US embassy cable - 03BRASILIA2124

UNCLAS SECTION 01 OF 02 BRASILIA 002124 
 
SIPDIS 
 
NSC FOR JOANNA WALLACE 
TREASURY FOR OASIA SEGAL 
PLS PASS FED BOARD OF GOVERNORS FOR ROBATAILLE 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, BR 
SUBJECT:  Economic Growth Remains Sluggish 
 
 
1.  Summary.  The Brazilian economy is showing the sluggish 
effects of high real interest rates, which were raised in 
October, 2002 to contain growing inflationary pressure.  On a 
quarterly basis, GDP fell slightly in the first quarter of the 
year.  Annual results are somewhat better, growing 2.2%. 
Industrial production has been particularly weak, particularly in 
sectors that rely on domestic demand.  End summary. 
 
2.  The Brazilian economy, to use a local term, "walked sideways" 
in the first quarter of the year.  Depending on the measure the 
economy either declined slightly or is growing modestly.  One 
thing is certain, though, and that is that economic growth is 
weak.  This is largely due to the high interest rates, which 
where increased by 8.5 percentage points since October to fight 
inflation, reaching 26.5% in February, thus weakening economic 
production.  On June 18, the Central Bank lowered the benchmark 
interest rate (SELIC) to 26%. 
 
3.  Part of the debate on the impact these high nominal interest 
rates have on the economy depends on just how high they are in 
real terms.  Deflating the basic interest rate levels (SELIC) by 
past inflation (IPCA), real interest rates ranged between 8-10% 
in 2002 and the first quarter of 2003, as higher nominal interest 
rates were offset by increasing inflation.  However, forward- 
looking inflation expectations have tumbled in recent months.  As 
a result, forward-looking real interest rates climbed up to 15%. 
 
4.  The GDP results, released by the Brazilian Institute of 
Statistics and Geography (IBGE), showed that the economy grew 
2.2% for the 12-month period ending in March.  This represents a 
steady improvement for the 12-month growth rate, which was 1.5% 
at the end of 2002, 0.5% as of September, 2002, and flat (0%) at 
the end of the first half of 2002.  (Note that production was 
weak in the last half of 2001 and the first quarter of 2002 
because of the 2001 energy crisis.  Given this low point of 
comparison, the 2.2% growth through March suggests that the 
economy remains sluggish.) 
 
5.  The concerns about a sluggish economy are reaffirmed by the 
quarterly data, which show that the economy declined by 0.1% in 
the first quarter of 2003, compared to the last quarter of 2002. 
Analysts suggest that this downturn is an indication that the 
modest uptick in growth that took place in the last quarter of 
2002 has been suppressed by a tight monetary policy. 
 
6.  The good story lies in agriculture, which has pulled the rest 
of the economy along.  On an annual basis, all sectors showed 
some growth, led by a strong agricultural sector:  agriculture, 
6.6%; industry, 3.2%; and services, 1.3%.  On a quarterly basis, 
however, industry, which accounts for about 37% of the Brazilian 
GDP, fell by 2.2%, while agriculture rose 3.7% and services 
stalled. 
 
GDP by Sector 
March 2003 
 
-                First quarter 2003       Annual 
-               (seasonally adjusted) 
GDP                   -0.1                 2.2 
- Agriculture          3.7                 6.6 
- Industry            -2.2                 3.2 
- Services            -0.1                 1.3 
 
7.  The poor performance by the industrial sector is troubling, 
since it has historically been an effective proxy for growth 
trends.  (Industry accounts for a larger share of the economy 
than does agriculture, while the services sector, which is even 
larger, is relatively stable.)  The industrial sector displayed 
its vulnerability to the interest rate increase imposed since the 
last quarter of 2002.  Investment has dropped due to credit 
restraints (credit to industry fell 5% from Oct02-Apr03) and 
consumer demand has fallen as well since real income has been 
depressed by rising inflation (13% in the same period).  On the 
plus side, the Brazilian Institute of Industrial Development 
(IEDI) points out that the industrial sector has benefited from 
the excellent results of exports and a temporary recovery of 
durable goods consumption prior to February 2003 (when the 
Central Bank again increased interest rates by a percentage 
point). 
 
8.  IBGE releases industrial production data on a monthly basis. 
Looking at industrial subsectors, intermediate goods had the most 
favorable results, mainly due to the growing petroleum output and 
the outstanding export performance of the pulp and paper sector. 
Intermediate goods production increased 2.7% in the first four 
months of 2002, compared to the same period in 2002.  Capital 
goods performed reasonably well, in part because of investment by 
exporting firms that are facing capacity constraints and because 
companies are switching to locally produced goods as part of an 
import substitution process which was triggered by exchange rate 
depreciation.  But even so, according to IBGE figures, capital 
goods output fell 1.5% in the first four months of the year. 
Subsectors which depend heavily on the internal market (and 
therefore on favorable credit conditions), such as durable goods 
(e.g. automobiles and home appliances) and non-durables 
(clothing, food, pharmaceuticals), fell 4.6% and 5.3%, 
respectively. 
 
LOOKING AT THE DEMAND SIDE 
-------------------------- 
 
9.  The demand side of GDP confirms the poor domestic 
performance.  Family consumption and investment both fell on 
annual basis, (-0.9% and 2.0%, respectively), as well as on a 
quarterly basis (-0.6% and 4.6%, respectively).  Roberto Olinto, 
, 
the Head of the National Accounts Department of IBGE, attributes 
the low consumption performance to falling real wage, low credit 
availability and high banking spreads.  Family consumption bears 
the highest weight in the growth calculation, equal to about 60%. 
 
10.  Growth was driven by trade, with exports of goods and 
services rising 12.9% on an annual basis, and imports decreasing 
9.5%.   Government consumption increased modestly, 0.5%.  Export 
success stories include high value added manufactures such as jet 
planes and also mineral and agriculture products such as iron ore 
and soybeans, all benefiting from a favorable exchange rate. 
 
GDP, Demand components 
March 2003 
 
-           First Quarter 2003    Annual 
-          seasonally adjusted 
GDP                 -0.1          2.2 
Family Consumption  -0.6         -0.9 
Government           0.5          0.5 
Investment          -4.6         -2.0 
Exports             -1.3         12.9 
Imports              4.5         -9.5 
 
ANOTHER INDICATOR: UNEMPLOYMENT RATES 
------------------------------------- 
 
11.  The current reduction of economic activity also reflects on 
unemployment rates.  At the same time that internal consumption 
and investment fall, the number of lay-offs tend to increase. 
According to the Brazilian Institute of Geography and Statistics 
(IBGE), the unemployment rate for the six main metropolitan areas 
increased to 12.1% in March, from 11.6% in February.  The number 
of informal employees increased by over 9% for the last 12 months 
prior to March, while the number of formal employees increased 
only by 3.3%.  The National Confederation of Industry (CNI) also 
shows a 7.7% decrease in real industrial payroll on a twelve- 
month basis. 
 
EXPECTATIONS 
------------ 
 
12.  Given the recent signals that a sluggish economy is slowing 
even more, some analysts have revised downwards their estimates 
for the 2003 economic growth.  In the Central Bank survey of 
market analysts, the average growth forecast is 1.8% for 2003 
(four weeks ago, the average forecast had been 1.9%).  The 
official Economic Research official agency (IPEA) dropped its 
forecast to 1.6%, from 1.8%.  The recent Central Bank decision to 
lower the SELIC rate 50 basis points, to 26%, probably will not 
provide much relief this year, since the market was already 
anticipating lower rates, real rates remain high given falling 
inflation expectations, and there is a six-month lag before 
changes in monetary policy have an impact on production. 
 
Hrinak