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### Viewing cable 04BRASILIA450, BRAZIL'S PUBLIC-DEBT VULNERABILITY LESSENS, FOR NOW

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
04BRASILIA450 | 2004-02-29 13:11 | 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 08 BRASILIA 000450

    SIPDIS

    NSC FOR SHANNON, DEMPSEY, CRUZ
    TREASURY FOR OASIA/SEGAL
    EXIMBANK FOR DIRECTOR FOLEY
    FED BOARD OF GOVERNORS FOR ROBATAILLE
    USDA FOR U/S PENN, FAS/FAA/TERPSTRA
    USDOC FOR 4322/ITA/IEP/WH/OLAC-SC
    SOUTHCOM FOR POLAD

    SENSITIVE

    E.O. 12958: N/A
    TAGS: EFIN ECON EINV ETRD PREL PGOV SOCI BR
    SUBJECT: BRAZIL'S PUBLIC-DEBT VULNERABILITY LESSENS, FOR NOW

    REF: (A) 03 BRASILIA 3682, (B) 03 BRASILIA 3911

    SUMMARY
    -------

    ¶1.    (U) Brazil's nominal net public debt and debt/GDP
    ratio both continued to rise in 2003, but there are grounds
    for guarded hope that the debt burden is not now the
    imminent threat it has been in recent years.  The debt/GDP
    ratio (58.2% end-December) is far down from its brief late-
    2002 spike of 64% and is forecast to decline year-on-year in
    2004 -- a first since 1993.  The GoB has worked well to
    reduce the debt's exchange-rate vulnerability:  foreign
    public debt grew fractionally in 2003, but the dollar-linked
    component of domestic debt was steeply down, to 10% of the
    total (20.5%, including swap exposure) from end-2002's 20.3%
    (53.5%, including swap exposure).  The Real's appreciation
    since late 2002 from almost four to under three per USD has
    in itself greatly eased service of the debt's foreign-
    currency component.  And Brazil's soaring exports have added
    a new shock-absorber against sudden depreciation of the Real
    and consequent surges in dollar-linked debt.

    ¶2.   (U) Eighty percent of the total debt is domestic, i.e.,
    denominated in Reals.  Half of that 80% is tied to the
    Central Bank's benchmark SELIC interest rate.  Thus, the
    SELIC's drop from 26.5 to 16.5% since June 2003, if
    continued, means future-year savings in interest payments of
    1.5-3.0% of GDP, as the GoB replaces or retires old debt
    issued at high SELIC rates.  In a "virtuous-circle" effect,
    the return of market confidence during Lula's first year has
    allowed the GoB to improve the composition of its
    securitized debt by issuing more fixed-rate paper, as well
    as (since August) lengthening maturities.  GoB optimists
    speak of cutting debt-service costs enough to achieve
    nominal/nominal balanced budgets by 2008, paving the way for
    debt/GDP to decline to the low 40% range within the decade.

    ¶3.   (SBU) Yet Brazil's public debt remains far too close
    for comfort to a macroeconomic knife's edge.  The Lula
    government's hard-won primary surplus of 4.32% of GDP in
    2003 still covered less than half of the interest payment
    (9.49%) on its debt stock.  The overall nominal debt and
    debt ratio each thus still grew by around three percent.
    (The Real's appreciation partly counteracted the nominal-
    deficit effect, by shrinking the valuation in Reals of
    foreign-exchange-linked debt.)  For 2004, the GoB itself
    projects only a modest reduction in the ratio, to 57.3% --
    even assuming 3.5% GDP growth.  Domestic and/or external
    shocks could reverse recent positive trends.  Meanwhile, the
    huge costs of debt-service sap the GoB's ability to make
    investments needed for growth, without which the debt burden
    will become more intractable.  Bottom line:  Lula's team in
    its first year made more progress in managing the public
    debt than even they might have dreamed possible -- but the
    debt worry looks sure to remain, hovering like a ghost over
    his entire term.  END SUMMARY.

    Scope and Structure
    -------------------

    ¶4. (U) Brazil's net public-sector debt rose in 2003 from 881
    to 913 billion Reals (from 55.5 to 58.2% of year-end GDP).
    Converted at the then-exchange-rate of Reals 2.89 per USD,
    the end-2003 total amounted to $316.1 billion.  That dollar
    figure may mislead, however.  Net public foreign debt
    constituted just USD 64.6 billion, or 20.4% of the total.
    The other four-fifths was domestic and denominated in Reals.
    Thus, the GoB can finance itself almost entirely on the
    local market.  About 90% of new debt issued is domestic;
    recent modest external issues have involved simply rolling
    over foreign-exchange debt.  The domestic debt admittedly
    includes foreign-exchange exposure of about USD 55.8 billion
    in the form of domestic securities tied to the exchange rate
    or currency swaps issued in parallel with those securities.
    The total foreign-exchange-rate exposure of Brazil's public
    debt thus amounts to roughly USD 121 billion, 30.4% of the
    total (40.9% including swaps).

    ¶5. (U) FOREIGN-DEBT NOTE:  The GoB (and IMF-approved) figure
    for Brazil's foreign public-debt total is net/net of
    official gross/gross reserves.  The latter at end-2003 were
    below USD 60 billion, of which over USD 38 billion
    represented IMF loans.  Net reserves then were under 20
    billion, a small fraction of their average since the early
    1980s.  The GoB has since increased its net reserves by over
    two billion dollars via open-market purchases, an ongoing
    process.   END NOTE.

                               -------
                               Table 1
                               -------

            Brazil's Consolidated Net Public Sector Debt
                (1998-2003, End-Year), Billion Reals

                  1998    1999    2000    2001    2002    2003

    Net Debt     385.9   516.6   563.2   660.8   881.1    913.1
    (% of GDP)    41.7    48.7    48.7    52.6    55.5     58.2

    Foreign 1/    57.2   108.8   111.3   130.8   226.8    186.4
    (in dollars)  47.3    60.8    57.0    56.4    64.2     64.6
    (% of GDP)     6.2    10.3     9.6    10.4    14.3     11.9

    Net Domestic 328.7   407.8   451.8   530.0   654.3    726.7
    (% of GDP)    35.5    38.4    39.1    42.2    41.2     46.3

    -1/ Net of Central Bank foreign exchange-denominated assets
    including gross reserves; converted at contemporary exchange-
    rate.

    Sources: Central Bank and Finance Ministry.

                               -------
                               Table 2
                               -------

                   Breakdown of Public-Sector Debt
                          Billions of Reals
                            December 2003

    NET PUBLIC SECTOR DEBT               913.1

    Gross Debt                              1,344.6
     - Federal Government                     940.0
     - Central Bank                           312.4
     - State Governments                       21.9
     - Municipal Governments               5.2
     - Federal para-statals               51.2
     - State para-statals                      13.9
     - Municipal para-statals                   0.3

    Assets netted out                        -431.5
     - Federal Government               -203.3
         (primarily domestic assets of the Workers' Guarantee
         Fund, assets of similar domestic funds and renegotiated
         state debts to federal government)
     - Central Bank                          -161.5
        (primarily international reserves)
     - State Governments                      -11.3
     - Municipal Governments                   -2.5
     - Federal para-statals              -52.6
         (includes foreign exchange deposits, renegotiated debt,
         other credits)
      - State para-statals                -0.3
      - municipal para-statals                 -0.1

    Source: Central Bank

    ¶6.  NOTE:  To avoid confusion amongst specialist followers
    of Brazilian finances, it should be noted that Brazil's net
    public domestic debt ("divida liquida") is not the same as
    its Federal Domestic Securitized Debt (FDSD -- "divida
    mobiliaria").  The latter includes some GoB paper which does
    not reflect net debt, e.g., extra issuances to sterilize the
    CB's open-market purchases of dollars to boost reserves, or
    other monetary-policy operations.  FDSD thus is sometimes
    greater, sometimes less, than net domestic debt, as a
    comparison of Table 1 above with Table 3 displays.

                               -------
                               Table 3
                               -------

              Federal Domestic Securitized Debt
                (1998-2003), Billion Reals

                  1998    1999    2000    2001    2002    2003

    Stock        323.9   414.4   510.7   624.1   623.2    731.4
     -(% of GDP)  35.0    39.1    44.2    49.7    39.2     46.1

    Source: Central Bank and Finance Ministry

    How Did We Get Here?
    --------------------

    ¶7. (U) Multiple dynamics raised Brazil's federal debt/GDP
    level from 1994's 30% to the current 58+%.  The key drivers
    have been: a) high nominal deficits (and, before 1998,
    primary deficits), generated fundamentally by the high
    interest rates to which successive GoBs have resorted to
    stabilize the currency and fight inflation in the face of
    various shocks; b) centralization of state, municipal and
    other liabilities at the federal level after the mid-1990s;
    c) currency devaluation since 1998; and d) stubbornly low
    GDP growth.

    High, Interest-Driven Deficits
    ------------------------------

    ¶8. (U) Before the 1997-99 emerging-market financial crisis,
    the GoB ran not just nominal but primary consolidated budget
    deficits.  The Cardoso government of that era maintained an
    overvalued exchange rate by means of high interest rates.
    When forced to float the Real in 1999, it raised interest
    rates still further to control inflation.  These factors
    help explain how interest costs of what was initially a
    relatively modest stock of debt have for years been so high.

    ¶9. (U) The years since 1998 have seen primary-budget
    surpluses of 3.2% of GDP or better.  However, in those same
    years debt service has grown to 7-9% of GDP in interest
    payments alone.  This tremendous expense soaks up as much as
    a quarter of government revenues (federal and state.)  It
    has been the primary agent behind Brazil's fiscal deficits
    since the Plano Real in 1994.  To illustrate:  the Lula
    government's hard-won 4.32% of GDP primary surplus covered
    less than half its interest expenditures (9.49% of GDP) in
    ¶2003.  Result: a nominal deficit of 5.16% of GDP.  Table 4
    illustrates the impact of debt service on Brazil's fiscal
    accounts over the last half-decade.

                               ------
                               TABLE 4
                               -------
               Interest Payments Drive Fiscal Deficits
              (In Billions of Reals and Percent of GDP)

    Year         1998    1999    2000    2001    2002     2003

    -Nominal
    Interest    68.3    87.4    78.0    86.4    114.0    145.2
    -% GDP       7.5     9.0     7.1     7.2      8.6      9.5
    (accrual basis)

    -Primary
     Surplus     0.1    31.1    38.2    43.7     52.4     66.2
    -Pct of GDP  0.0     3.2     3.5     3.6      4.0      4.3

    -Nominal
     Deficit    68.2    56.3    39.8    42.7     61.6     79.0
    -Pct of GDP  7.5     5.8     3.6     3.6      4.6     5.16

    Source: Ministry of Finance and Central Bank

    ¶10. (SBU) NOTE:  Unibanco's chief economist once lamented to
    Econoff that his former employer, the World Bank, had ever
    convinced the IMF to fix primary surpluses instead of actual
    deficits as program benchmarks.  This policy, he said, masks
    the extent of a country's fiscal problems.  In Brazil's
    case, even the current 4.3% of GDP primary surplus is not
    enough to bring down the debt-to-GDP ratio, he argued.  END
    NOTE.

    "Skeletons"
    -----------

    ¶11. (U) The Cardoso administration's responsible process
    through the late-1990s of acknowledging bad state, municipal
    and parastatal debt, plus some other liabilities, has also
    driven up the official GoB debt level.  Much of these debts,
    commonly referred to as "skeletons", have been centralized
    in the federal government.  "Skeletons" added an officially
    estimated 8.62% of GDP to the stock of federal public debt
    in the eight years to December 2003.  Pessimists opine that
    more skeletons remain to be unearthed, perhaps another 5-8%
    of GDP, but this upper figure seems increasingly unlikely.

    Currency Depreciation
    ---------------------

    ¶12. (U) Since 1998, the dominant factor in worsening the
    debt/GDP ratio has been the exchange rate.  This was
    reflected by the jump in the ratio after the GoB was forced
    to float the Real in early 1999.  From 41.7% in 1998, the
    ratio leapt to 48.7% at the end of 1999.  (The particularly
    high interest rates briefly imposed in 1999 were also a
    factor, but those rates themselves stemmed from the need to
    staunch capital flight and inflationary effects arising from
    the devaluation.)  The Real's renewed plunge from April into
    October 2002 -- combined with the effects of high interest
    rates employed to combat inflation and restore market
    confidence during the presidential campaign -- likewise took
    a toll, causing the brief spike at 64%.

    ¶13. (U) A CSFB study gave as the rule-of-thumb for the
    second half of 2002 (with the Real in the 3.50-4.0/dollar
    zone) that a 10% currency devaluation translated to a 2
    percent rise in Brazil's debt/GDP.  At its worst, in
    November 2002, it meant a 3.4% increase.  This effect was
    not mainly due to Brazil's relatively modest foreign public
    debt.  Rather, it was driven by the then-burgeoning level of
    the dollar-linked portion of domestic public debt.  That, in
    turn, was generated by the GoB's practice, adopted out of
    necessity, of holding down interest rates on its new debt by
    increasing issuance of dollar-linked instruments.  As part
    of this process, starting in April 2002 the Central Bank
    also began issuing dozens of billions of dollars' worth of
    swaps in parallel with new Treasury SELIC issuances.  (IMF
    rules forbid Treasury from selling swaps or other
    derivatives.)

    ¶14. (U) Lula's GOB has assiduously reduced this exposure to
    exchange-rate volatility.  As market confidence in his
    financial team has grown, the latter has been able to
    retire, rather than roll over, massive portions of dollar-
    linked debt coming due, replacing them with non-dollar-
    linked debt.  In 2003, it retired from the market over $20
    billion in dollar-linked debt and debt-related swaps.  By
    year's-end, the dollar-linked part of the domestic debt had
    halved, from 20.3 to 10.0%, year-on-year.  Including swaps,
    the drop was from 33.5 to 20.5%.  The process has
    accelerated since, with a total of $7.6 billion more in
    dollar-denominated debt retired in the first two months of
    2004, according to the latest GoB figures.

                               -------
                               Table 5
                               -------

                COMPOSITION OF DOMESTIC FEDERAL DEBT

                          End-2002     Sept.'03   End-2003
                          --------     --------   --------

    Fixed-interest            1.5%       6.9%          9.5%
    Floating-interest        42.4%      48.9%         46.5%
    Inflation linked          9.2%       9.8%         10.3%
    Total Dollar and
     Dollar-linked        45.8%      33.0%         32.4%
     Others                   1.6%       1.4%          1.4%

    Source:  Central Bank and Finance Ministry

    FLOATING INTEREST RATE EXPOSURE
    -------------------------------

    ¶15. (U) As the debt's foreign-exchange component has shrunk,
    its interest-rate component has grown.  Half the domestic
    debt is floating-rate, linked to the Central Bank's discount
    (SELIC) rate.  To illustrate the potential downside of this
    factor: the Central Bank's interest-rate hikes in response
    to the crisis of confidence in 2002 increased average
    interest on Brazil's domestic public securitized debt to a
    peak of 31.7% in November 2002.

    ¶16. (U) The GoB has begun to turn the tide in this area, as
    seen in Table 6.  New financial-market confidence has
    allowed it to reduce interest rates, increase issues of
    fixed-rate debt (from under two to over twelve percent of
    the total, year-on-year by end-2003) and, beginning in
    August 2003, also to lengthen maturities.  By December 2003,
    the SELIC had dropped to 16.5% from 26.5% in mid-2003, and
    the average interest rate on domestic debt was down to
    around 22%.  This, to be sure, still left the real rate well
    in the double-digit range.  As for foreign-debt service:  by
    January 2004, the GoB was able to launch a 30-year Eurobond
    with a spread of 377 basis points above U.S. Treasuries --
    quite remarkable after the spreads of 24% above U.S.
    Treasuries little more than a year before.

                               -------
                               TABLE 6
                               -------

      DOMESTIC SECURITIZED FEDERAL DEBT INDICATORS/1

                          End 2002  Sept 03    Dec 03

    Ave. maturity
           (months)        33.20       31.20     31.34
    - fixed rate            3.06        6.64      6.50
    - SELIC linked       21.83      22.38     22.74
    - Dollar linked         35.47      40.82     40.51
    - inflation link        79.18      75.29     77.88

    Duration (months)       20.0        15.2
    Percent maturing within one year
     (total)                38.9        32.1      33.4
    - fixed rate            96.8        86.9      85.9
    - SELIC linked          48.8        30.9      28.9
    - Dollar linked         31.1        33.5      42.7
    - inflation link         1.3         1.7       1.4

    Average Interest Rate
    - w/swap exposure    20.9           18.6
    - w/out swaps        29.1           21.2

    Exchange-Rate Exposure (Billions of Reals)
    - Dollar-linked       139.47         83.24    78.67
    - Swaps                91.10       103.37     82.72
    - Total               230.57        186.62   161.39

    1/ Federal domestic debt in the form of securities
       held by the public

    Source: Ministry of Finance and Central Bank

    GDP:  The Stagnant Variable
    ---------------------------

    ¶17. (U) The final variable in the debt/GDP equation is GDP
    itself.  Brazil's anemic growth over the last several years
    has exacerbated the ratio's increase.  Growth in 2004 is
    widely forecast to recover to 3.5%.  But even if that
    scenario is borne out, along with market expectations of
    relative exchange-rate stability (3.1-3.2 Reals/$) plus a
    further decline in the SELIC interest rate to 13.5% at end-
    year, private-sector specialists calculate debt/GDP at end-
    2004 will still be 58%.  The GoB itself forecasts just a
    modest fall, to 57.2%.

    ¶18. (U) After 2004, projections of declining debt/GDP levels
    depend critically on sustained growth rates of at least 3.5
    to 4%.  Indeed, the public debt will only be payable to the
    extent that Brazil solves its longer-term growth problem.
    That solution, in turn, hinges on the raft of microeconomic
    reforms necessary to increase economic efficiency and
    promote investment (Ref A.)

    ¶19. (U) Meanwhile, Brazil's debt level in itself stymies
    longer-term growth.  Most GoB borrowing is to roll over
    maturing debt and to pay current fiscal deficits.  Public
    investment has dried up, squeezed both by debt service and
    constitutional spending earmarks which leave only about 9%
    of the federal budget as discretionary spending.

    COMMENT
    -------

    ¶20. (SBU) Financial-market enthusiasm for Brazil debt-paper
    seems ready for the long-haul.  Certainly Brazil has come a
    good way from the "vicious circle" near-panic induced by the
    presidential campaign of 2002, with that period's plummeting
    exchange rate, interest-rate hikes, and extreme difficulty
    in debt-rollover.  But, for all the debt-management skill
    and progress of Lula's first year, Brazil's public-debt
    profile could quite easily again fall prey to negative turns
    of market mood if, e.g., local interest-rate or global risk-
    capital trends take a bad turn, and/or domestic growth in
    the real economy continues not to materialize.

    ¶21. (SBU) Beyond keeping its fingers crossed against
    external and domestic shocks, the GoB can now best improve
    its debt sustainability by enacting structural and
    microeconomic reforms to attract investment and boost
    growth.  Unfortunately, the early results of its efforts to
    reform the tax, pension and regulatory systems have been
    economically underwhelming, however politically resolute.
    The phantoms of doubt about Brazil's debt have withdrawn to
    the wings for now, but will surely hang around, ready again
    to haunt the GoB, through Lula's term.

    HRINAK

`