US embassy cable - 04BRASILIA1160

UNCLAS SECTION 01 OF 05 BRASILIA 001160 
 
SIPDIS 
 
SENSITIVE 
 
TREASURY FOR U/S TAYLOR, DAS LEE AND SSEGAL 
NSC FOR DEMPSEY 
STATE FOR EB/IFD/OMA/O'REILLY 
STATE PASS FED BOARD OF GOVERNORS FOR ROBITAILLE 
USDOC FOR 3134/USFCS/OIL/WH 
USDOC FOR 4332/ITA/MAC/WH/OLAC 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, PGOV, ELAB, PREL, EINV, BR, Macroeconomics & Financial 
SUBJECT:  SECOND MEETING OF TREASURY-FINMIN "GROUP FOR 
GROWTH" 
 
 
This cable is Sensitive but Unclassified, please protect 
accordingly. 
 
1.   (SBU) SUMMARY:  Treasury U/S for International Affairs 
John Taylor, Ministry of Finance Treasury Secretary Joaquim 
Levy, and Economic Policy Secretary Marcos Lisboa presided 
on April 19 in Rio de Janeiro over the second meeting of the 
Treasury/Ministry of Finance Group for Growth (GfG), an 
outcome of the June 2003 summit between Presidents Lula and 
Bush.  The GfG meeting's main themes were infrastructure 
investment and access to credit; prospects for growth in 
both countries were also presented.  This cable reports on 
the extensive general discussion of Brazil's economic 
situation and the GoB policy agenda.  Lisboa pronounced 
Brazil's 2002-2003 macroeconomic stabilization efforts a 
success, with the current sharp drop in inflation, stable 
debt-to-GDP ratio, and lowest real-interest rates in a 
decade.  Levy added that Brazil is now less vulnerable to 
external shocks, thanks to to lower exchange-rate 
volatility, reductions in dollar-based debt, and increased 
exports.  The GoB officials maintained their expectation of 
3.5% economic growth this year and claimed that solid 
recovery began in the second half of 2003.  Lisboa also 
focused in detail on the GoB's microeconomic and structural 
reform agenda, which aims to sustain growth by decreasing 
banking spreads, creating incentives for entrepreneurship, 
sparking innovation, and providing an affordable social- 
safety net.  Levy addressed the fiscal situation in more 
detail, discussing debt-servicing, the rising tax burden, 
and falling central-government investment levels.  He said 
the single biggest fiscal challenge facing the GoB is the 
social-safety net.  END SUMMARY. 
 
Background 
---------- 
 
2.   (U) Treasury U/S for International Affairs John Taylor, 
Ministry of Finance Treasury Secretary Joaquim Levy and 
Economic Policy Secretary Marcos Lisboa presided over the 
second Group for Growth (GfG) meeting in Rio de Janeiro on 
April 19.  The GfG is an outcome of the June 2003 summit 
meeting of Presidents Bush and Lula.  The first GfG meeting 
was held in Washington in September 2003 and focused on 
productivity growth.   This second meeting focused on 
infrastructure issues and access to credit, including micro 
credit, as well as on current prospects for growth in both 
countries.  The U.S. delegation, led by U/S Taylor, included 
Treasury DAS Nancy Lee, DAS for Public Affairs Tony Fratto, 
Western Hemisphere Office Director Ramin Toloui, Brazil Desk 
Officer Stephanie Segal, Regional Treasury Attache Matthew 
Haarsager, Rio Econoff and Emboff.  In addition to Levy and 
Lisboa, the Brazilian delegation was rounded out by Ministry 
of Finance staffers Aline Diegues and Daniel Silgemann. 
Additional presentations were made by Armando Castelar of 
Brazil's Institute for Applied Economic Studies, who spoke 
on infrastructure and investment, Elizabeth Wallace of the 
European Bank for Reconstruction and Development (EBRD), who 
outlined a micro-credit pilot project being implemented in 
Russia and former Soviet republics, and Carlos dos Santos of 
Brazil's technical assistance agency for small businesses 
(SEBRAE), who spoke on SEBRAE's role in the provision of 
micro-credit. 
 
The Starting Point 
------------------ 
 
3.   (U) Lisboa gave an extensive briefing on Brazil's 
current economic situation and the GoB policy agenda.  The 
2002 crisis, he said, arose from a combination of external 
shocks with fiscal imbalances, which resulted in a sharp 
exchange-rate devaluation, acceleration of inflation, 
increased country risk, and difficulties rolling over public 
debt.  The new GoB's macroeconomic stabilization effort has 
reduced inflation to an expected 6% in 2004, after a spike 
of 17.2% in 2003.  The increase in interest rates necessary 
to combat the sharp increase in inflation, however, led to 
reductions in real wages, a fall in domestic demand and 
ultimately to negative real GDP growth of 0.2% in 2003. 
Those factors notwithstanding, Lisboa pointed out that this 
result compared favorably to financial/payments crises in 
other countries such as Russia in 1998, Mexico in 1994 and 
Thailand in 1997, where the subsequent falls in GDP were 
much sharper, ranging from -4.9% in Russia to -10.5% in 
Thailand. 
 
Successful Adjustment 
--------------------- 
 
4.   (SBU) Lisboa pronounced GoB 2002/2003 stabilization 
efforts a success.  The goal was to control inflation so as 
to stop the slide in real wages, reduce real interest rates, 
and mitigate sources of external vulnerability, thus laying 
a foundation for more sustainable growth.  Fiscal adjustment 
was key to all these goals and was the first priority upon 
President Lula's entering office.  The increase in Brazil's 
national tax burden, up from 28% in 1998 to 36% of GDP in 
2003, has been the single most important long-term 
contributor to fiscal adjustment. 
 
5.    (SBU) Levy and Lisboa emphasized that Federal non- 
interest expenditures fell as a percentage of GDP in 2003, 
contributing to the adjustment.  They admitted that it had 
occurred in large part through real reductions in the 
government wage bill.  The fiscal adjustment (and the return 
of financial-market confidence), in turn, allowed an easing 
of interest rates.  Real interest rates are now at their 
lowest since the Plano Real was introduced in 1994. 
External vulnerability had been reduced by sharply reducing 
the quantity of exchange-rate-linked public debt.  Stellar 
export growth has reduced the net-external-debt-to-exports 
ratio from 3.6 in 1999 to 2.2 in 2004.  The current account 
turned positive in 2003 for the first time since 1994 and is 
expected to remain so this year. 
 
6.    (SBU) The biggest challenge to fiscal sustainability, 
according to Levy, is the social-safety net.  Brazil in 2002 
paid out almost 11% of GDP on public and private sector 
pension benefits, a level comparable to that of Sweden, even 
though Sweden's retirement-age population, as a percentage 
of its workforce, is almost double that of Brazil.  The 
issue is primarily with the private-sector (INSS) system, 
Levy said, as last year's reform of the public-sector 
pension system had halted the growth of the deficit in that 
system.  Levy predicted that the GoB would be forced to make 
hard decisions in the near future, including a cap on 
pension benefits in the INSS system. 
 
Current Growth Scenario 
----------------------- 
 
7.   (U) Lisboa maintained there is considerable evidence 
that the economy has already returned to a growth 
trajectory.  Industrial production of consumer durables, 
capital goods, and intermediate goods all recovered in the 
last quarter of 2003 and continued to grow in the first 
months of 2004 (although there was a drop in both consumer- 
durables and capital-goods production from January to 
February 2004).  The retail-sales index shows a similar 
evolution.  Unemployment data, Lisboa said, was mixed.  The 
official unemployment rate, based on household surveys in 
only a few major cities, has risen.  However, Lisboa opined 
that the increase was because many who had formerly stopped 
actively seeking work, thus falling off the statistical 
radar, are now hopefully re-entering the job force, swelling 
the ranks of the unemployed for purposes of the calculation. 
Other measurements, including surveys of hiring by firms, 
showed 3.37% growth in formal jobs from March 2003 to March 
2004.  Much of this job growth reported by firms was taking 
place outside the large urban centers, however, and so was 
not reflected in the official unemployment-rate calculation. 
Lisboa presented a breakdown showing job growth of 4% 
outside urban centers, much of this from agribusiness, and 
only 2.5% job growth in urban areas.  This added up to 
almost 100,000 more jobs created, in absolute terms, outside 
of urban areas than in urban areas, he said. 
 
Longer-Term Sustainability 
-------------------------- 
 
8.    (U) Macroeconomic indicators aside, Lisboa 
acknowledged that the microeconomic agenda is key to 
sustainable growth.  One GOB priority is passage of the 
Public-Private Partnerships (PPP) law to attract private 
infrastructure investment.  Lisboa added that the Finance 
Ministry has been working to eliminate barriers to 
entrepreneurship and to promote innovation.  On the former 
front, Lisboa reported success in obtaining agreement from 
all but one of Brazil's states on a unified system and set 
of procedures for setting up a business.  The next step is 
to obtain the same agreements from each of Brazil's 5000- 
plus municipalities.  Lisboa hoped to complete this 
painstaking task within another one to two years.  The 
result would be a one-stop shop, allowing anyone to fill out 
one form to create a small business.  Still under debate in 
the Senate, the bankruptcy law, modeled on the U.S. Chapter 
11, aims to create a more rational system that better 
secures creditor rights while giving businesses a chance to 
emerge from bankruptcy whole, something that does not happen 
today.  Reform of the competition law, also planned, would 
help create a more benign environment for small business. 
 
9.    (U) Levy argued that, at heart, the GoB's evolving 
industrial policy is "an innovation policy," aiming to 
strengthen a network of laboratories and create incentives 
for research and development work.  A key part of this 
effort is to strengthen the Intellectual Property Institute 
(INPI) so as to clear the backlog of patent applications and 
give innovators some hope of securing their rights.  Lisboa 
added that a new Innovation Law would allow professors and 
their universities to benefit from the profits of their own 
research, as U.S. universities do. 
 
Access to Credit 
---------------- 
 
10.  (U) In the discussion about increasing access to 
credit, Levy and Lisboa outlined several macroeconomic and 
structural issues that contribute to Brazil's infamously 
high interest-rate spreads and difficulties of small firms' 
access to credit.  The primary, well-known reason offered 
was that the Government's high borrowing needs crowd out 
private sector and consumer credit, forcing interest rates 
higher.  While that problem may not be fixable in the near 
future, the GOB is attacking the problem from the other 
side, such as with a current bill which favors applying anti- 
trust laws in the financial sector.  Other initiatives aim 
to improve the functioning of housing markets, including by 
creating a framework for new financial instruments and 
securitization of mortgages, and to require banks to share 
credit information with other financial institutions at the 
borrower's request (personal credit histories should improve 
a borrower's ability to shop among banks.) 
 
11.  (U) Carlos dos Santos, of the Federation of Industries' 
technical assistance agency for small businesses (SEBRAE), 
outlined the stark reality of access to credit by small 
businesses in Brazil.  A government survey recently found 
that of 10 million micro-enterprises (those with 6 or fewer 
employees) in Brazil, most are informal and only 4.9% had 
access to credit.  While formally-registered firms 
theoretically have a few more options, a survey of 400,000 
small but formal businesses in Sao Paulo found that 79% had 
no access to banking credits.  Those that could get 
financing often relied on supplier credits (64% of cases), 
state-owned banks (3%) or loan sharks (3%).  Many 
entrepreneurs wind up using credit cards at usurious rates. 
When small businesses can get bank loans, they are at 
spreads of up to 43.5% above the base SELIC rate.  Factors 
contributing to spreads were credit risk, taxes (up to a 
quarter of the spreads), lack of judicial enforcement of 
collateral, and lack of competition among banks, Santos 
said. 
 
12.  (U) Elizabeth Wallace, who manages a pioneering micro- 
credit program for the European Bank for Reconstruction and 
Development (EBRD), outlined the program's market-oriented 
approach to train banks and bankers in techniques to make 
micro-credit lending a profit center.  The EBRD program 
leverages existing banking infrastructure but emphasizes 
training and technical assistance to alter banks' business 
models and loan-officers' mindsets as well as transfer 
credit technology, introduce credit analysis and streamline 
procedures.  The program also stresses the importance of 
commercial pricing of loans, and of adequate scale to spread 
fixed costs in order to ensure the viability of micro-credit 
lending.  Competition among micro-lenders to bring down 
spreads is also critical.  The EBRD program has achieved 
costs as low as $59/loan in origination and administration 
fees, without sacrificing portfolio quality, a far lower 
rate than comparable programs administered by NGOs, asserted 
Wallace. 
 
Infrastructure Investment 
------------------------- 
 
13.  (U) Armando Castelar Pinheiro of the Institute for 
Applied Economic Studies noted that periods of higher 
investment rates have clearly been correlated with higher 
productivity growth in Brazil.  Investment rates, however, 
declined significantly early in the 1980s.  Subsequent 
economic reforms at the beginning of the 1990's helped 
increase investment rates and concomitant productivity 
growth, but investment still remains low in comparative 
terms, at 19% of GDP.  The picture was further complicated 
in the late 1990's and early 2000's by increasing public 
deficits, which reduced public investment and soaked up 
private savings. 
 
14.  (U) Levy and Lisboa outlined steps the GoB is taking to 
increase savings and investment.  It has created a new set 
of investment accounts that allow investors to rebalance 
their portfolios without being subjected to the financial 
transactions tax (CPMF).  This should help reduce the CPMF's 
distortion of investment decisions.  The GoB also has begun 
to exempt capital goods from the industrial production tax 
in hopes of encouraging firms to invest. 
 
15.  (U) The centerpiece of the GoB's efforts to increase 
investment is its draft law on Public-Private Partnerships 
(PPPs).  The PPP bill, currently undergoing Senate scrutiny 
after passage in the Chamber of Deputies, would create a 
framework for long-term private investment in infrastructure 
to be paid back through user fees.  Importantly, in cases 
where the return on the project is not sufficient to justify 
private investment, the public sector could subsidize the 
project or top-up the payment stream.  A guarantee fund 
would give long-term security to the private investors. 
Castelar lauded those positive points of PPPs, but pointed 
out several problems with their application in the Brazilian 
context.  These include the uncertainty over the conduct of 
Brazil's sometimes mercurial judges and over project 
jurisdiction, the absence of a sound regulatory framework in 
many sectors, as well as problems in obtaining environmental 
licenses (and judicial intervention in that process), and 
open questions regarding the appropriate 
budgeting/accounting treatment for PPPs.  Uncertainty over 
the commitment of future administrations to PPP guarantees 
could be overcome if the public sector makes a sufficient 
down payment up-front, Castelar noted. 
 
COMMENT 
------- 
 
16.  (SBU) This GfG meeting was characterized by candid 
discussion of Brazil's current economic situation and the 
challenges that the GoB's policy agenda faces.  The 
discussion of the EBRD micro-credit experience in Eastern 
Europe and Eurasia provoked the most numerous and pointed 
questions from Levy and Lisboa, sparking discussion of what 
pieces might be applicable in the Brazilian context.  The 
failure of many of Brazil's past micro-credit efforts make 
improving access to such credit a special limus test. 
 
17.  This cable cleared and coordinated with AmConGen Rio 
and Treasury. 
 
HRINAK