US embassy cable - 04BRASILIA935

UNCLAS SECTION 01 OF 02 BRASILIA 000935 
 
SIPDIS 
 
RIO FOR TREASURY DELEGATION - STEPHANIE SEGAL 
NSC FOR DEMPSEY 
TREASURY FOR OASIA 
PLS PASS FED BOARD OF GOVERNORS FOR ROBATAILLE 
USDA FOR FAS/FAA/TERPSTRA 
USDOC FOR 4322/ITA/IEP/WH/OLAC-SC 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, PGOV, PREL, EINV, SOCI, BR, Macroeconomics & Financial 
SUBJECT:  GOB'S FINANCIAL-MARKET HONEYMOON FINALLY COOLING? 
 
1.  Top front-page story in most national media Friday April 16 
was JP Morgan's scaling-back of its recommendation for Brazil 
bonds from overweight to market-weight, and the sharp market 
reaction.  News accounts generally headlined the JPM report's 
unease over the direction of GoB fiscal policy, and its 
judgment that the GoB is showing itself to be lax with regard 
to outlays for public-sector workers and pensioners.  The 
report also listed concerns about the GoB's putative goal of 
exempting infrastructure investment from future primary-budget 
surplus calculations, as well as about increased potential for 
negative exogenous events such as early U.S. interest-rate 
hikes or a disturbance of China's commodity demand. 
 
2.  The JPM analysts see recent developments as threatening 
Brazil's long-term debt/GDP trend.  Their report characterized 
January-February fiscal results as below expectations and, 
without openly so stating, insinuated that this year's GoB 
budget-surplus target is at risk.  Its summary of the political 
status quo was that "the government has lost an important 
opportunity to launch a more positive reform agenda...". 
 
3.  Reaction:  by Thursday evening, Brazil's country risk was 
up over 10% to 618, highest since last October (in January 2004 
it briefly dipped below 400.)  The benchmark C-bond was down 
2.6% to 93% of face value.  Commentators quickly pointed out 
the extra difficulty this would mean for the GoB's plans to 
raise a further USD 2.5 billion on international markets for 
debt-service needs in 2004.  The BOVESPA likewise dropped over 
2.5%.  The foreign-exchange rate showed greater steadiness. 
The Real closed down by a mere percent, at 2.918 per USD, even 
on a day when USD 5.1 billion in public-debt payment -- by far 
the largest of this year -- fell due, and in the immediate wake 
of the Central Bank's latest quarter-point cut of the SELIC 
interest rate last Wednesday (as expected.) 
 
4.  Seemingly surprised as well as stung by these developments, 
Planning Minister Mantega was quickly quoted as disparaging any 
implication that the 4.25% budget-surplus target for 2004 might 
not be met.  Public-sector pay agreements, he stressed, are 
being held in tight, fiscally responsible reins.  Fortuitously, 
Mantega was able to point to just-released first-quarter 
revenue figures including a record collection for March as 
providing more than enough margin to fund public-servant wage 
agreements arrived at to date.  Also by happy coincidence, the 
GoB had just forwarded to Congress both its 2003-2007 
Pluriannual Plan and its budget outline (LDO in Portuguese 
acronym), in which the notion of counter-cyclical budget 
spending has been officially dropped.  (Mantega said counter- 
cyclical novelties at Brazil's current juncture would risk 
confusion.)  Both the LDO and the PPA re-confirmed that the 
budget-surplus target for 2005 remains 4.25%. 
 
5.  In the aftermath, various market voices have opined that 
sellers' nerves were unduly taut and that the JP Morgan report 
contained little news and was overblown.  True, a day later 
Citibank also lowered its Brazil-bond recommendation, and 
Merrill Lynch issued a more general recommendation to move 
assets from Brazilian stocks towards Mexican instruments. 
Citibank's well-known analyst, however, attributed his shift 
purely to external considerations, explicitly asserting that he 
had no reservations about GoB policies.  Meanwhile, other banks 
(ABN Amro, West LB) reaffirmed their strong Brazilian "buy." 
 
6.  The JP Morgan report came in for relaxed roasting at the 
April 16 blue-ribbon Businessmen's Seminar in Bahia, attended 
inter alia by former president Cardoso as well as Finance 
Minister Palocci.  Comments ran along the lines that the report 
must have been composed by a junior analyst who got out of bed 
in a bad mood.  In the process, Palocci went out of his way to 
be quoted admitting that his policies have been a continuation 
of FHC's, and that he is proudly ready to continue doing so for 
ten years more.  Friday April 16 market results walked back 
much of Thursday's damage. 
 
7.  NOTE:  The episode seems to be an amusing case of 
"rational" markets' logic.  In descending from "over-market" to 
"market-weight" (i.e., 23% of the world emerging-market index, 
reportedly) for its Brazil-bond recommendation, JPM was 
literally just endorsing the general market assessment of 
Brazil bonds' profitability, in place of its previous second- 
guessing of the general market assessment.  But its very 
endorsement caused that assessment to adjust itself downwards. 
END NOTE. 
 
COMMENT 
------- 
8.  This episode does have its frivolous aspect.  Not least, 
JPM raised its recommendation to "above-market" just six weeks 
ago, on the premise that damage to the GoB from the Dirceu 
scandal had been exaggerated.  Yet the more sober view of 
Brazil's longer-term prospects meshes with opinions we heard 
from the chief economist of another top Brazil-based U.S. bank 
in Sao Paulo last month.  After a protracted honeymoon during 
which, in our assessment, an eager market made more of Lula's 
first-year reforms and policy than the latter's material 
benefits objectively warranted, are we at an inflection point 
in the market's rosy-tinted view of Brazilian Treasuries?  The 
big profits have already been made, and the benign external 
environment may indeed be due for a change of weather.  Many 
would agree the GoB has failed to make the most of its first 
year in terms of reforms, and there is less and less trust that 
first-quarter GDP data will be reassuring when released in May. 
 
9.  Where we, and apparently most of the rest of the market 
players, see the JP Morgan report as dead wrong is its notion 
that the GoB is starting to fall off the fiscal-control wagon. 
For us, Lula and his team have demonstrated by any reasonable 
criteria that the opposite is true, even as pressure for fiscal 
relaxation has swollen across Brazil's socio-political 
spectrum.  The various new GoB programs for housing, industrial 
stimulus, land-reform, etc. that have admittedly been announced 
of late, when examined, prove to be reasonably circumscribed in 
fiscal practice.  (Septel on "Brazil's 2004 Budget Blues".) 
Lula's latest litmus test in this sphere will be the GoB 
decision, due any day now, over this year's increase in the 
minimum wage (Septel.) 
 
HRINAK