US embassy cable - 05BRASILIA2649

UNCLAS SECTION 01 OF 02 BRASILIA 002649 
 
SIPDIS 
 
NSC FOR CRONIN 
TREASURY FOR OASIA - DAS LEE AND FPARODI 
STATE PASS TO FED BOARD OF GOVERNORS FOR ROBITAILLE 
USDOC FOR 4332/ITA/MAC/WH/OLAC/JANDERSEN/ADRISCOLL/MWAR D 
USDOC FOR 3134/ITA/USCS/OIO/WH/RD/DDEVITO/DANDERSON/EOL SON 
AID/W FOR LAC/SA 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, ETRD, Economic Policy & General Analysis 
SUBJECT: THE SURGING REAL HAS EXPORTERS SINGING THE BLUES 
 
REF: Brasilia 2477 
 
1. Summary. The Brazilian export sector is pressuring the 
Central Bank to curb the slide of the dollar (US$) against 
the Real (R$). As of September 29, the dollar was trading 
for Real 2.21, its lowest price since May 8, 2001. 
Exporters are concerned that if the devaluation of the US$ 
against the Real continues, the healthy growth in exports 
which the country saw in 2004 will come to an end. The Real 
has appreciated 15.4% so far this year and 24.8% in the last 
12 months.  End Summary. 
 
Impact of the Exchange Rate on Exports 
-------------------------------------- 
 
2. The Brazilian government's Institute of Applied Economic 
Research (IPEA) has just released a study regarding the 
current exchange rate.  The study, based on information 
gathered from 36 industries, shows that most exporters could 
withstand an appreciation of the Real of up to 30 percent 
from its point of equilibrium (about R$2.90 to the US$) as 
their losses would be less than if they abandoned the 
overseas market altogether.  Subtracting 30 percent from 
R$2.90 would yield an inflection point of about R$2.00 - 
i.e., the level at which, if breached, Brazilian exports 
would begin to drop significantly. 
 
3. While exporters and the private sector are blaming the 
declining exchange rate as one of the key reasons Brazil 
could lose ground overseas, government policy makers appear 
less worried. Minister of Development, Industry and Commerce 
Luis Fernando Furlan, (i.e., the principal advocate for the 
business community with the government) has noted "Brazil 
has room to improve its infra-structure and lower the cost 
of exports." In other words, efforts to improve 
infrastructure, reduce costs, and increase efficiency might 
compensate for the unfavorable exchange rate.  To a certain 
extent, some of this is already happening.  Well-known macro 
consultant Carlos Langoni argues that as a result of: 1) 
large imports of capital goods, 2) better use of information 
technology, and 3) skilled intensive labor, productivity 
growth is increasing.  Data from the IBGE (Brazil's main 
statistical agency) points to 6 percent productivity growth 
in the industrial sector in 2004 and 2.7 percent this year 
through July. 
 
The Central Bank's Line 
----------------------- 
 
4. During his recent visit to Washington for the Bank Fund 
meetings, Central Bank President, Mr. Henrique Meirelles, 
told investors that the Central Bank is not going to 
intervene in the market, noting that under the floating rate 
system (which Brazil has had in place since 1999) exchange 
rates must float. Inflation, he declared, was still the 
number one enemy of the Brazilian economy. Meirelles said 
that while Central Bank will continue to buy dollars the 
objective of these purchases will be to increase foreign 
reserves and not to intervene in the exchange rate market. 
As Meirelles will likely remain as Central Bank President, 
having desisted from his early stated intention of running 
for Governor of Goias State, this hands-off approach could 
represent Central Bank policy for the foreseeable future. 
 
Market Fundamentals 
------------------- 
 
5. During the past few weeks three factors have driven the 
continuing devaluation of the dollar against the real. 
First, has been the emerging perception that the government 
will maintain its embrace of sound economic fiscal policy 
notwithstanding the threat of presidential impeachment or 
departure of Finance Minister Palocci from the cabinet. 
Second, the market is expecting Brazilian interest rates to 
decline slowly but surely, with GOP growth prospect 
improving accordingly.  Last but not least, are the signs 
that the Fed will continue to tighten monetary policy in the 
United States. These developments have raised the country's 
profile among emerging markets in the last two weeks and 
foreign investors have started looking for Brazilian assets. 
Parking money here is tempting as real interest rates are 
13%, the highest in the world, and EMBI country risk has 
declined to 353 basis points. 
 
6. According to Luiz Sergio Guimaraes, journalist at the 
daily financial newspaper "Valor Economico", another factor 
behind the devaluation of the dollar against the real is the 
speculative operations that are being launched by foreign 
arbitrage investors. While the market consensus predicts an 
exchange rate of 2.35 by the end of the year, those foreign 
investors who believe the dollar will continue to fall are 
buying Reais thus further contributing to the dollar's 
weakness. 
 
7. For his part, Afonso Bevilaqua, Director of Economic 
Policy at the Brazilian Central Bank, theorizes that the 
current appreciation of the Real is due to an increase in 
prices of the goods and services the country exports.  In a 
recent press article, he noted that it was natural that the 
Real would strengthen as Brazil is richer now than it was 
before.  Bevilaqua disagreed with market analysts who think 
that the high interest rates are the main reason behind the 
strong Real.  The balance of payments (BOP) numbers, he 
stated, do not show any influx of foreign capital into 
Brazil as a result of the high interest rates.  Bevilaqua 
pointed out that the government's September 2005 BOP report 
shows the bulk of the capital inflow was long term.  From 
January to August 2005, there was US$ 15.5 billion entering 
as long-term capital and US$ 5.3 billion as short-term 
capital. 
 
Comment 
------- 
 
8. The current situation, with the Brazilian Real steadily 
gaining against the dollar at the same time as exports reach 
records numbers, is somewhat worrisome and at best awkward 
for the Brazilian economy.  Notwithstanding the non- 
interventionist comments of Central Bank Chief Meirelles, 
Brazilian Government authorities surely would like to 
identify for certain where the equilibrium point is, that 
is, what exchange rate ratio is business-government-market 
acceptable while still allowing for continued export growth. 
And while the IPEA study contemplates no large drop off in 
exports until the dollar hits the 2.0 reais level, it is 
clear that some exporters will be hurt long before it 
reaches that point.  The automakers, for instance, have 
repeatedly told us that the breakeven point for their 
exports is around the 2.6 level.  To date, however, the 
exporters who have been hurt the most are small and medium 
sized companies (SMEs).  It has traditionally been hard for 
the SMEs to develop their clientele base and enter the 
foreign markets.  Now they see their prices going through 
the roof as they lose ground to their competitors. All that 
said, Brazilian SME exporters won't give up easily.  It is 
in their interest to keep and maintain their markets 
overseas, and that is where the GOB is putting its cards. 
The government's message to the exporters is simple.  Cut 
costs, increase efficiency, and find new and cheaper ways to 
do business.  The most immediate effect has been that in an 
effort to improve their cost structure, SMEs have begun to 
lay off employees. However, should the exchange rate remain 
at or near the current level for an extended period of time, 
they will also need to improve quality and cut margins if 
they are to survive. 
 
DANILOVICH