US embassy cable - 04BRASILIA1917

UNCLAS SECTION 01 OF 04 BRASILIA 001917 
 
SIPDIS 
 
SENSITIVE 
 
STATE PASS USTR FOR CRONIN 
TREASURY FOR OASIA - DAS LEE AND SSEGAL 
NSC FOR RENIGAR AND DEMPSEY 
STATE FOR E - TOM SMITHAM 
STATE FOR WHA/EPSC - URS 
USDOC FOR 4332/ITA/MAC/WH/OLAC/DMCDOUGALL/ADRISCOLL 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSON/WBASTIAN 
USDOC FOR 3134/USFCS/OIO/EOLSON/DDEVITO 
 
E.O. 12958: N/A 
TAGS: EFIN, ECON, ETRD, EINV, ENRG, EAGR, PREL, BR, Macroeconomics & Financial 
SUBJECT:  U/S LARSON ARGUES FOR STRUCTURAL REFORM, IMPROVED 
INVESTMENT CLIMATE 
 
REF: A) BRASILIA 1835    B) BRASILIA 1864 
 
This cable is Sensitive But Unclassified, please protect 
accordingly. 
 
1.   (SBU) Summary:  U/S Larson congratulated Central Bank 
President Henrique Meirelles and senior Finance Ministry 
officials on the success of Brazil's macroeconomic 
stabilization after the 2002 financial crisis.  Larson noted 
investor concerns about the electrical sector, the judicial 
system and arbitrary actions by the governor of Parana that 
had affected U.S. investment, and urged the GoB to build an 
climate that could attract investment to meet pressing 
infrastructure needs.  Larson also urged the GoB to join the 
Capetown Convention on Aircraft Financing. 
 
2.    (SBU) Meirelles highlighted the strength of Brazil's 
current recovery, which has been export and capital-good- 
spending led.  The healthy external balance and fact that 
price-pressure is under control makes this recovery much 
more sustainable, according to Finance Ministry Executive 
Director Appy.  Export growth in particular has surprised 
everyone.  The GoB also is pursuing an ambitious agenda of 
microeconomic reform, including a new law on Public-Private 
Partnerships (PPPs), which should attract needed investment. 
Appy and Meirelles acknowledged the damage inflicted on 
Brazil's investment climate by Governor Requiao of Parana, 
but pointed out that the judicial system lately has begun to 
reassert itself and reversed some of Requiao's actions.  The 
GoB plans to address some persisting energy-sector investor 
concerns as it drafts the regulatory framework implementing 
the new energy model.  End Summary. 
 
3.   (U) Background: During a July 20-21 visit to Brazil, 
U/S Larson met in Sao Paulo with representatives of a cross- 
section of U.S. businesses and in Brasilia with senior GoB 
officials to discuss the full breadth of the bilateral 
economic agenda.  He met with Central Bank President 
Henrique Meirelles, Central Bank Director for International 
Affairs Alexandre Schwartsman, Finance Ministry Executive 
Secretary Bernard Appy and International Secretary Luis 
 
SIPDIS 
Pereira to discuss the economic situation and reform agenda. 
Ref B reported on U/S Larson's meetings on IPR and trade 
issues.  Ref A reported on U/S Larson's conversations on 
President Lula's hunger initiative. 
 
Dinner with U.S. Business Community 
----------------------------------- 
 
4.   (SBU)  In Sao Paulo, U/S Larson attended a dinner with 
10 senior representatives of U.S. companies operating in 
Brazil.  The banking, pharmaceutical, energy, agriculture, 
construction, and consumer-products sectors were 
represented.  Larson solicited the business representatives' 
views on the GOB's macroeconomic policy, the investment 
climate, President Lula's domestic and international anti- 
hunger initiatives, and the prospects for sustained growth 
in Brazil.  There was consensus that several key factors 
significantly increase the cost of operating in Brazil and 
deter foreign direct investment:  the failure to enforce 
contracts, due in part to the sluggish and unpredictable 
judicial system; lack of a clear and transparent regulatory 
environment, in particular in the energy and agricultural 
biotechnology sectors; and high and complex taxes.  The high 
cost of capital for domestic investment was also identified 
as a major drag on growth.  The poor transportation 
infrastructure was flagged by agribusiness participants as 
an obstacle to further growth in Brazil's best-performing 
export sector. 
 
5.    (SBU) The business representatives indicated support 
for the Lula administration's macroeconomic policy, and 
expressed confidence in Finance Minister Palocci and his 
economic team.  They were cautious, however, about the 
prospects for sustained growth and expressed serious 
reservations about the prospects for establishing a stable, 
transparent regulatory regime.  Energy-sector 
representatives expressed frustration with the GOB's 
proposed new energy model, in particular the provisions that 
would provide preferential conditions for new investors in 
the sector, prejudicing those firms that entered the market 
during the first wave of parastatal privatizations in the 
1990s.  Most participants expressed doubt that the GOB's 
initiative to establish public-private partnerships would 
succeed in attracting much new FDI, in the absence of 
regulatory certainty.  While they lauded the economic team, 
they expressed disappointment with the overall level of 
competence and ideological bent of most of Lula's cabinet 
and subcabinet appointees.  They attributed the failure of 
Lula's flagship Zero Hunger program and other social 
programs to get off the ground to the administrative 
inexperience of the senior officials in the social 
ministries. 
 
Stabilization, Inflation and Potential Growth 
--------------------------------------------- 
 
6.    (SBU) Larson congratulated Meirelles and Appy, in 
separate meetings, on the GoB's very successful 
stabilization after the financial crisis of 2002.  Now that 
interest rates had come down and growth seemed to be 
returning, there is room to focus on what Brazilian 
potential growth might be and what inflationary threats are 
out there.  Larson noted U.S. efforts to convince OPEC oil 
ministers to increase production to help reduce the 
inflationary threat to the world economy from oil prices. 
Unfortunately, there is not much spare global capacity, he 
said, and that which exists is concentrated in Saudi Arabia, 
Kuwait and the UAE.  OPEC, Larson said, appears to have 
settled on a new price band of $28 to $36. 
 
7.   (SBU) The potential growth rate of the Brazilian 
economy, Meirelles said, is unclear.  He argued that the 
astounding performance of Brazilian exports might be 
instructive, albeit the analogy was imperfect.  When we 
embarked on our efforts to increase exports, many doubted it 
could be done, noted Meirelles, citing infrastructure 
bottlenecks and the relatively low level of investment by 
Brazilian business in product development and distribution 
mechanisms.  Nevertheless, export growth has surprised 
everyone.  Meirelles argued everyone had underestimated the 
positive effects of the establishment of a predictable 
macroeconomic framework anchored to an inflation target and 
fiscal primary surplus.  Even the 1994 Real Plan, while 
delivering low inflation, had been anchored to an 
unsustainable exchange-rate peg.  The consistent pursuit of 
these goals since 1999, Meirelles said, along with the 
reduction of exposure to exchange-rate linked debt, had 
reduced volatility and uncertainty.  This confidence in the 
policy framework, in turn, spurred investment in product 
development and distribution channels, contributing to the 
current export boom. 
 
8.   (SBU) Meirelles noted that spending on capital goods 
was one of the factors leading the current economic 
recovery.  Central Bank International Director Schwartsman 
pointed out that this is the first time in recent memory 
that capital-goods spending had been so robust so early in a 
cyclical recovery.  He attributed this in part to high 
capacity utilization in industry, particularly those linked 
to exports, which had forced investment in additional 
capacity to meet growing demand.  The economy had created 
one million formal sector jobs in the first half of 2004, 
according to Schwartsman.  He expected investment to reach 
20% of GDP by year-end, up from 18% of GDP in the first 
quarter of 2003 and 19% in the first quarter of 2004.  There 
was less certainty about the behavior of productivity, but 
Schwartsman believed it to be trending upwards, particularly 
as Brazilian industry became more exposed to competition 
from trade. 
 
Reform Agenda and FDI 
--------------------- 
 
9.   (SBU) Appy stated that the macroeconomic policy 
framework was about right, and did not require major 
adjustment.  He argued that Brazil is in a situation in 
which growth can be sustained, given the healthy external 
balance and that price pressures are under control. 
Consistent growth, however, required increases in investment 
and in productivity, Appy stated.  Given the GoB's fiscal 
situation, Brazil needed as much private-sector investment 
as it could obtain.  The GoB agenda, therefore, included 
prompt passage of a Public-Private Partnership (PPP) law 
that would create a framework for private investment in 
major infrastructure projects.  Pereira enumerated several 
other initiatives, including the new bankruptcy law, 
incentives for innovation, judicial reform, creating 
incentives for participation in formal labor markets, 
deepening of credit markets, and reduction of red tape for 
opening a business, all of which also are high on the GoB 
reform agenda. 
 
10.  (SBU) Larson asked whether the GoB was concerned by the 
fall-off in FDI.  He noted cases of arbitrary actions by the 
governor of Parana and concern over electricity-sector 
regulation.  Larson emphasized the importance of creating an 
investment climate where businesses already in-country 
become the best advocates for further FDI.  This was 
particularly important to meet government investment 
priorities through initiatives such as PPP. 
 
11.  (SBU) Schwartsman noted that a certain amount of 
reduction in FDI flows was to have been expected with the 
conclusion of the privatization program.  He estimated that 
between a third and a half of FDI during the peak of 
privatization was linked directly to foreign purchases of 
parastatals or follow-on investments in those enterprises. 
Meirelles noted that the change of management that 
accompanied privatization had resulted in large productivity 
gains. 
 
12.  (SBU) Both Meirelles and Appy acknowledged that the 
governor of Parana had done serious damage to Brazil's 
investment climate with his various steps to re-negotiate 
existing contracts.  Appy pointed out that Brazil's judicial 
system was now beginning to reassert itself and that its 
latest decisions had gone against the Parana state 
government.  Meirelles called for judicial reform in order 
that the system deal more sure-handedly with cases such as 
that of Parana's governor. 
 
13.  (SBU) Appy stated that the energy sector in particular 
was troubled.  In the aftermath of the 1998 devaluation, 
energy companies, many of them newly-purchased in 
privatizations, had been unable to service their dollar- 
denominated liabilities.  Along with poorly-written 
contracts, judicial decision limiting price increases 
exacerbated the sector's problems.  Appy said the GoB is 
attempting to address, through the new energy model's still- 
evolving regulatory framework, the complaint of existing 
investors in the energy sector that they were being 
disadvantaged vis-a-vis new investment.  Larson noted the 
importance of investors' having confidence in the 
independence and objectivity of the regulatory agency. 
 
14.  (SBU) Larson urged Appy and Pereira to consider joining 
the Capetown Convention on Aircraft Financing.  He also 
emphasized the importance of competition through trade in 
increasing potential growth. 
 
15.  (U) U/S Larson was unable to clear this message before 
his departure from post. 
 
DANILOVICH