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### Viewing cable 06SAOPAULO261, The Ever-Rising Real Part II: The Emergence of Dutch

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
06SAOPAULO261 | 2006-03-10 19:58 | 2011-07-11 00:00 | UNCLASSIFIED//FOR OFFICIAL USE ONLY | Consulate Sao Paulo

`

    VZCZCXRO5550
    RR RUEHRG
    DE RUEHSO #0261/01 0691958
    ZNR UUUUU ZZH
    R 101958Z MAR 06
    FM AMCONSUL SAO PAULO
    TO RUEHC/SECSTATE WASHDC 4638
    INFO RUEHBR/AMEMBASSY BRASILIA 5801
    RUEHMN/AMEMBASSY MONTEVIDEO 1853
    RUEHBU/AMEMBASSY BUENOS AIRES 2086
    RUEHSG/AMEMBASSY SANTIAGO 1600
    RUEHLP/AMEMBASSY LA PAZ 2637
    RUEHRG/AMCONSUL RECIFE 2752
    RUEHRI/AMCONSUL RIO DE JANEIRO 6885
    RUEHAC/AMEMBASSY ASUNCION 2437
    RUCPDOC/USDOC WASHDC 2310
    RUEATRS/DEPT OF TREASURY WASHDC

` `

    UNCLAS SECTION 01 OF 04 SAO PAULO 000261

    SIPDIS

    STATE PASS TO USTR FOR MSULLIVAN
    NSC FOR SUE CRONIN
    TREASURY FOR FPARODI
    USDOC FOR 3134/USFCS/OIO/WH/EOLSON
    USDOC FOR 4332/ITA/MAC/WH/OLAC/MWARD
    STATE PASS FED BOARD OF GOVERNORS FOR ROBITAILLE

    SENSITIVE
    SIPDIS

    E.O.  12958: N/A
    TAGS: EFIN ETRD BEXP ECON EINV PGOV BR
    SUBJECT: The Ever-Rising Real Part II:  The Emergence of Dutch
    Disease?

    REF:  Brasilia 366

    ¶1.  (U)  This is the second of a two-part series on the
    macro-economic consequences of the recent rise in the Brazilian
    real.  The first cable in the series, Brasilia 366, looked at the
    GOB's macro and debt management policies.  This cable, authored by
    ConGen Sao Paulo, considers the effect of the strengthening real on
    the business sector.

    ¶2.  (U) Summary.  As the real reaches its highest level in five
    years (reftel), some economists believe the Brazilian economy may be
    suffering from a form of "Dutch disease," a diagnosis stoutly denied
    by government officials.  Nonetheless, Development/Industry/Trade
    Minister Furlan has warned that the current exchange rate threatens
    exports and has called for adjustments.  Export-dependent industries
    are increasingly concerned about their future competitiveness if the
    real continues to strengthen, and many are freezing or cutting back
    investment.  Even some import-competing industries, such as
    textiles, are beginning to feel pressure.  More ominously, some
    agricultural giants are feeling the pressure and are moving major
    production facilities to other countries.  End Summary.

    -------------------------------
    DUTCH DISEASE: A DIRE DIAGNOSIS
    -------------------------------

    ¶3.  (U) Critics of Brazil's monetary policy have added a new concept
    to their artillery: "Dutch disease."  Originally given the moniker
    "national resource curse," the term was coined by The Economist
    magazine in 1977.  Dutch disease refers to the deindustrialization
    of a nation's economy owing to the discovery of a natural resource,
    the export of which raises the value of that nation's currency,
    thereby making manufactured goods less competitive with those of
    other nations, increasing imports, and decreasing exports.  The
    phenomenon was first noticed in the Netherlands in the 1960s after
    the discovery of North Sea gas.  In recent weeks, several prominent
    Brazilian economists, such as Professors Carlos Eduardo Goncalves
    and Joaquim Eloi de Toledo of the University of Sao Paulo, and
    Francisco Eduardo Pires de Souza, advisor to the Department of
    Planning at the state-owned National Bank for Economic and Social
    Development (BNDES), have argued that Brazil is suffering from Dutch
    disease symptoms.

    ¶4.  (SBU) Some analysts claim that Dutch disease has afflicted
    Brazil because of the rise in the country's exports of minerals and
    high-priced commodities like soybeans.  In 2005, agribusiness
    accounted for nearly 86 percent of Brazil's trade surplus, which
    came in at a record USD 44.8 billion.  Domestically, the effects of
    the strengthened real are already reportedly affecting industries
    that generate many jobs, even those that don't export (e.g.,
    footwear and textiles) forcing factories to shut down in the face of
    increasing competition from Asian countries, such as China.  Recent
    estimates claim the strong real forced nearly 1,000 companies,
    principally small and medium-sized enterprises, out of the export
    market last year.  Officials at CIESP, a prominent Sao Paulo state
    industry federation, note that while Brazil registered record
    exports in 2005 - US$118 billion -- the country's export base was
    quite narrow:  40 companies were responsible for 45% of exports
    while 60 companies accounted for 65% of exports.  Trade balance
    figures released February 19 showed that imports grew more than
    exports in the third week of February.  The trade surplus (exports
    minus imports) fell from US$ 881 million in the previous week to US$
    579 million.

    ¶5.  (SBU) Carlos Velloso, a prominent economist with links to the
    opposition PSDB party, argued to Econoffs that Brazil is seeing
    Dutch Disease-like effects due to burgeoning exports of high priced
    commodities.  These effects, he pointed out, extended to all
    tradable goods sectors, including import-competing sectors such as
    textiles.  And while low-priced Chinese textile imports were a key
    competitive threat for the Brazilian textile sector, he said, so was
    the appreciated Real.

    -----------

    SAO PAULO 00000261  002 OF 004

    GOB DENIALS
    -----------

    ¶6.  (SBU) Brazilian government officials are quick to dismiss the
    notion that the country has caught Dutch disease.  In a recent press
    interview, BNDES President Guido Mantega said, "Dutch disease does
    not apply to Brazil, which faces no risk of deindustrialization, or
    of returning to an agro-exporter past."    Mantega, a former
    Minister of Planning and one of the leading economists in the
    governing Workers' Party (PT), noted that manufactured products
    comprise a majority of Brazil's exports, and that "Brazilian
    industry has never been stronger."  Mantega further observed that
    Brazil's share of the world market is growing and that the Brazilian
    car industry exported 33 percent more vehicles in 2005 than in 2004.
     Mantega pointed out that the automotive industry was the sector
    that posted the highest level of growth in the past three years,
    with increases in output, productivity and job creation.  (Note:
    Many of the low-priced vehicles manufactured in Brazil are exported
    for sale to consumers in Mexico; in turn, Mexican producers
    manufacture vehicles for sale in the more lucrative U.S. market.)

    ¶7.  (U) Minister of Development, Industry and Foreign Trade Luiz
    Fernando Furlan also argues that Dutch disease does not apply to
    Brazil, pointing out that the country can boast of a wide variety of
    export sectors, of which industrial products represent a large
    share, with no single commodity or sector dominating.  Nevertheless,
    both Furlan and Mantega acknowledge that the continued rise in the
    real is worrisome.  With respect to the decline in the trade surplus
    announced last month, Furlan publicly noted that this was the first
    time in recent years the trade surplus had dropped in the month of
    February in comparison with February of the previous year.

    ¶8.  (SBU) Local economists are divided on the subject.  Some have
    "diagnosed" the disease and maintain that the country has already
    suffered deindustrialization as a consequence.  Others insist that
    the difficulties faced by Brazil's industrial sector are the result
    of overly high interest rates and taxes, combined with shortcomings
    in infrastructure and technology.  Although most interlocutors tell
    EconOffs that the strong real is their main concern, all agree that
    Brazil's unfavorable business climate would still be a hindrance
    even if the real remained weak.  Brazil's non-competitive business
    climate is generally blamed for Brazil's failure to grow, while it
    is the strong real that has been blamed for actual export shrinkage.

    ¶9.  (U) Fernando Cardim de Carvalho, a professor at the Federal
    University of Rio de Janeiro, believes that although the situation
    differs from the experience of the Netherlands, Brazil is in fact
    suffering the effects of currency overvaluation.  In a recent
    interview, Carvalho argued that the overvaluation of the national
    currency is not an inevitable consequence of the surplus of dollars
    brought about by exports of products for which world market prices
    or export volumes have rapidly risen.  He pointed out that Argentina
    and China have also experienced major growth in export revenues, but
    have maintained exchange rates favorable to exports, and low
    interest rates, converting their trade surpluses into currency
    reserves, unlike Brazil.  Carvalho contended that the problem with
    Brazil lies with high benchmark interest rates set by the Central
    Bank, which make it too costly to expand reserves the way that China
    and other countries with large trade surpluses have done.  In
    addition, he added, high interest rates have attracted speculative
    capital (as opposed to Foreign Direct Investment), which has further
    exacerbated the overvaluation of the real.  Carvalho warned that
    depending on agricultural or mineral exports is "bad business,
    because world market prices for primary sector commodities are
    highly unstable."  Regardless of whether Brazil is facing Dutch
    disease or not, economists and government officials agree that
    export industries are suffering from the strong real.

    -----------------------
    INDUSTRY FEELS THE PAIN
    -----------------------

    ¶10.  (SBU) The business newspaper Valor Economico cites a poll

    SAO PAULO 00000261  003 OF 004

    conducted in the U.S. with 203 American companies operating in
    Brazil, which shows an abrupt change in their plans to invest here.
    According to the study, disappointment with poor GDP results in 2005
    and the increasing valuation of the real vis-a-vis the dollar have
    led U.S. companies to reduce investments in Brazil.  Interlocutors
    throughout the Sao Paulo consular district (which accounts for close
    to 70 percent of Brazil's GDP) have consistently complained to
    EconOffs that the strengthening real is hurting local industry and
    that the effects of the weakened dollar will be evident in 2006
    first quarter reports.  While most complaints have involved
    industrial sectors (auto, machinery, etc.), recent trends show that
    the strong real is starting to affect Brazil's agricultural sector
    as well.  This is especially bad news, given that agro-business
    accounted for 86 percent of Brazil's 2005 record trade surplus.
    Although strong international prices for commodities buoyed
    agro-exports during the real's 2005 rally (gaining almost 17
    percent), it appears that large agro-business is finally feeling the
    real's pinch.  This is evident in the experiences of agro-business
    companies Bunge and Archer Daniels Midland (ADM).

    Agro Agony
    ----------

    ¶11.  (U) American agro-giant Bunge, which processed 13 million tons
    of soy in Brazil last year, announced in February that it will have
    to close brand new factories that it just completed constructing in
    ¶2005.  In December, it suspended processing at 7 of its 49
    fertilizer plants, and shut down 2 of its 12 soy processing
    factories.  Meanwhile, Bunge just finished construction on a soy
    plant with a capacity to process 19 million tons a year in
    neighboring Argentina.  Bunge states that it is transferring a
    portion of its Brazil operations to Argentina for tax and
    "competitiveness" reasons.  Moreover, Bunge investment in Brazil
    over the next four year will be cut by 70 percent.  Bunge
    representatives remarked, "the impact of the exchange rate has
    become violent for our company.  The only way to maintain viable
    operations that would still be acceptable to our shareholders was
    for us to reduce operations."

    ¶12.  (SBU) But the damage is not confined to the closing of
    factories.  Bunge representatives warned of unfolding
    deindustrialization in the Brazilian agro-sector.  According to
    Bunge, "tax difficulties, the exchange rate, and infrastructure and
    logistic problems are leading soy producers to gradually reduce
    operations."  The Brazilian Association of Vegetable Oil Industries
    warns that while Brazilian grain exports will grow 10 percent in
    2006, exports of processed products (such as soy oil and meal) will
    fall by four percent.  Bunge claims that they already experienced
    this four percent decrease in 2005.  Bunge's export volume for 2005
    was a mammoth USD 2.2 billion, but company executives note that this
    high figure masks an underlying problem: high exports represent an
    increase in prime material (grain) and a reduction in processed
    goods (oil and meal).  According to Bunge, "this dramatic reduction
    in industry is not easily reversed.  Brazil is turning into a
    world-class provider of prime material, but it's losing industrial
    capacity.  This is not a trend that will simply reverse itself once
    it's discovered."

    ¶13.  (SBU) U.S. company Archer Daniels Midland Company (ADM),
    another of Brazil's principal soy producer, is experiencing the same
    problems as Bunge.  ADM has reduced soy processing operations in
    Brazil by 30 percent.  Factories in the southern cities of Tres
    Passos, Rio Grande do Sul and Paranagua (Parana state), with
    capacities to process 1,000 tons of soy per day, will not return to
    operations for the 2006-07 crop.  ADM remarks, "the increasing cost
    of the real has provoked a loss in international competitiveness.
    This has forced us to refrain from investing and close down
    factories."  Although it was in the middle of its corporate
    investment cycle, ADM has suspended further investment in Brazil,
    though the company could return to invest again if the exchange rate
    softened.  ADM admitted, "with the current exchange rate, Brazil is
    not the export platform it used to be."

    Auto Anguish

    SAO PAULO 00000261  004 OF 004

    ------------

    ¶14.  (SBU) The effects of the strong real are felt most acutely by
    businesses that produce manufactured and semi-manufactured goods,
    with strong dependence on low internal costs.  Damiel Prates, a
    researcher at the Center for Political Economy at the University of
    Campinas, remarked, "the exchange rate is critical in the area of
    manufactured goods.  Brazil has just started to face the realities
    of exchange rate politics.  The figures already show that industrial
    exports are falling by the wayside."  The irony, according to Jose
    Ricardo Roriz Coelho of the Federation of Industries of Sao Paulo
    State (FIESP), "...  is that the real's 2005 increase of 16.75
    percent is an effective tax break on imports, while at the same time
    an increased tax on exports."  This export tax is being felt across
    industrial sectors.  For example, the American company Eaton, which
    produces automotive power train components in Brazil, has felt the
    pinch.  With 30 percent of its revenue tied to exports, Eaton has
    already received demands from clients: reduce costs or we'll seek
    alternative suppliers.  According to Eaton's Vice President for
    Latin America, Carlos Alberto Briganti, "the automotive industry has
    already asked for a 10 percent cut in costs.  The strong real limits
    new gains in productivity in the automotive supply chain, a sector
    that has not dealt with inflation for a long time."  Briganti notes
    that Eaton's challenge isn't just maintaining contracts, but also
    acquiring new contracts.  "The real concern is the future," says
    Briganti.

    -------------------------
    Strong Real: Weak Growth?
    -------------------------

    ¶15.  (SBU) Comment:  The real concern is the future.  This sentiment
    is prevalent among our business interlocutors.  Brazil experienced
    less-than-mediocre GDP growth of 2.3 percent in 2005 (in the
    hemisphere, only Haiti performed worse).  While many estimates for
    2006 range between 3.5 to 4 percent, achieving this could be
    difficult as export industries feel the squeeze of the strong real.
    And, while the Dutch Disease-diagnosis seems to us to be premature,
    should these nascent deindustrialization trends consolidate, Brazil
    could lose some of the ground it has gained in industrial exports
    and see itself returning to its previous status as primarily an
    export platform for raw materials and prime agricultural goods.  The
    Lula administration has resorted to targeted benefits for certain
    export-oriented sectors in an attempt to ameliorate the effect of
    the appreciated Real on export industries.  Given current
    expectations that the Real will appreciate further and remain strong
    into the medium term, however, the GoB may find such simple
    palliatives wanting.  But, we have no expectation that broad-based
    tax reform or other necessary microeconomic reforms, which could do
    much to offset the effects of the exchange rate by reducing costs
    for businesses and increasing their competitiveness, will be
    addressed by the Congress at all during this presidential election
    year.  End Comment.

    ¶16.  (U) This cable was coordinated with Embassy Brasilia.

    McMullen

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