazilian
    Statistical and Geographic Institute (IBGE), questioning
    (with some justification) the reliability of the IBGE
    estimates.  Lula and Palocci both have publicly backed the
    Central Bank and its continued independence to set interest
    rates.

    Role of the Weak Dollar/Strong Real
    -----------------------------------

    ¶4. (U) The strengthening Real, which in recent months has
    consistently traded at relatively appreciated levels against
    the dollar (a band between 2.15 and 2.3 Reals per dollar),
    may be beginning to affect price-sensitive agricultural
    exports.  There is anecdotal evidence that the strong Real
    is affecting investment decisions at the margins.  One
    recent prominent example was a decision by Arcelor, reported
    in the press on November 29, to cancel a joint venture
    project with Brazilian mining giant CVRD to build a steel
    plant in the state of Maranhao due to the strong Real, which
    reduced the expected competitiveness of the plant's export-
    destined production.  China's Baosteel, according to the
    press, also cited the appreciated Real when it called off
    its plans to construct a steel plant in the northeast.
    While these are only anecdotal data points, the fall in
    investments (-0.9%) in the third quarter IBGE data was the
    third such contraction in the last four quarters and
    suggests that investment is on a clear downward trend.  This
    raises concerns about the foundations for future growth.

    Will 2006 Be Better?
    --------------------

    ¶5. (SBU) Not all the data was negative.  Carlos Mussi, an
    economist with the United Nations Economic Commission for
    Latin America and the Caribbean, pointed out in a December 2
    meeting with Econoff that private consumption had posted
    good growth for the second consecutive quarter.  This
    consumption is being fueled in part by continued access to
    credit at lower interest rates available under new payroll
    deduction loans, which give banks greater assurance of being
    repaid.  He argued that falling interest rates, when
    combined with stable employment and higher personal incomes,
    have created the conditions for a positive credit cycle that
    could sustain increased personal consumption, laying the
    foundation for stronger growth in 2006.  This scenario gains
    credibility in light of a November poll which found consumer
    confidence to be at its highest level in recent years.

    ¶6. (SBU) Growth in 2006 also should benefit from a fiscal
    stimulus over the next six to eight months.  Lula Chief of
    Staff Dilma Rousseff has led a political charge to force the
    Finance Ministry to spend (rather than save) any revenues
    above the primary surplus target, reportedly set informally
    by Lula and Palocci at between 4.6% and 4.7% of GDP
    (somewhat higher than the formal 4.25% of GDP target
    included in the budget).  The GoB was running a primary
    surplus well ahead of this level (at least 5.1% of GDP in
    the first nine months of 2005), cushioned by better than
    expected tax revenues, which creates room for substantial
    end-of-year spending without endangering overall fiscal
    restraint.  There also will be pressure to obligate as much
    money as possible during the first six months of the 2006
    election year, after which point election-related limits on
    signing large new contracts go into effect until after the
    October 2006 election.  The extent to which significantly
    increased expenditures on investment projects is possible is
    debatable, however, as the GOB's administrative capacity to
    spend is severely handicapped by its dysfunctional
    bureaucracy.  While it is true that Palocci has been stingy
    in handing out funding to the ministries, many agencies have
    proven unable to spend a significant portion of the public
    investment monies they have received.

    ¶7. (SBU) Comment: Lula's more forceful recent backing of his
    finance minister and efforts to plaster over differences
    within his administration on fiscal policy mitigate the
    concern that Palocci might be forced out in a policy
    disagreement, despite the poor third quarter GDP result.
    While December 6 statements by Lula to the effect that there
    will be "adjustments" in GOB macroeconomic policy on the
    surface sound ominous, in the end it will be the ultra-
    orthodox Ministry of Finance and Central Bank that implement
    any adjustment (likely in the manner they see fit).  Palocci
    nevertheless remains vulnerable should evidence emerge to
    support the many allegations of wrongdoing made against him
    (refs B and C), as this would likely would lead to his
    departure.  Specifically, his upcoming mid-December
    appearance before the congressional committee investigating
    illegal bingo operations could prove particularly difficult.
    To date, his previous two congressional appearances have
    been softball affairs in front of the upper and lower house
    economic committees.

    ¶8.  (SBU) Even political survival, however, may be cold
    comfort for Palocci should the economy continue to perform
    as poorly as it did last quarter.  And, while there is clear
    potential for 2006 to be a better year for Brazilian
    economic growth than 2005 now looks to be, the falling
    investment trend and death of Lula's microeconomic reform
    agenda exacerbate concerns about the sustainability of
    robust growth levels.  Look for continued middling economic
    performance from Brazil into the medium term.

    LINEHAN

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