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Country Report

Brazil

September 2007

The Economist Intelligence Unit 26 Red Lion Square London WC1R 4HQ United Kingdom

Brazil at a glance: 2008-09

OVERVIEW The president, Luiz Inácio Lula da Silva of the leftist Partido dos Trabalhadores (PT), continues to enjoy record levels of popularity and favourable economic conditions. However, the government seems unlikely to capitalise on its strong position to advance any ambitious reforms before the governing coalition begins to unravel, as political manoeuvring starts ahead of mid-term elections in late 2008. A framework encompassing fiscal discipline, a floating exchange rate and inflation-targeting will be maintained. Measures to stimulate investment in infrastructure and tax breaks for targeted sectors will help to accelerate GDP growth beyond the country!s sluggish long-term average. However, structural fiscal weaknesses will restrict the scope for increased public investment or an alleviation of the tax burden and will constrain the pace of interest rate reductions, although credit conditions will be easier than in the past. Following real GDP growth of an estimated 4.7% in 2007, the Economist Intelligence Unit forecasts a moderate slowdown in 2008-09, with growth averaging 4.3%. The current-account surplus will narrow as import growth outweighs export expansion.

Key changes from last month

Political outlook • No substantial change. Despite his acquittal by his peers of corruption

charges, the Senate president, Renan Calheiros, remains compromised, which could continue to obstruct legislative business.

Economic policy outlook • The Banco Central do Brasil (the Central Bank) cut interest rates by 25 basis

points at its September meeting and also signalled a more cautious stance owing to rising inflation expectations. We continue to expect one further cut of 25 basis points before the end of 2007, on the assumption that inflation moderates as supply side pressures on food prices ease.

Economic forecast • GDP growth in the first half of 2007, of 4.9%, is in line with our estimate of

4.7% for the year as a whole. We have already factored in an expected slowdown in the rate of credit growth, but with foreign financing having contributed to the expansion of lending, a sharper adjustment may occur in response to tightening global conditions.

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Brazil 1

Country Report September 2007 www.eiu.com © The Economist Intelligence Unit Limited 2007

Contents

Brazil

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2008-09 7 Political outlook 8 Economic policy outlook 9 Economic forecast

13 The political scene

19 Economic policy

23 The domestic economy 25 Employment, wages and prices 27 Financial and other services 29 Sectoral trends

31 Foreign trade and payments

List of tables 8 International assumptions summary 9 Gross domestic product by expenditure 11 Forecast summary 20 Central government primary accounts 21 Non-financial public-sector fiscal results 22 Gross domestic product 23 Disaggregated retail sales 23 Capacity utilisation and business confidence 26 Consumer price inflation indices 26 Market-based credit 28 New funding from capital markets 28 Gross domestic product growth by economic sector 29 Agricultural output 29 Beef exports 30 Cattle inventories 30 Industrial production 32 Exports by region 32 Imports by category 33 Current account

2 Brazil


List of figures 12 Gross domestic product 12 Consumer price inflation 25 Automotive sales 26 Unemployment 32 Exports, imports and trade balance

Brazil 3


Brazil September 2007

Summary

The president, Luiz Inácio Lula da Silva of the leftist Partido dos Trabalhadores (PT), continues to enjoy record levels of popularity and favourable economic conditions. However, the government seems unlikely to capitalise on its strong position to advance any ambitious reforms before the governing coalition begins to unravel, as political manoeuvring starts ahead of mid-term elections in late 2008. A framework encompassing fiscal discipline, a floating exchange rate and inflation-targeting will be maintained. Measures to stimulate investment in infrastructure and tax breaks for targeted sectors will help to accelerate GDP growth beyond the country!s sluggish long-term average. However, structural fiscal weaknesses will restrict the scope for increased public investment or an alleviation of the tax burden and will constrain the pace of interest rate reductions. Following real GDP growth of an estimated 4.7% in 2007, the Economist Intelligence Unit forecasts a moderate slowdown in 2008-09, with growth averaging 4.3%. The current-account surplus will narrow as import growth outweighs export expansion.

A corruption scandal involving the president of the federal Senate has delayed legislative business since June and damaged the reputation of the upper house, which had been largely free of the vote-buying scandals in the Chamber of Deputies in 2005-06; some implicated in the latter may now face charges in the civil courts. Political reform appears shelved until at least 2009. The latest air tragedy has prompted the launch of a shake-up of civil aviation. Government-military tensions have underscored Brazil!s growing democratic maturity.

The benchmark Selic overnight rate has been eased by a further 75 basis points since June but minutes from the September meeting signalled a more cautious stance ahead. Controversially, the inflation target for 2009 has been maintained at 4.5%, instead of being lowered as many expected. Fiscal revenue growth remains strong, but concerns are rising over growth of current expenditure.

GDP growth of 5.4% in the second quarter took accumulated first-half growth to 4.9%. Growth of retail sales has remained robust and capital goods industries have benefited from strong domestic and external demand, prompting increased investments.

The January-August trade surplus remained strong despite surging imports and flat demand in the US market, thanks to rising sales to Asia and the EU.

Editors: Justine Thody (editor); Robert Wood (consulting editor) Editorial closing date: September 20th 2007 All queries: Tel: (44.20) 7576 8000 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Outlook for 2008-09

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 Brazil


Political structure

Federative Republic of Brazil

Federative republic

The president, who is elected for a term of four years, chooses a cabinet, which he heads

Elected president, who controls the budget

Bicameral national Congress: 81-seat Senate (the upper house) with representatives of 26 states, plus the federal district of Brasilia; 513-member directly elected Chamber of Deputies (the lower house). The 26 states and the district of Brasilia each have a legislature

Each state has its own judicial system; the country has a system of courts for dealing with disputes between states and matters outside the jurisdiction of state courts

Municipal elections every four years, with next due in October 2008; presidential, congressional and state elections every four years, with next due on October 3rd 2010

Luiz Inácio Lula da Silva took office for a second term on January 1st 2007

Partido dos Trabalhadores (PT); Partido do Movimento Democrático Brasileiro (PMDB); Partido da Social Democracia Brasileira (PSDB); Demócratas (DEM); Partido Progressista (PP); Partido Socialista Brasileiro (PSB); Partido Democrático Trabalhista (PDT); Partido da República (PR); Partido da Mobilização Democrática (PMD); Partido Comunista do Brasil (PC do B); Partido Socialismo e Liberdade (PSOL); Partido Verde (PV); Partido Trabalhista Brasileiro (PTB)

President Luiz Inácio Lula da Silva Vice-president José Alencar

Agrarian development Guilherme Cassel Agriculture Reinhold Stephanes Cities Márcio Fortes Civil chief-of-staff Dilma Vana Rousseff Communications Hélio Costa Culture Gilberto Gil Defence Nelson Jobim Development, industry & trade Miguel Jorge Education Fernando Haddad Environment Marina Silva Finance Guido Mantega Foreign affairs Celso Amorim Health José Gomes Temporão Institutional relations Walfrido Mares Guia Justice Tarso Genro Labour & employment Carlos Lupi Mines & energy Márcio Zimmerman National integration Geddel Vieira Lima Planning, budget & management Paulo Bernardo Science & technology Sérgio Rezende Social development Patrus Ananias Social security Luiz Marinho Sport Orlando Silva Júnior Tourism Marta Suplicy Transport Alfredo Nascimento

Henrique Meirelles

Official name

Form of state

The executive

Head of state

National legislature

Legal system

Key ministers

Central Bank governor

National elections

National government

Main political organisations

Brazil 5


Economic structure

Annual indicators

2003a 2004a 2005 a 2006 a 2007a

GDP at market prices R bn 1,699.9 1,941.5 2,147.9 2,322.8 2,516.8

GDP US$ bn 552.2 663.6 882.0 1,067.4 1,261.5

Real GDP growth (%) 1.2 5.7 2.9 3.7 4.7

Consumer price inflation (av; %) 14.7 6.6 6.9 4.2 3.6

Population (m) 179.0 181.6 184.2 186.8 189.3

Exports of goods fob (US$ m) 73,084 96,475 118,309 137,808 161,164

Imports of goods fob (US$ m) -48,290 -62,835 -73,606 -91,349 -116,463

Current-account balance (US$ m) 4,177 11,679 13,985 13,622 8,540

Foreign-exchange reserves excl gold (US$ m) 49,111 52,740 53,574 85,561 173,296

Total external debt (US$ bn) 236.6 220.4 188.0 191.2 207.9b

Debt-service ratio, paid (%) 65.9 46.2 55.5 26.0 19.8b

Exchange rate (av) R:US$ 3.08 2.93 2.44 2.18 2.00

a Actual. b Economist Intelligence Unit estimates.

Origins of gross domestic product 2006 % of total Components of gross domestic product 2006 % of total

Agriculture 5.1 Final consumption 80.3

Industry 30.9 Fixed investment 16.8

Services 64.0 Trade balance (goods & services) 2.9

Principal exports 2006 US$ m Principal imports 2006 US$ m

Transport equipment & parts 20,098 Machinery & electrical equipment 23,560

Metallurgical products 15,068 Oil & derivatives 15,201

Soybeans, meal & oils 10,481 Chemical products 14,414

Chemical products 3,936 Transport equipment & parts 10,301

Main destinations of exports 2006 % of total Main origins of imports 2006 % of total

US 17.9 US 16.3

Argentina 8.5 Argentina 8.8

China 6.1 China 8.7

Germany 4.1 Netherlands 0.9

6 Brazil


Quarterly indicators 2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrGovernment finance (R m)a Revenue 118,329 144,717 117,628 136,041 138,809 163,054 138,190 158,669Expenditure 126,813 149,215 125,311 144,295 151,674 167,722 149,442 164,188Balance -8,484 -4,498 -7,685 -8,253 -12,866 -4,668 -11,253 -5,521Outputb Real GDP at 1995 prices (R bn) 223.5 225.4 228.5 227.2 233.6 236.0 238.1 240.0Real GDP at 1995 prices (% change, year on year) 3.1 3.1 3.9 1.6 4.5 4.7 4.2 5.6Industrial prodn index (2002=100) 111.9 112.6 113.8 114.3 115.3 116.5 118.0 120.8Industrial prodn index (% change, year on year) 1.6 1.4 3.5 1.5 3.0 3.4 3.7 5.6Employment, wages and prices Unemployment rate (% of the labour force) 9.5 9.2 9.9 10.3 10.4 9.2 9.8 10.0Real average earnings ® 1,038.5 1,154.9 1,060.0 1,072.7 1,079.3 1,213.6 1,113.2 1,110.8Real average earnings (% change, year on year) 2.3 4.5 3.1 5.6 3.9 5.1 5.0 3.6Consumer prices (1993=100)c 2,487 2,525 2,561 2,577 2,582 2,604 2,638 2,662Consumer prices (% change, year on year) 6.2 6.1 5.5 4.3 3.8 3.1 3.0 3.3General price index (1994=100)d 328.6 330.3 332.6 333.2 336.8 342.1 345.6 347.5General price index (% change, year on year) 3.2 1.7 0.8 0.0 2.5 3.6 3.9 4.3

Financial indicators Exchange rate R:US$ (av) 2.34 2.25 2.20 2.19 2.17 2.15 2.11 1.98Exchange rate R:US$ (end-period) 2.22 2.34 2.17 2.16 2.17 2.14 2.05 1.93Deposit rate (av; %) 18.2 17.2 15.8 14.4 13.6 11.9 11.5 10.7Money market rate (av; %) 19.7 18.8 17.2 15.7 14.6 13.6 12.9 12.3M1 (end-period; R m) 117,089 144,204 128,167 131,417 142,587 173,590 154,926 n/aM1 (% change, year on year) 6.8 13.1 10.1 12.7 21.8 20.4 20.9 n/aM2 (end-period; R bn) 1,098.2 1,167.5 1,219.6 1,257.7 1,307.3 1,387.8 1,428.4 n/aM2 (% change, year on year) 17.0 19.6 19.3 20.6 19.0 18.9 17.1 n/aIbovespa stockmarket index (end-period;

29/12/83=100) 31,584 33,456 37,952 36,631 36,449 44,474 45,805 54,392Ibovespa stockmarket index (% change, year on year) 35.9 27.7 42.6 46.2 15.4 32.9 20.7 48.5Sectoral trends Vehicle production (�000) 657.5 623.0 630.3 670.5 671.3 638.9 655.8 727.6Manufacturing production index (2002=100)b 111.2 112.1 113.1 113.7 114.5 115.7 117.2 120.0Metals production index (2002=100)b 106.7 109.3 106.1 109.1 113.6 113.1 115.8 117.3Pharmaceuticals production index (2002=100)b 109.0 109.6 113.1 108.4 108.7 115.5 108.9 114.5Pulp, paper & products production index (2002=100)b 117.9 120.4 120.9 120.6 121.3 121.1 121.2 120.2Retail trade index, volume (2003=100) 112.6 131.0 109.8 117.0 119.4 140.2 120.5 128.5

Foreign trade and payments (US$ m) Exports fob 33,042 31,589 29,458 31,599 39,900 36,851 34,002 39,212Imports fob -20,068 -19,510 -20,130 -21,394 -25,217 -24,608 -25,237 -27,339Trade balance 12,974 12,080 9,329 10,204 14,683 12,243 8,765 11,873Services balance -2,220 -2,532 -1,722 -2,475 -2,864 -2,593 -2,229 -3,275Income balance -5,999 -7,440 -6,925 -7,684 -5,505 -7,376 -5,760 -6,988Net transfer payments 916 959 943 1,094 1,175 1,095 982 1,014Current-account balance 5,670 3,066 1,625 1,139 7,489 3,369 1,759 2,625Reserves excl gold (end-period) 56,801 53,574 59,569 62,401 73,130 85,561 109,241 146,815

a Treasury finances only. b Seasonally adjusted. c IPCA index. d IGP-DI index.

Sources: Fundação Getúlio Vargas, Conjuntura Econômica; IMF, International Financial Statistics; Banco Central do Brasil.

Brazil 7


Outlook for 2008-09

Political outlook

Nine months into his second term, the president, Luiz Inácio Lula da Silva of the leftist Partido dos Trabalhadores (PT), continues to enjoy record levels of popularity and very favourable economic conditions. However, his government seems unlikely to capitalise on its strong position to advance any ambitious agenda before the ruling coalition begins to unravel ahead of mid-term elections in October 2008. The Programa de Aceleração do Crescimento (PAC, growth-acceleration programme) launched in early 2007 aims to boost investment, but does not entail the difficult structural reforms that would be needed to promote greater competitiveness. Opportunities for patronage entailed in the PAC, with its focus on public works, will help to ease the passage of some measures. Even so, PAC implementation is advancing slowly, in part because of a loss of momentum in the Senate owing to a corruption scandal surrounding its president, whose position remains in doubt. Once the municipal elections are over, there will be another window of opportunity to push ahead with the legislative agenda in 2009, although this could potentially be interrupted by Supreme Court trials of legislators implemented in the 2005-06 congressional vote-buying scandals. Preparations for the 2010 presidential election are expected to start earlier and, therefore, could also hamper progress of the government!s agenda in 2009. More broadly, tensions among the more than ten parties in the pro-government camp will be a constant complication of the legislative progress. A political reform that had been on the government!s agenda has been effectively shelved until at least 2009, and significant changes to improve governability are not expected. A crisis in the aviation industry has so far left the president!s popularity unscathed, but the success or otherwise of Nelson Jobim, the new defence minister, in improving the situation, may prove a significant test of the government!s standing (as well as of Mr Jobim!s chances of becoming a presidential candidate for the Partido do Movimento Democrático Brasileiro, PMDB, in 2010).

Lula!s foreign policy emphasises south-south trade co-operation and third world solidarity, albeit with an increasingly robust stance on defending Brazil!s interests, such as following nationalisation in Bolivia. Notwithstanding periodic friction, relations with the government of the Venezuelan president, Hugo Chávez, will remain pragmatic, amid growing Brazilian exports and foreign direct investment (FDI) to Venezuela. Brazil remains at the forefront of (increasingly forlorn) attempts to help revive the Doha round of multilateral trade negotiations within the framework of the World Trade Organisation (WTO).

Domestic politics

International relations

8 Brazil


Economic policy outlook

An orthodox macroeconomic policy framework encompassing fiscal discipline, a floating exchange rate and inflation-targeting, which was successful in stabilising inflation and the exchange rate in Lula!s first term, will be main-tained in his second. The centrepiece of policy in the outlook period will be the PAC, unveiled in January. Through the programme the government ambitiously aims to raise average annual GDP growth to 5% per year (well above the 3.1% average for 2000-06), principally through increased public and private investment in infrastructure, which will be fostered in part through targeted tax breaks. The Economist Intelligence Unit expects the PAC to be partly successful in the short term, but fiscal and structural reforms needed to improve long-term competitiveness are unlikely to achieve more than piecemeal advances, given the president!s ambivalent stance and congressional resistance to politically sensitive measures. These include fiscal and labour market reforms, streamlining the excessively complex tax system, strengthening the regulatory framework and improving the quality of social spending. In the absence of structural fiscal reform, monetary policy will remain relatively tight, and the tax burden, which has risen virtually without interruption in the past decade (from 29% of GDP in 1997 to over 35% of GDP in 2006), will stay relatively high for a middle-income country with generally poor public services.

Strong corporate profitability and household income growth, combined with a rise in formal employment and increased imports, have been underpinning the public finances. Data for January-July show a marked improvement in the non-financial public-sector (NFPS) primary fiscal balance (excluding interest payments) to 5.6% of GDP, up from 4.8% of GDP in the same period of 2006. Investment expenditure is expected to accelerate in the remainder of the year, as implementation of the PAC is stepped up. Fiscal measures included in the PAC, notably ceilings on new public-sector hiring and limits on minimum-wage adjustments, will stabilise other primary fiscal expenditure as a share of GDP. Declining local interest rates will reduce the burden of interest costs on the public debt, allowing steady erosion in the primary surplus without endangering the overall fiscal position. We expect the primary surplus to fall from an estimated average of 4.1% in 2006-07 to just under 2% by 2009. The overall accounts will remain in deficit, albeit a relatively moderate 2.5% of GDP, as the government steps up investment expenditure. It will have few problems financing a deficit of this magnitude on the domestic market. Our projections imply a steady continued decline in the net public debt/GDP ratio (to 40.4% of GDP by the end of the outlook period). In gross terms, public debt stood at 65% of GDP at the end of July this year, but this ratio is mitigated by the fact that funds equivalent to around 10% of GDP are held in deposits at the Banco Central do Brasil (BCB, the Central Bank), destined for pre-financing operations.

A cycle of monetary easing that began in September 2005 has reduced the benchmark Selic overnight rate by 825 basis points, in 17 successive cuts, to 11.25% in September 2007. Our central scenario continues to envisage a further 25-basis-point cut before the end of 2007, most probably at the monetary authority!s next meeting on October 17th, resulting in an average Selic rate of

Fiscal policy

Monetary policy

Policy trends

Brazil 9


12% for the year as a whole. However, rising inflationary concerns and innternational financial market turbulence increase the possibility that the Comitê de Política Monetária (Copom, Monetary Policy Committee) will pause the easing cycle until 2008. Either way, we expect easing in the outlook period to take the Selic to 9.5% by the end of 2009. This implies an average real rate of 8.2% in 2007 and 5.8% in 2008 and 5.6% in 2009, which is low for Brazil. The monetary authority has retained its 4.5% target (with a 2% tolerance band) for 2008-09, while signalling that it would pursue below mid-point objectives.

Economic forecast

International assumptions summary (% unless otherwise indicated)

2006 a 2007 b 2008c 2009c

GDP growth World 5.3 5.1 4.8 4.7

US 2.9 1.9 2.1 2.8

EU27 3.0 2.7 2.4 2.3

Exchange rates US$ effective (2000=100) 84.6 81.1 79.2 79.8

¥:US$ 116.2 116.8 106.3 96.5

US$:� 1.26 1.36 1.38 1.32

Financial indicators US$ 3-month commercial paper rate 5.03 5.16 4.70 4.80

¥ 3-month repo rate 0.28 0.68 1.13 1.86

Commodity prices Oil (Brent; US$/b) 65.3 69.4 69.0 63.3

Soybeans (US$/tonne) 265.5 336.8 353.3 355.3

Food, feedstuffs & beverages (% change in US$ terms) 16.1 19.3 4.1 -1.1

Industrial raw materials (% change in US$ terms) 49.6 12.2 -5.8 -12.4

a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

Although our central forecast is for a steady deceleration in global GDP growth in the outlook period, the risks of a sharp slowdown"and a recession in the US"have increased sharply in recent weeks, amid turmoil in global financial markets. Although global liquidity remains sufficiently ample potentially to underpin risk appetite for some time, greater volatility is in prospect. Portfolio adjustments in response to further confidence shocks triggered by a sharp downturn in global growth and commodity prices could result in massive selling of emerging-market assets. Currently we expect Asia to continue to grow rapidly in 2008-09, which will underpin demand for Brazil!s major exports. However, commodity prices and global demand would be severely hit by a US recession. Even without a US recession, global credit conditions will be markedly tighter in 2008-09 than in 2006-07, which will constrain lending-led expansions of investment and consumption across many emerging markets, including Brazil. Under our baseline forecast, the projected fall in industrial raw materials prices disguises a forecast 10% further increase in prices of iron ore, one of Brazil!s major exports, in 2008 and continued increases in prices for oilseeds, another of Brazil!s major exports, which are being bolstered in part by

International assumptions

10 Brazil


rising demand for biofuels. Overall, we project only a mild deterioration in Brazil!s terms of trade in 2008-09.

Gross domestic product by expenditure (R bn at constant 1990 prices where series are indicated; otherwise % change year on year)

2006a 2007 a 2008b 2009b

Private consumption 561.4 593.9 622.5 646.6

4.4 5.8 4.8 3.9

Public consumption 185.2 190.0 193.2 196.3

3.6 2.6 1.7 1.6

Gross fixed investment 153.1 169.2 182.7 193.7

8.8 10.5 8.0 6.0

Final domestic demand 899.7c 953.0 c 998.4 1,036.6

5.1c 6.1 c 4.7 3.8

Stockbuilding -0.2c 1.6 c 1.6 1.6

0.2d 0.2 d 0.0d 0.0d

Total domestic demand 899.5c 954.7 c 1,000.0 1,038.2

4.9c 6.1 c 4.9 4.0

Exports of goods & services 122.8 130.9 143.0 155.7

4.7 6.6 9.2 8.9

Imports of goods & services 91.6 107.7 121.9 131.4

18.0 17.6 13.1 7.8

Foreign balance 31.2 23.2 21.1 24.3

-1.0d -0.9 d -0.2d 0.3d

GDP 925.3 968.9 1,012.2 1,053.6

3.7 4.7 4.5 4.1

a Actual. b Economist Intelligence Unit forecasts. c Economist Intelligence Unit estimates. d Contribution to real GDP growth (as a percentage of real GDP in the previous year).

First-half growth of 4.9% year on year is in line with our estimate of full-year growth of 4.7%, with annual growth weakening marginally in the second half of 2007 as the base of comparison becomes stronger. As in 2006-07, domestic demand will be an important driver of growth throughout the outook period. Following an acceleration in 2007, investment growth is set to remain robust, underpinned by deepening credit markets. Although household expenditure growth will soften somewhat in 2008-09 following a boom in 2007, it will be underpinned by robust growth of real wages, employment and consumer credit. Fiscal policy is forecast to be largely neutral, on the assumption that government consumption growth will ease, as the authorities seek to restrain the expansion of current expenditure in order to foster higher investment. Throughout the outlook period, export volume growth will be underpinned by continued strong demand in some markets, notably emerging Asia. Export volume expansion will nonetheless be outpaced by import volume growth, which will be sustained by a strong exchange rate and firm domestic demand. The contribution to growth from the external balance is expected to turn slightly positive by 2009 on the assumption that real import growth, although still strong, softens. Real export growth will accelerate from 2008 in line with strengthening world trade growth.

On the supply side, continued gradual improvements of credit conditions will support growth of agricultural production, while infrastructure investment and government housebuilding incentives will boost construction. Extractive

Economic growth

Brazil 11


industries are also expected to remain robust, reflecting strong demand for raw materials from emerging Asian markets. Capital goods industries will continue to capitalise on robust domestic and external demand, but many labour-intensive manufacturing activities will struggle to cope with rising import competition. Among services, the financial sector will remain one of the strongest growth areas, as lower interest rates and rising real disposable incomes encourage financial institutions to diversify investment instruments.

An uptick in inflation in the past three months, with the consumer price index rising by 3.7% year on year in June and July and 4.2% in August, has been primarily the result of food price pressures. Although both headline and core inflation were still well within the Central Bank!s target of 4.5% for 2007-08 and inflationary expectations remain contained, another high outturn in September would increase the likelihood of a pause in the cycle of monetary easing. Our baseline assumption is that although rising soft commodity prices will continue to exert upward pressure on food prices, this will be mitigated by disinflation in other goods, as well as in services. We estimate that inflation will end 2007 at 4.2% and project year-end inflation of 4% in 2008 and 3.9% in 2009. The strong Real will continue to encourage robust growth of imports, which will prevent strong domestic demand from creating higher inflationary pressures.

The Real quickly recovered most of the ground it temporarily lost"briefly it fell by 16% during turbulence in global financial markets during August 2007"and since the end of August has been trading in a narrow range just under R2:US$1. On September 20th the currency stood at R1.87:US$1, almost at its previous high and 14% stronger in nominal terms than at the start of the year. The strength of the external accounts will be supportive of the currency in the outlook period. Although we project an erosion of the current-account surplus, the decline is expected to be relatively gradual owing to the continued strength of commodity prices. Although we assume that tighter conditions in the global financial markets will result in softer portfolio inflows into the capital account, interest differentials will remain favourable and we expect Brazilian assets to remain among the more attractive to international investors, while FDI inflows are forecast to remain very strong by historical standards. Our estimate of a year-end exchange rate of R1.95:US$1 in 2007 allows renewed weakening in response to tightening external credit conditions. However, we expect this to be contained, both because of the supportive external accounts and because, amid increased inflation concerns, we anticipate that the monetary authority, which holds a huge cushion of international reserves (US$162bn in mid-September), would intervene to prevent any sharp depreciation of the currency.

Despite a rapid expansion in import spending, which has been outstripping export earnings growth since the start of 2006, the trade surplus has remained very strong, totalling US$27.5bn in January-August, only a moderate decline on the year-earlier period (US$29.7bn). This reflects rising export volumes (across the board, but particularly of primary commodities) and surging commodity prices. The latest data are in line with our full-year estimate of a trade surplus of around US$44bn in 2007. Strong import spending growth will contribute to a widening services deficit and this will be the main driver of an erosion of the

External sector

Inflation

Exchange rates

12 Brazil


overall current-account deficit, which we expect to average 0.3% of GDP in 2008-09, down from 1.3% in 2006 and an estimated 0.7% in 2007. The income deficit, which rose markedly in 2004-06, driven mainly by flows related to FDI, is projected to stabilise over the forecast period, on the assumption that income credits rise firmly, driven by accelerating outward flows of portfolio and direct investments abroad and a rapidly rising stock of international reserves. On the assumption of only modest further accumulation in coming months, we estimate that international reserves will reach US$175bn at the end of 2007 and just over US$205bn by the end of 2009.

Forecast summary (% unless otherwise indicated)

2006 a 2007 a 2008b 2009b

Real GDP growth 3.7 4.7 4.5 4.1

Industrial production growth 2.9 5.5 4.0 3.8

Gross fixed investment growth 8.8 10.5 8.0 6.0

Consumer price inflation (av) 4.2 3.6 4.0 4.0

Consumer price inflation (year-end) 3.1 4.1 4.0 3.9

Short-term interbank rate (av)c 15.3 12.0 10.1 9.8

Nominal PSBR (% of GDP) 3.0 1.8 b 1.9 1.8

Exports of goods fob (US$ bn) 137.8 161.2 183.1 197.5

Imports of goods fob (US$ bn) -91.3 -116.5 -137.5 -151.8

Current-account balance (US$ bn) 13.6 8.5 2.4 3.3

Current-account balance (% of GDP) 1.3 0.7 0.2 0.3

External debt (year-end; US$ bn) 191.2 207.9 d 220.5 226.2

Exchange rate R:US$ (av) 2.18 2.00 2.13 2.32

Exchange rate R:¥100 (av) 1.87 1.71 2.01 2.41

Exchange rate R:� (av) 2.73 2.71 2.94 3.07

a Actual. b Economist Intelligence Unit forecasts. c Selic overnight rate. d Economist Intelligence Unit estimate.

Brazil Latin America

Gross domestic product(% change, year on year)

Brazil Latin America

Consumer price inflation(av; %)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

20

03

04

05

06

07

08

09

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

20

03

04

05

06

07

08

09

Brazil 13


The political scene

In the past quarter, a new corruption scandal has reared its head, this time seriously damaging the standing of the federal Senate (the upper house of Brazil�s bicameral legislature), which had largely escaped involvement in the congressional corruption scandals of 2005-06. A stable and productive Senate is critical to the ability of the president, Luiz Inácio Lula da Silva, to implement his legislative agenda. Since June, the Senate has been paralysed amid corruption allegations against its president, Renan Calheiros of the pro-government Partido do Movimento Democrático Brasileiro (PMDB). In May it was revealed that Cláudio Gontijo, a lobbyist for Mendes Júnior, a construction firm, was making monthly payments on behalf of Mr Calheiros to a journalist with whom the senator had fathered a child out of wedlock. On June 6th the Comissão de Ética do Senado (Senate ethics committee) opened an investigation into Mr Calheiros�s relations with Mr Gontijo. Mr Calheiros had been expected to take a leave of absence during the investigation, temporarily leaving the Senate vice-president, Tião Viana of the ruling Partido dos Trabalhadores (PT), in charge. However, Mr Calheiros insisted on remaining in his post, prompting allegations that he would be in a position to influence the outcome of the inquiry.

Attempting to portray the investigation as an attack on the entire Senate, Mr Calheiros took to the floor on several occasions to denounce his critics, hinting that he had knowledge of corrupt activities by a number of his senatorial peers. During the investigation, it was revealed that Mr Calheiros, who is a senator for the north-eastern state of Alagoas, amended his 2007 tax return to increase the declared income from his agricultural and cattle interests. This was widely perceived as a belated attempt to reconcile unexplained recent deposits into Mr Calheiros!s bank accounts.

On September 5th, in an open (public) vote, the ethics committee voted 11 to 4 to recommend Mr Calheiros!s expulsion from the Senate on the grounds of quebra de decoro parlamentar, or conduct unbecoming a senator. Expulsion carries with it the loss of political rights for a period of eight years. The committee recommendation was considered by the full Senate in a special session held on September 12th. In accordance with the constitution, both the session and the roll-call vote were secret, although some of the debate was leaked to the media by visiting federal deputies, who gained access to the session only after a court order and a violent clash with Senate security officers. With all 81 senators (including Mr Calheiros) present and voting, 35 were in favour of expulsion and 40 against, with six abstentions (these were de facto votes in favour of Mr Calheiros). Following the vote, Mr Calheiros announced that he planned to serve out his full two-year term as Senate president, which ends on February 1st 2009.

Mr Calheiros�s insistence on remaining in his post during the investigation, and on speaking and voting on his own behalf during the secret session, were widely criticised as violations of republican principles. Moreover, parliament-ary decorum broke down on several occasions, with exchanges of insults and fist fights on live television. Finally, the holding of the secret session, combined

A corruption scandal paralyses the Senate

Doubts continue to hang over the Senate president

14 Brazil


with the dissembling of many senators (the day after the vote, some 45 senators claimed publicly to have voted in favour of conviction), led to demands for greater transparency in corruption investigations. The difference between the public vote in the ethics committee and the secret vote on the floor could not have been more stark. Most importantly, the Senate agenda was paralysed for months, with numerous senators (and not only from the opposition) obstructing roll-call votes and committee sessions as long as Mr Calheiros held the chamber presidency. The pro-government coalition, of which Mr Calheiros�s PMDB is the largest party, currently controls 49 of the 81 votes in the upper house.

Mr Calheiros is one of the two prime architects of the PMDB�s alliance with the PT (the other is José Sarney, a former president who is now a senator and credited with the leading role in saving Mr Calheiros from expulsion). Although only 52 years old, Mr Calheiros already enjoys a lengthy track record as a major powerbroker, having served as congressional floor leader during the Collor years (1990-92), minister of justice during the Cardoso period (1995-2003) and a loyal Senate president under the Lula government. Thus, Lula had a clear interest in maintaining Mr Calheiros in office, although he let it be known that he disapproved of the senator�s decision to stay in his post during the investigation. Overall, however, Mr da Silva maintained a safe distance from the crisis, asserting that the investigation was an internal matter of the Senate.

Lula�s priority in the Senate is the renewal of the CPMF, a tax on financial transactions first implemented in 1994. For his part, Mr Calheiros knows that Lula is dependent on the CPMF and claims that only he can engineer its renewal. However, Mr Calheiros may have been wounded politically by the 35 votes for expulsion, and the ethics committee is considering further charges against him. Lula is likely to allow some time for Mr Calheiros to try to make some headway on the CPMF, but if paralysis continues in the Senate, he may well encourage Mr Calheiros to step down.

As Mr Calheiros struggled to maintain his post, another leading PMDB senator became embroiled in a bribery scandal. In March Joaquim Roriz, a senator for the Federal District (Brasília) and the dominant figure in local politics over the past two decades, was recorded on a federal police wiretap discussing a money-laundering operation. Mr Roriz could not account for a R2.2m (US$1.1m) cheque that he cashed at the state-owned Banco Regional de Brasília, a bank formerly under his direct control. When in July Veja, the leading weekly current affairs magazine, reported that the money had been used to bribe two electoral judges in Brasília during the 2006 elections, Mr Roriz promptly resigned his Senate seat to avoid certain expulsion and loss of political rights. By resigning, Mr Roriz may retain his right to be a candidate in 2010 (either for the Senate or for the governorship of the Federal District, to which he has been elected three times since 1990), but accusations of electoral manipulation are still making their way through the courts. In common with Mr Calheiros, Mr Roriz is a major figure in the national PMDB.

Another senator is embroiled in a separate scandal

Brazil 15


A long-awaited discussion of �political reform� in Congress began in June but was quickly aborted. The Chamber of Deputies (the lower house) began the discussion of the reform package by considering the electoral system, which has the strongest direct effect on the careers of professional politicians. The proposal before the house was to move from an �open-list� proportional representation system to a closed-list system. The open list, whereby candidates are unranked and voters select individuals, favours personalistic campaigns and weak party loyalty. Under a closed list, parties would pre-rank the candidates and voters would select a party slate. A closed-list system would be expected to strengthen the party leadership and improve discipline. The legislature began considering the proposal on June 13th. Although the committee designing the political reform was strongly in favour of the closed list, backbenchers protested that it would give too much power to party bosses. On June 29th the closed-list proposal was defeated by a margin of 252 to 181 in a lower house vote. Almost all parties were internally divided on the issue, dampening enthusiasm for further debate on political reform. Chamber leaders were criticised for beginning the reform discussion with the most controversial proposal, not least because the bill!s defeat also shelved discussion of other elements of the proposed reform package, which included public financing of campaigns and an end to inter-party coalitions in proportional representation elections. Amid the ongoing paralysis in the Senate, political reform now appears dead at least until after the October 2008 municipal elections.

On March 27th the Tribunal Superior Eleitoral (TSE, the electoral tribunal) had ruled that federal deputies who switched parties after the elections would have to forfeit their seats in Congress. Party switching is extremely common in Brazil, and up to one-third of all deputies can be expected to change parties during a four-year legislative term, so banning the practice would have a major effect on party politics. Several parties challenged the TSE ruling and it is now before the Supreme Court. More than 30 deputies switched parties in the first three months of 2007, but party defections slowed to a trickle after the TSE decision. On August 14th the Chamber of Deputies voted overwhelmingly to offer amnesty to all deputies who switched parties in 2007, and the legislation deters the Supreme Court from any retroactive application of a ban on party switching. Deputies are now free to change parties until October 5th if they plan to run in the October 2008 municipal elections, and thus the ongoing court battles will have little impact on the political scene in the short term.

However, these decisions damaged the Demócratas (DEM; formerly Partido da Frente Liberal, PFL) and Partido da Social Democracia Brasileira (PSDB) parties, the two main opposition groupings, both of which suffered defections to pro-government parties after the October 2006 elections. Party switching tends to work in favour of the ruling alliance, since the Brazilian executive controls numerous patronage resources. The PSDB and DEM are now unlikely to recover the seats they have lost over the past year.

The latest air disaster resulted in the most critical media coverage of Lula�s government in more than a year in July. On July 17th a TAM Airbus A320 jetliner skidded off the end of the runway in heavy rain at Congonhas airport

Political reform is now unlikely before 2009

Second plane crash in a year deepens civil aviation crisis

Amnesty on party switching benefits government parties

16 Brazil


in downtown São Paulo and crashed into a support building, killing all 187 passengers and crew plus another 12 persons on the ground. Initially, it appeared as if the accident might be related to incomplete resurfacing of the runway, but a subsequent investigation revealed that one of the two thrust reversers on the Airbus was inoperative prior to the landing. At only 1,940 metres in length, the runway at Congonhas had long been criticised by com-mercial pilots, who have compared landing there to landing on an aircraft carrier (by comparison, the runway at suburban Guarulhos, the São Paulo international airport, is 3,700 metres long). Independently of the direct cause (pilot error or mechanical failure), the lack of an adequate runway safety area (RSA) appears to have been the principal underlying factor, given that the tight urban space at Congonhas cannot accommodate overshoots or undershoots.

The Congonhas tragedy, which came just ten months after a mid-air collision between a Boeing passenger jet operated by Gol (a Brazilian airline) and a Legacy corporate jet owned and operated by a US company, claimed 154 lives in northern Brazil, forced Lula to take several measures that his critics claimed were long overdue to address severe strains in the country�s air travel infra-structure. In Brazil, civil aviation is under the control of the Air Force. On July 25th Lula dismissed the defence minister, Waldir Pires (PT), who had been criticised for his slow response to the mounting air traffic disruption in 2006-07. Mr Pires was replaced by Nelson Jobim (PMDB), a long-time politician from Rio Grande do Sul. Mr Jobim, a respected former congressman and justice minister who had most recently served as president of the Supreme Court, has been elevated to the status of an �aviation czar�, with broad authority to reform the sector.

The new minister promptly obtained the resignations of several top officials in the two main civilian aviation agencies, Infraero and the Agência Nacional de Aviação Civil (ANAC), and made it clear that the Air Force commandant would be subordinated to direct ministerial control. Mr Jobim also announced immediate measures to improve security and relieve congestion in São Paulo, transferring a large number of domestic flights to Guarulhos and limiting the use of Congonhas as a hub for domestic flights. The government also plans to expand Viracopos airport in Campinas, which was the international airport for São Paulo before Guarulhos opened in 1985, and to plan for future light rail links to both airports.

The government�s awareness of the political dimension of the aviation crisis was illustrated on July 20th when Marco Aurélio Garcia (PT), a leading presidential adviser, was photographed celebrating and making obscene gestures in the presidential palace when TV news first reported that the TAM crash could have been caused by a failure of the thrust reverser on the Airbus (thus potentially absolving the government of blame in the tragedy). Even so, in early August a Datafolha poll revealed that Lula!s popularity was largely unharmed by the aviation crisis, given that only 8% of Brazilians reported ever travelling by air.

Air traffic congestion eased somewhat following Mr Jobim�s initial directives, but many believe that more drastic measures"such as a total overhaul of Infraero and ANAC, an end to military involvement in civil aviation, and the

Brazil 17


construction of a third airport in São Paulo"will be necessary to restore confidence in the sector. Lula has delegated ample authority to Mr Jobim, who served in the Cardoso government as justice minister and has excellent relations with the opposition PSDB. Mr Jobim�s performance in the coming months will be a significant factor shaping how the Lula government is seen by the prestige press and the urban middle class.

Although the majority of deputies recommended for expulsion in connection with the mensalão congressional vote-buying scandal that broke in mid-2005 were absolved by their peers in 2006, several now face charges in the courts. If, as appears likely, the cases drag on, the mensalão scandal could yet have a significant impact on the 2010 presidential and congressional elections. Parallel to the internal congressional investigations that were launched in 2005, Antônio Fernando de Souza, the Procurador Geral da República (federal prosecutor), launched an independent criminal investigation that lasted nearly two years. In Brazil, senior elected officials who are accused of crimes have the right to have their cases heard in a �privileged forum� (foro privilegiado), in this case the Supremo Tribunal Federal (STF, the Supreme Court). On August 22nd Mr Souza asked the STF to open criminal proceedings against 40 legislators implicated in the mensalão affair, including some who had already been disciplined by Congress. For example, Roberto Jefferson of the Partido Trabalhista Brasileiro (PTB), who initially divulged the mensalão scheme in June 2005, was formally accused of money-laundering. José Dirceu, Lula!s former chief of staff, who along with Mr Jefferson was expelled from Congress in late 2005 and lost his political rights for eight years, was accused both of racketeering and of intent to corrupt others (corrupção ativa), as were a former PT president, José Genoino, and the party treasurer, Delúbio Soares. All in all, Mr Souza�s brief indicted four senior PT officials, ten federal deputies in the PT and allied parties, a dozen members of legislative staff, and several bank employees who allegedly operated the scheme.

The STF deliberated nearly 30 hours, considering each case individually under intense media and public scrutiny. On August 28th the high court caused a sensation by announcing that it would approve all 40 indictments and that each of the accused would have to stand trial in the STF. Although no senior politician has ever been convicted by the court, and the foro privilegiado system has been criticised as an elitist anachronism, the initial STF decision was nonetheless a major victory for Mr Souza and his staff. The fact that both Mr Souza and six of the ten STF justices (there is currently one vacancy) were appointed by Lula himself lends added significance to the outcome. Public pressure from the media and civil society was undeniably important; one STF justice was later overheard complaining into his mobile phone that the court had voted "with a knife to its throat".

Mr da Silva was reserved in his comments, saying only that his former PT colleagues would now have the opportunity to clear their names in the nation�s highest court. Given the high court�s caseload of more than 100,000 cases per year, it is expected that the STF will take at least two years to analyse the 40 accusations and that no decisions will be handed down until late 2009 or 2010. A guilty verdict in the Supreme Court in any one of the dozen cases involving

Historic indictments in mensalão affair

18 Brazil


elected politicians (five of whom are from Lula�s own party, the PT) would constitute a landmark break with the historic pattern of impunity for Brazilian political elites.

Two developments in the past quarter have sparked tensions between the government and the military, in the process underscoring Brazil�s increasing democratic maturity and openness with regard to its authoritarian past. On July 12th the justice minister, Tarso Genro (a former president of the PT), granted posthumous amnesty to Carlos Lamarca, a former leader of the armed resistance to the military regime of 1964-85. Mr Lamarca, then an army captain, abandoned his unit in February 1969 and subsequently led numerous oper-ations carried out by the Vanguardia Popular Revolucionaria (VPR, the Popular Revolutionary Vanguard) before being killed in a shootout in 1971. Mr Lamarca is lionised by segments of the Brazilian left, whereas the Army characterises him as a deserter, thief and murderer. Mr Genro�s directive posthumously promoted Mr Lamarca to the rank of colonel, awarded his widow a large sum of cash representing years of back pay corresponding to the increased rank, and provided for the same pensions that are given to the surviving relatives of deceased generals.

Mr Genro�s decision, taken following a recommendation by the Conselho de Anistia (a consultative body), sparked strong opposition from the armed forces. As is common in Brazil, it was left to the associations of retired officers (clubes militares), which are broadly understood to represent military opinion, to speak out. On September 10th all three associations filed a joint lawsuit against Mr Genro�s directive, arguing that posthumous promotions can only be awarded to officers who died with satisfactory performance, whereas the final entry in Mr Lamarca�s service record is his desertion on February 13th 1969. For his part, Mr Genro welcomed the lawsuit, saying that he was confident that the courts would reach the same conclusion as the Conselho de Anistia.

A few weeks later, on August 29th a special government human rights com-mission released its long-awaited report, entitled Direito à Memória e à Verdade (The Right to Truth and Remembrance). The commission, established under the Cardoso government in 1995 and which completed its formal investigations in 2006, was charged with clarifying the Brazilian state�s responsibility for human rights abuses under military rule and providing a full accounting of the tortured and disappeared. The panel functioned exclusively as a �truth commission� with no accusatory powers, since almost all crimes were covered by a contro-versial amnesty law approved in 1979. The performance of the commission was widely praised across the political spectrum, but not in the armed forces.

Senior generals objected not only to the content of the report but to the fact that it was publicly released in the presidential palace in Lula!s presence, giving it official endorsement. Mr Jobim, who established the investigatory commission in December 1995, issued a clear directive to the three service branch commanders that no individual protests should be made. On August 31st the Army did release a terse communiqué stating that the period of military rule in Brazil is open to historical interpretation. This public declaration was signifi-cantly watered down after Mr Jobim threatened to dismiss any service chief

Civil-military tensions show democratic consolidation

Brazil 19


who defied his authority, and Mr Jobim personally edited the final draft. He then resumed normal business by accompanying the commanders on an official visit to Haiti.

The fact that the Direito à Memória e à Verdade report was released in the presence of the president and that the defence minister was able to neutralise military opposition illustrates the extent to which civilian democracy has consolidated in the past two decades. It also shows the continuing dis-satisfaction of the armed forces with what is now increasingly the mainstream historical depiction of the military regime. However, in recent years the military has become increasingly unable to put forward any alternative version of past events, and its political influence has waned considerably.

Economic policy

Continued easing by the Comitê de Política Monetária (Copom, Monetary Policy Committee) has reduced the benchmark Selic overnight rate by a further 75 basis points in the past quarter, taking it to 11.25% in September. In its June meeting, following a decision in May to resume faster policy easing because of the strength of the exchange rate (June 2006, Economic policy), a 50-basis-point cut was implemented. However, three out of seven of Copom!s members favoured confining the cut to 25 basis points, concerned that a stronger mone-tary stimulus could encourage overheating amid already dynamic aggregate demand, as reflected in very strong growth of retail sales and consumer credit. Yet the 50-basis-point cut was insufficient to prevent exchange-rate appreciation; in mid-July the Brazilian Real was 13% stronger than at the start of the year. This convinced a majority of Copom members that surging imports would be sufficient to help contain inflation, despite strong domestic demand. In July and August, however, the picture changed, as food prices soared (see The domestic economy), while global financial market turbulence saw the exchange rate weaken. In Copom!s September meeting, there was unanimous agreement behind a smaller (25-basis-point) cut. The minutes from the September meeting also signalled a more cautious outlook. Participants considered keeping rates on hold in September, and barring a further significant strengthening of the currency, the possibility that there will be no further rate reductions this year has now increased. However, following a 50-basis-point cut by the Federal Reserve (the US central bank) in its benchmark rate on September 18th, the Economist Intelligence Unit!s maintains its assumption that a further 25-basis-point cut will be implemented before the end of 2007, probably at Copom!s October 17th meeting.

Among the factors that could increase the prospects of rates remaining on hold are that non-tradeable prices are rising much more strongly than overall inflation and that credit expansion remains rapid. However, unlike during the inflation cycle of 2004, there is only limited evidence of pricing power among final goods producers. Meanwhile, halting to the easing cycle could compound pressure on the currency to appreciate, particularly following the cut by the Federal Reserve (the US central bank). The cost of holding a large and growing stock of international reserves has resulted in the Central Bank recording a net

After accelerating, monetary easing might now be on hold

20 Brazil


loss of more than Rs30bn (US$16bn) in the first half of 2007, which will have to be absorbed by the Treasury next year. The carrying cost of foreign reserves has become even higher following the cut on the Federal Funds rate. In this context, the Banco Central do Brasil (BCB, Brazil!s central bank) may find it difficult to justify much further reserves accumulation. In June-August the BCB purchased US$19bn in foreign reserves, with US$5bn purchased in August amid the global financial market turmoil. Since the start of the year, reserves have risen by more than US$75bn, taking them to US$162bn in mid-September. Sources of inflows have remained diverse, encompassing liquidation of sales receipts by exporters, initial public offerings in the equity and debt markets, private equity acquisitions, and purchase of non-financial assets.

The extent to which appetite for Brazilian assets is likely to hold up should become clearer from late September, assuming that trading begins to normalise following the recent turmoil and vacations in the northern hemisphere during August. If foreign-exchange inflows remain significant, reserve accumulation may continue. Anecdotal evidence suggests sustained appetite for higher-quality emerging-market equities and debt, albeit in a tighter price environ-ment. Several sizeable Brazilian offerings are set to take place before the end of the year, with 26 primary public equity offerings already in the pipelines of the São Paulo stock and futures exchanges. However, several debt issues planned for the global market have had to be postponed, especially in the Eurobond market. Others were cleared on less favourable terms than originally expected. Furthermore, some credit lines to exporters are being cancelled or renegotiated on more stringent terms. Further such developments in the debt market will have a bearing on the exchange rate and thus on monetary policy decisions.

Despite the turmoil in the debt markets, the currency is being supported by the expectation of an imminent investment grade rating for Brazilian sovereign debt. The recent turbulence saw only momentary overshooting in the sovereign bond and foreign-exchange markets, when for a period of a few minutes Brazilian five-year credit default swaps traded as high as 180 basis points over equivalent US paper, while the Real fell as low as R2.13:US$1 (a 16% fall). Within days, however, both had recovered substantially, with Brazilian sovereign bonds now yielding only 30 basis points more than equivalent Mexican paper, and on a par with Colombian and Peruvian paper. That said, Brazilian assets have yet to be tested by a sharp adjustment in commodity prices, the buoyancy of which have provided essential underpinning to Brazil!s external accounts.

The most controversial decision made by the Conselho Monetário Nacional (CMN, National Monetary Committee) in the past quarter was to retain the inflation target for 2009 at 4.5% with a 2% tolerance band, as applies currently. With inflation-linked bonds pricing in inflation of less than 4%, many analysts had anticipated a lower target, and even expected the target rate for 2008 to be adjusted downwards. The BCB sought to signal that although the official target would be 4.5%, it would pursue a 4% inflation rate for both 2008 and 2009. This mixed signal followed categorical assertions by Mr da Silva that growth should not be subordinated to lower inflation. The episode has underscored afresh the Central Bank!s lack of formal independence but only marginally increases medium-term inflation risks: the government will remain committed

Inflation target is retained at 4.5% for 2009

Brazil 21


to inflation containment, which is a cornerstone of its popular support. Market expectations for 2008 have remained at 4% according to the BCB!s regular survey of economic analysts, although amid the market turmoil longer-term inflation expectations subsequently rose to 4.5%.

Meanwhile, a decision by the CMN to permit mutual funds, with certain restrictions, to invest as much as 20% of their net asset value in eligible instruments in the global markets is not expected to have a major impact on the foreign-exchange market in the near term. For the most part, fund managers have preferred to invest predominantly in Brazilian assets, either because they have more expertise in local markets or because they regard Brazilian assets as offering better value overall. The measure is nonetheless significant in marking another step towards a fully open capital account. Among the other key decisions announced by the CMN during the past quarter, the Taxa de Juros de Longo Prazo (TJLP, the basic long-term interest rate used as a benchmark by Banco Nacional de Desenvolvimento Econômico e Social"BNDES, the state-owned development bank) was reduced to 6.25% in July, in what is expected to be the last reduction for some time.

In line with economic performance, tax revenue has continued to expand rapidly, and has continued to be underpinned by strong corporate profitability, higher personal incomes, growth of formal employment, and surging imports, retail sales and industrial production. General federal tax revenue rose by 9.5% year on year in the second quarter of 2007, and social security revenue rose by 15%, with higher minimum wages and growth of formal employment providing a particular boost to the latter. Fiscal expenditure has also increased rapidly, widely spread across payroll, social security and ordinary investments. To some extent, this is the counterpart of trends in receipts: expenditure on social security and unemployment benefits (booked as "other expenses") remain in line with social security receipts. Some concern has been expressed by an expansion, in nominal and real terms, of the cost of the state bureaucracy. However, this cost has remained stable as a share of GDP. Investment spending has been somewhat behind budget but is expected to pick up in the second half of the year. An acceleration of GDP growth and an increased primary surplus have been reflected in a continued gradual improvement in the public solvency ratio. General government net debt totalled Rs1.1trn (44% of GDP) in July, a decline equivalent to 0.5% of GDP since the start of the year. Gross general government debt represented 65% of GDP.

Central government primary accounts (R bn)

2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrTotal revenue 116.2 137.0 125.6 135.6 134.9 147.1 142.9 152.6 National Treasury 89.7 103.5 98.5 106.7 104.4 108.5 112.2 119.9 Social security 26.2 33.2 26.7 28.5 30.2 38.1 30.4 32.4 Central Bank 0.3 0.3 0.4 0.4 0.3 0.5 0.3 0.3 Transfers to local governments 18.6 23.8 22.1 23.7 22.0 25.1 24.7 27.7

Fiscal revenue growth has remained strong

22 Brazil


Central government primary accounts (R bn)

2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrNet central government revenue 97.6 113.2 103.5 111.9 112.9 122.0 118.2 124.9 Total primary expenditure 86.3 110.3 88.5 87.9 102.8 120.4 99.2 101.1 Payroll 22.8 25.9 26.0 22.5 25.9 30.6 29.2 26.2 Social security 34.6 46.3 36.6 37.6 45.3 46.1 41.6 42.0 Other expenses 28.2 37.6 25.8 27.6 31.4 43.2 28.0 32.4 Central Bank 0.7 0.5 0.1 0.2 0.2 0.5 0.4 0.5Central government primary balance 11.5 3.0 14.6 23.7 10.0 1.3 18.9 24.0 National Treasury 19.9 16.1 24.5 32.8 25.1 9.3 30.1 33.6 Social security -8.4 -13.1 -9.9 -9.1 -15.1 -8.0 -11.2 -9.6

Source: Ministério da Fazenda.

The latest fiscal results show a notable improvement in the finances of local governments. With expenditure restrained by the Lei de Responsabilidade Fiscal (LRF, Fiscal Responsibility Law), local governments recorded a nominal surplus in the first half of 2007. The first phase of the economic expansion, from 2003 to 2006, was driven primarily by exports and corporate profitability, which mainly benefited the central government, as federal tax revenue is driven largely by income, payroll, and corporate profits. Since the start of 2006, local government revenue, which relies heavily on sales taxes, has been benefiting from a change in the pattern of growth, whereby domestic demand has become the major driver, with retail sales expanding more rapidly than industrial production and services performance very solid. One consequence is that local governments, many of which are now in a healthy financial condition, are pressing for a relaxation of statutory controls on investment spending. A significant rise in local government investment can be expected in the near future, once the political negotiations are concluded.

Non-financial public-sector fiscal results (% of GDP; Jan-Jun)

2005 2006 2007Primary surplus 5.7 4.8 5.6 Central government 3.8 3.2 3.4 Local governments 1.2 1.0 1.5 Public corporations 0.6 0.6 0.6Interest expenses 7.6 7.3 6.5 Central government 6.1 6.0 5.4 Local governments 1.4 1.4 1.2 Public corporations 0.1 -0.1 -0.1

Nominal deficit 1.9 2.5 0.9 Central government 2.3 2.8 1.9 Local governments 0.2 0.3 -0.3 Public corporations -0.5 -0.7 -0.7

Sources: Ministério da Fazenda; Banco Central do Brasil.

Domestic demand boosts local government finances

Brazil 23


The domestic economy

Year-on-year real GDP growth accelerated in the second quarter of 2007, albeit (as in the first quarter) not by as much as many market participants were anticipating. According to data published by the Instituto Brasileiro de Geografia e Estatística (IBGE, the national statistics authority), GDP at market prices expanded by 0.8% quarter on quarter, seasonally adjusted. Domestic demand performed strongly overall, despite flat government expansion, which followed a particularly strong performance in the first quarter. Consistent with retail sales figures, household consumption expanded by 1.5%, while fixed investment booked a strong performance for the fourth consecutive quarter. This took the 12-month accumulated growth of real investment to 9.8%. Easier access to finance, and the availability of much cheaper capital good imports thanks to the strength of the exchange rate, has been encouraging firms to step up investment, which could boost export growth in subsequent quarters. In year-on-year terms, real GDP grew by 5.4%, up from 4.2% in the first quarter of the year. Accumulated growth in the first six months of the year was 4.9%, a sharp acceleration on the 2.9% growth recorded in the first half of 2006. However, although second-quarter 2007 growth was the highest in three years, this partly reflected a weak base of comparison.

It is not yet clear to what extent tighter global credit markets will affect con-sumption and investment. Although the local banking system has not been directly hit by the recent turmoil, anecdotal evidence suggests that foreign investors have been significant suppliers of funding for lending expansion to both companies and households. Smaller banks depend heavily on the ability to sell securitised credit to investors in order to have adequate levels of funding at competitive prices. The larger companies also depend on liquid conditions in the global bond markets to raise bond finance. Anecdotal evidence suggests that by and large global investor appetite has not disappeared, but will demand more stringent terms in future deals. This may particularly affect homebuilders, which have raised a considerable amount of equity capital and will have to raise large sums through debt in order to deliver promised targets to investors. Local banks have been in great part responsible for financing housing construction activity until now, but some additional finance from foreign investors will be necessary if expansion plans are to be met.

Gross domestic product (% change, quarter on quarter; seasonally adjusted)

2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrHousehold consumption 0.9 1.4 0.4 2.1 1.2 2.1 0.8 1.5Government consumption -0.4 0.1 1.2 -0.2 0.8 0.0 2.7 0.2Gross fixed investment -0.9 1.7 2.3 -1.6 5.2 2.0 2.7 3.2

Exports of goods & services 0.9 0.6 4.7 -4.0 12.4 -1.4 1.0 0.9Imports of goods & services 1.9 0.6 12.4 1.9 8.6 3.4 4.1 1.5

GDP at market prices -1.2 0.7 1.6 -0.4 2.8 1.0 0.9 0.8

Source: Instituto Brasileiro de Geografia e Estatística.

Domestic demand acceleration may face tighter conditions

24 Brazil


Growth of retail sales has remained robust. Expansion in the second quarter was widespread across the major categories. Cheaper ethanol prices have bolstered fuel consumption, which had remained weak until the end of 2006. Supermarket sales have remained strong in real terms, despite higher food prices. Apparel sales, which are much more sensitive to income as opposed to credit, expanded strongly. But vehicles acquisition, which is almost wholly dependent on credit conditions, surged by 28% year on year. Overall retail sales were 15% higher year on year in volume terms. Preliminary data for the third quarter confirm even stronger sales performance. In August 235,000 vehicles were sold, compared with 217,000 in July and 178,000 in August 2006.

Disaggregated retail sales (% real change, year on year)

2006 2007 3 Qtr 4 Qtr 1 Qtr 2 QtrFuel & lubricants -7.7 -4.5 4.8 6.1Food, beverages & tobacco 7.7 7.3 7.2 6.9 Supermarkets 8.2 7.8 8.4 7.2Apparel & footwear -0.5 2.5 6.8 12.7Household appliances 10.6 11.8 20.3 13.0

Pharmaceuticals & personal care 3.4 3.2 5.3 8.8Office equipment 26.5 19.7 20.2 24.2

Reading & paper 1.9 -1.7 5.1 7.5Other personal & household 18.9 18.9 21.8 27.0Vehicles 11.8 12.6 17.4 28.3

Construction materials 12.2 11.2 6.0 13.2Overall retail sales 8.2 8.8 11.8 15.4


Vehicle manufacturers had been reticent to expand production amid rapid growth of imports, but faced with rocketing demand have resumed full capacity utilisation and are pursuing new investment plans. Contrary to the cyclical demand surge in 2004, when intermediate goods suppliers com-manded significant pricing power, in the current consumption-led expansion, this has largely disappeared owing primarily to stronger import levels. Never-theless, amid stable export-oriented production, capacity utilisation remains very high, and despite the maturing of recent investments, capacity constraints may emerge in the near future, which could have some effect on prices.

Capacity utilisation and business confidence 2006 2007 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrCapacity utilisation (%) 83.6 83.1 83.2 84.5 85.2

Business confidence 106.3 107.6 104.6 120.7 121.7 Current 105.1 110.9 110.5 124.4 123.3 Expectations 107.5 104.3 98.7 117.0 120.0

Source: Fundação Getúlio Vargas.

Rising disposable incomes continue to bolster retail sales

Brazil 25


Automotive sales(units; seasonally adjusted)

0

50,000

100,000

150,000

200,000

250,000Domestic Automotive Sales Exports

JulAprJan07

OctJulAprJan06

OctJulAprJan05

OctJulAprJan04

OctJulAprJan2003

Employment, wages and prices

Although capacity constraints are emerging in some specific sectors, there does not appear to be any significant structural bottleneck in the labour market. Despite strong growth of demand for labour by virtually every sector of the economy, including the government, the unemployment rate remains at levels comparable to 2005. This largely reflects demographic factors; data to July show there were 40.5m Brazilians aged over ten years in the six largest metropolitan areas, 2.3% more than in 2006. The share accounted for by the economically active population has remained stable at 56.8% but this is expected to rise as the populati0n ages. In coming years, it is estimated that demographic trends alone could increase the supply of labour by 3% per year. Even with mild productivity gains"which may be constrained by a high level of underemployment"GDP growth of 5% per year may be sufficient only to stabilise the unem-ployment rate.

There have been few alterations to structural trends in the labour market. Formal employment grew 5.2% year on year in July. The number of informal workers rose by 4.4% and autonomous workers by 4.7%. Data from July show sizeable growth in public-sector employment (2.9% compared with June), which might presage a stronger government contribution to GDP in the third quarter. Wages among formal workers remain stable, but the average income earned by autonomous workers was up by 9.5% year on year in July, probably reflecting the boom in the construction sector. Along with financial services, construction has been one of the industries to have experienced the most rapid growth of demand for labour. Employment in the construction industry was up by 7% year on year in July, and financial services by 9.7%. In São Paulo alone, where construction activity is particularly strong, there were 16.5% more people employed in the sector.

Demographic trends continue to boost labour supply

26 Brazil


Unemployment(% of economically active population; six largest metropolitan areas)

8.0

9.0

10.0

11.0

12.0

13.0

14.02007200620052004

DecNovOctSepAugJulJunMayAprMarFebJan

Inflation had been expected to soften in the second quarter of 2007, driven by deflation in regulated prices. Electricity tariffs were indeed revised down by the regulatory agency, in accordance with contractual terms, while ethanol prices remained very low and there was some small seasonal deflation in apparel prices. Meanwhile, services prices were already expected to be higher than overall inflation. However, food inflation far surpassed all predications. Food price inflation, which had already been running ahead of headline inflation since February, jumped to 9.3% in August. This reflected rising agricultural and livestock prices (wholesale prices appear to have risen by as much as 15%), driven by several factors. These include a decision by the US to promote ethanol usage and an expansion of the area sown for corn in the US, which has pushed up other grains prices.

With this dynamic prompting some farmers to switch from less profitable activities in favour of grains, other prices have been affected. In Brazil, this was particularly the case of milk production. With milk prices depressed during several quarters, many producers decided to abandon or scale back production, delivering a big shock to prices. Climatic conditions further compounded price pressures: a second year of dry conditions in southern Brazil severely curbed the productivity of wheat plantations. As stockpiles of wheat were already very low at the outset of the year, prices have doubled since the start of 2007, with knock-on effects on the prices of processed foods. Higher prices along the whole agricultural chain raised the cost of livestock feed, pushing the prices of meat, and chicken in particular, upwards.

It is difficult to distinguish cyclical from secular trends in these dynamics, and prices may well not fall back to previous levels if, as appears likely, upward pressure on food prices from energy prices and the growth of demand in emerging economies persists. A permanently higher price level for food would be particularly significant for consumers in developing economies, including Brazil, where food still accounts for a large share of households! consumption.

Food chain disruptions exert upward pressure on inflation

Brazil 27


Consumer price inflation indices (% change year on year unless otherwise indicated)

2006 2007 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul AugFood & beverages 0.3 0.9 1.1 1.2 2.0 3.1 4.3 4.6 4.8 6.6 7.9 9.3Housing 4.3 4.1 3.3 3.1 3.2 3.0 2.7 2.5 2.4 2.2 1.5 1.4

Home appliances -2.6 -2.6 -2.2 -2.7 -3.0 -3.1 -3.3 -2.8 -2.4 -2.4 -2.8 -2.6Apparel 6.0 5.9 5.7 5.1 4.8 4.6 4.9 4.0 3.8 4.1 4.2 4.1

Transportation 5.3 2.9 2.1 3.0 2.1 1.4 0.5 0.8 1.5 2.0 1.6 1.9Communication -0.1 -0.2 -0.2 -0.2 -0.2 -0.5 -0.6 -0.5 -0.4 -0.5 0.0 1.0

Healthcare 6.2 6.1 6.0 6.0 5.8 5.7 5.5 4.8 4.4 4.4 4.3 4.4Personal expenses 7.0 7.2 7.3 7.3 7.0 7.1 7.1 7.4 7.8 8.0 7.8 7.4Education 5.9 6.3 6.3 6.2 5.7 4.7 4.0 4.0 4.1 4.2 4.1 4.6

IPCA 3.7 3.3 3.0 3.1 3.0 3.0 3.0 3.0 3.2 3.7 3.7 4.2

Sources: Instituto Brasileiro de Geografia e Estatística; Banco Central do Brasil.

Financial and other services

Credit to both companies and individuals continued to expand solidly in the second quarter of 2007. Many lenders implemented a further gradual extension of maturities in order to reduce the monthly burden of amortisation and interest payments. The average delinquency rate on personal credit eased for the second consecutive quarter in April-June, in line with employment and income performance, although at 7.1% in May according to Federação Brasileira de Bancos (Febraban), it remains well above the overall non-performing loan (NPL) ratio. Expansion of credit to individuals has remained concentrated in payroll-linked credit and vehicle finance, although credit card usage has also been quite strong despite persistently high rates (excluding payroll-guaranteed credit, consumer lending rates averaged 65% in July). Indeed, spreads on rates for personal credit have not come down materially, despite growing com-petition associated with the public banks! expanding their portfolios and smaller banks pursuing more aggressive credit policies. Several banks have raised capital through initial public offerings (IPOs), as part of a drive to deliver a substantial expansion of credit portfolios to individuals and companies. Spreads charged to companies, by contrast, shrank significantly. For example, financing for acquisition of goods is now available at 5% over the benchmark Selic, whereas just a year ago rates as high as 12% over the benchmark were usual. Delinquency rates for corporate loans remain low, averaging 2.7% in the second quarter.

Market-based credit (end-period)

2006 2007 Jun Sep Dec Mar JunCompanies Outstanding (R bn) 199.0 204.7 210.0 224.5 235.13-month variation (%) 5.2 2.9 6.4 3.5 4.7Durationa 219 224 228 240 260

Lending still growing rapidly apart from some mortgages

28 Brazil


Market-based credit (end-period)

2006 2007 Jun Sep Dec Mar JunIndividuals Outstanding (R bn) 177.2 186.7 191.8 204.5 217.43-month variation (%) 5.4 5.4 2.7 6.6 6.3Durationa 332 346 364 384 404

a Days.

Source: Banco Central do Brasil.

The area in which lending growth has been slower than expected has been growth of mortgage credit. After a strong start to the year, new concessions in the free mortgage market have stabilised in recent months at around Rs110m (US$55m) per month, low by any standards. This suggests that although banks are comfortable lending large sums to homebuilders, they are more reticent about financing home acquisition. Real interest rates remain very high, con-straining the affordability of mortgages for the vast majority of the population. Failure by the banking system to deliver appropriate financing could prompt the postponement of some planned investments in housing.

The money supply is growing rapidly. The monetary base, savings accounts and mutual funds investments have all been expanding at around 20% per year, double the rate of nominal GDP. Although growth of term deposits has stabilised, with purchases of foreign currency by the BCB supplying ample liquidity, larger banks appear comfortable keeping their funding structure weighted towards the short term. Smaller banks can access ample and cheap funding in the capital markets through securitised credit portfolios.

Local markets were shaken by turbulence in the global markets in August. Investors were carrying large leveraged positions on Brazilian assets, and several of them were forced out of the market. At the height of the panic, the Ibovespa main stock exchange index fell by 23%, the Brazilian Real weakened by 16%, long-term rates rose by 250 basis points, and the spread on sovereign debt instruments widened by 100 basis points. Although credit markets have not resumed the extremely tight spreads prevalent in late June, in the context of heightened uncertainty in the global financial markets, credit spreads remain remarkably narrow, at only around 50 basis points above their June levels. Domestic fixed income markets, which were jolted by the higher than expected domestic inflation numbers in July and August, were unable to resettle at the relatively low rates traded in June. The headline Ibovespa index rebounded quickly, largely recovering its pre-turbulence peak by the end of August, although performance within the index was diverse. Shares in Companhia Vale do Rio Doce, a large Brazilian mining company, surged and were alone responsible for one-third of Ibovespa!s rebound. Petróleo Brasileiro (Petrobrás, the state oil company) also performed very well, as did major steelmakers, but several stocks"notably housebuilders"had yet to recover to their pre-turbulence prices as of mid-September.

Most asset prices recovered rapidly after August turmoil

Brazil 29


Given heightened uncertainty in global financial markets, there is some anxiety about the demand for future IPOs. In July a total of 14 companies sold Rs7.9bn (US$4bn) in primary initial public offerings of equity and another Rs7.2bn in secondary offerings. With global investor demand for Brazilian equity very strong, companies from a range of sectors were able to access the capital markets, including financial, logistics, tourism, retailing, healthcare, agricultural, slaughterhouses, real estate and even textile companies. Brazil accounted for a significant share of global equity IPOs in the first half the year. Following a seasonal lull during the northern hemisphere vacations in August, as of mid-September there were 27 companies in the IPO pipeline. In the past few months, declining interest rates have been encouraging investors to add more risk to their portfolios in order to maintain overall returns. There has been significant inflow of investor savings into equity funds and hedge funds, and direct purchase of equity from private investors has also been expanding fast.

New funding from capital markets (R bn)

2006 2007 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul AugEquity 0.5 3.5 1.0 1.7 2.6 4.5 4.1 7.1 0.0 7.0 15.0 0.0 Primary 0.5 2.6 0.6 0.5 2.1 1.9 1.9 3.9 0.0 5.3 7.9 0.0 Secondary 0.0 0.9 0.4 1.2 0.5 2.6 2.6 3.2 0.0 1.7 7.1 0.0

FDIC 0.7 0.4 2.7 2.5 0.3 0.4 0.4 1.2 1.0 2.3 0.1 0.4Debentures 1.6 1.6 0.0 10.0 0.2 0.1 0.1 2.5 0.2 0.5 4.1 0.0

Source: Conselho de Valores Mobiliários.

Sectoral trends

Growth in the second quarter of 2007 was evenly spread among cyclical sectors of the economy. In year-on-year terms, industry expanded 6.8%, mining output grew by 6%, manufacturing industry by 7.2%, utilities by 6% and construction by 6.2%. Among services, commerce expanded by 8.1%, transportation by 5.7%, information services by 7.5% and financial services by an impressive 9.6%.

Gross domestic product growth by economic sector (% real change, quarter on quarter)

2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrAgriculture & livestock value added -7.5 2.2 1.8 3.1 6.2 -1.1 -4.0 0.5Industry value added 0.1 1.4 1.5 -2.6 3.4 1.5 0.4 1.3

Services value added 0.5 0.9 1.2 0.3 1.2 1.1 1.6 0.7GDP at basic prices -0.1 0.8 1.4 -0.5 2.8 1.1 0.9 0.8


However, agricultural and livestock data were disappointing. This might reflect the greater weighting accorded to coffee and rice harvests in second-quarter figures, minimising the strong performance of soya and corn output. The latest estimates for total coffee production have been revised down owing to hot and dry conditions in growing areas. The harvest this year is now expected to be 15% smaller than in 2006. Next year, production should be much larger, as plantations sown in 2004-05 mature despite significant damage wreaked by the

Second quarter growth was evenly spread among sectors

Agriculture disappoints but outlook remains good

30 Brazil


weather. Although real agricultural growth was weak according to the data, output at current prices expanded by 23% compared with the second quarter of 2006. An increase of this magnitude, which has been driven much higher by global and local prices, has added to general optimism in agriculture. Brazilian producers have traditionally reacted rapidly to changes in price levels and relative prices. Given the expectation of a durable upward shift in agricultural prices, underpinned by soaring demand from emerging economies and the bio-fuel industry, the general outlook for the agricultural sector remains benign.

Agricultural output (m tonnes unless otherwise indicated)

2005 2006 2007 a % changeb

Sugarcane 422.9 455.3 514.1 12.9

Soybeans 51.1 52.4 58.2 11.1

Corn 35.1 42.6 52.2 22.5

Manioc 25.7 26.7 27.5 3.0

Orange 17.9 18.1 18.3 1.1

Rice 13.2 11.5 11.0 -4.3

Wheat 4.7 2.5 4.0 60.0

Coffee 2.1 2.6 2.2 -15.4

a Estimates. b Year on year.


Strong growth of sugarcane output has driven down the prices of sugar and ethanol. Fuel ethanol traded at 58 centavos per litre in São Paulo in August, down from 86 centavos in May and 82 centavos in August 2006. Investments in sugar and ethanol processing facilities are continuing, with large and well-capitalised producers seeking to force the smaller and less capitalised ones out of the market, in order to promote a consolidation of the industry prior to an expected boom in the sector.

Beef exports ('000 tonnes)

2005 2006 2007 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrTotal cattle beef exports 318.8 347.7 208.9 246.1 290.0 350.4 339.0 349.3 349.4

Source: Ministério do Desenvolvimento.

Cattle beef exports stabilised in the second quarter at 350,000 tonnes. In July Russia, the largest importer of Brazilian beef, demanded new packaging standards, which will probably be reflected in reduced export v0lumes in the third quarter, but export levels are expected to normalise in the fourth. Indeed, notwithstanding some short-term disruption, Brazil seems set to emerge as the major global supplier of beef. It has been steadily adding more cattle heads to global inventories and, given its unique supply of potentially arable un-cultivated land"estimated at 328m hectares by the IBGE"it is the only major cattle producer in a position to expand output on a sustained basis. Furthermore, there is significant scope to raise production even at current inventory levels: Brazil currently slaughters only 22.4% of its cattle inventory every year, compared with 46.1% in Russia, 38.4% in China, 35% in the US, 33.2% in the EU and 27% in Argentina.

Sugar and beef are performing especially well

Brazil 31


Cattle inventories (m head; end-period)

2003 2004 2005 2006 2007a % changeb

Indiac 283.1 282.5 282.3 282 282 -0.4

Brazil 165.5 169.6 173.8 180.1 187.7 13.4

China 134.7 137.8 141.6 145.3 149.5 11.0

US 94.9 95.4 97.1 98.4 98.6 3.9

Europe 87.5 86.4 85.8 85.2 84.8 -3.1

Argentina 50.8 50.2 50.2 50.8 51 0.4

Australia 26.6 27.3 27.8 28.6 29 9.0

Others 143.2 138.9 136.1 133.8 131.5 -8.2

a Estimates. b 2007 on 2003. c High India inventories mainly reflect religious motives.

Source: US Department of Agriculture.

Capital goods production booked a fourth consecutive quarter of strong growth in April-June. After increasing by 7.4% quarter on quarter in January-March, production increased by a further 3.3% in the second quarter of 2007. Consumer goods production, both durable and non-durable, also expanded strongly, suggesting that the long-awaited recovery of the sector has begun. With demand growing at double digits, vehicle production rose strongly, with 10% year-on-year growth of output in July. Even apparel and textile production recovered in the second quarter, despite growing imports. However, the print-ing, footwear, wood, tobacco and communication materials industries have continued to decline, as businesses lose out to Asian imports. Growth of inter-mediate goods production has been dampened by a mediocre performance in fuel refining industries, mainly because of delayed maturation of Petrobrás investments; a recovery is expected in the second half of this year.

Industrial production (average real quarter-on-quarter change; seasonally adjusted)

2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrCapital goods 0.8 2.2 -0.4 0.5 3.2 3.6 7.4 3.3Intermediate goods -0.8 0.3 0.7 0.7 0.8 0.3 1.6 1.6

Consumer goods -0.8 1.0 2.4 0.2 -0.2 0.9 0.8 2.8 Durable -3.7 0.0 6.8 -1.5 -1.4 0.5 4.2 2.6 Non-durable 0.0 0.9 2.3 -0.1 -0.2 1.0 0.5 2.8Overall industrial production -0.5 0.7 1.2 0.5 0.6 1.1 1.4 2.5


Foreign trade and payments

The trade surplus has been largely stable in recent months amid surging exports and imports. Export volume growth was surprisingly strong in the second quarter of 2007. In the first six months as a whole, average export prices rose by 9% and volumes rose by 7.6%. The main driver of volume growth was raw materials exports, volumes of which rose by 15% year on year, driven prin-cipally by meat and metals. This performance reflects surging demand in Asia, amid a boom in infrastructure investment and strong orders from heavy industries. With larger exporters having resumed investments in response to

Continued strength in capital goods production

Commodities support trade surplus despite import surge

32 Brazil


strong local and global demand, further robust growth of export volumes appears likely in coming quarters. With commodities trading at new highs in mid-September, the outlook for export earnings also remains promising. Higher agricultural prices, if sustained, could add as much as an additional US$7bn to export earnings in the coming 12 months. Iron ore prices are also forecast to rise further in the next 12 months, potentially boosting export earnings by a further US$4bn. These trends will ensure that the trade surplus remains solid even as import spending soars.

Exports, imports and trade balance(US$ m; 12-month accumulated)


0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

Trade balance fob-cif basis; right scaleTotal exports fob; left scaleTotal imports cif; left scale

AugJulJunMayAprMarFebJan07

DecNovOctSepAugJulJunMayAprMarFebJan2006

Although overall export performance appears not to have been materially impaired by the appreciation of the Real in the second quarter, the striking stagnation of export sales to the US is partly a reflection of the weakness of the dollar relative to the Real. In January-August, export sales to the US market rose by only 1.6% year on year. With ethanol exports expected to be lower in the second half of 2007 than in the same period of 2006, sales to the US for the year as a whole will probably fall. EU expenditure on Brazilian goods, which has expanded almost as rapidly as that of China"and in absolute terms accounts for more than three times the latter!s purchases"has been boosted by a strong euro. Growth of export sales to Latin America has not been especially strong, considering the continued strength of economic performance through-out most of the region. This may partly reflect exchange-rate trends"although most Latin American currencies have been strengthening against the dollar, few have done so as dramatically as the Brazilian Real"but it may also reflect trends in the Brazilian vehicle market, with surging domestic demand restraining expansion of vehicle exports. According to Associação Nacional dos Fabricantes de Veículos Automotores (Anfavea, national association of vehicle manufacturers), the number of exported vehicles has decreased by 8% so far this year, although booming production might reverse this trend in the near future. Nonetheless, the fact that export volumes have grown strongly despite stagnation of the US market underscores the strength of Brazil!s diversified profile of export markets.

Exports boomed despite stagnation in the US market

Brazil 33


Exports by region (US$ bn unless otherwise indicated; Jan-Jul)

Exports % of total 2006 2007 % change 2006 2007EU 19.8 25.1 26.8 22.4 24.5Latin America 20.2 22.9 13.4 22.8 22.4

US 16.1 16.4 1.9 18.2 16.0Asia 13.6 16.3 19.9 15.3 15.9 China 5.6 7.2 28.6 6.3 7.0Africa 4.7 5.6 19.1 5.3 5.4Middle East 3.4 4.3 26.5 3.8 4.2

Eastern Europe 2.3 2.7 17.4 2.6 2.6Other 8.4 9.1 8.3 9.5 8.9

Total 88.4 102.4 15.8 100.0 100.0

Source: Ministerio do Desenvolvimento.

Whereas consumer goods imports led import spending growth at the beginning of 2006, during 2007 expansion has become more evenly distributed among the major categories. The exception is spending on fuels imports, growth of which has been somewhat more subdued than the other categories. This reflects growth of the local petrochemicals industry and the proposed invest-ments by Petróleo Brasileiro (Petrobrás, the state oil company) substantially to increase refining potential, which could over time result in a contraction of the fuel import bill. Brazil plans to capitalise on tight global refining capacity to become a net exporter of distillate fuel in the long term. The rapid expansion of spending on intermediate goods imports reflects the increased globalisation of Brazilian industry, with local firms increasingly outsourcing labour-intensive activities to Asia as well as to some countries elsewhere in Latin America. This trend is expected to yield a boost to productivity and profitability in coming months and years. The fact that in the past 12 months Brazilian import purchases from China were equivalent to less than 1% of GDP"compared with purchases from the EU and US each equivalent to 1.7% of GDP"suggests that there may still be significant room for Brazilian industry to capitalise on Asian productivity.

Imports by category (US$ bn unless otherwise indicated; Jan-Aug)

2006 2007 % changeRaw materials & intermediate goods 29.1 37.6 29.2

Capital goods 12.2 15.7 28.7Consumer goods 7.4 9.8 32.4Lubricants & fuels 9.9 11.8 19.2

Total 58.6 74.9 27.8

Source: Ministério do Desenvolvimento, Secretaria do Comércio Exterior.

The performance of the trade balance was reflected in a strong current-account surplus in the second quarter of 2007. Profit remittances by foreign investors were strong, totalling US$5.5bn in the second quarter compared with US$3.1bn in the first quarter. This was partly offset by lower net outflows on the interest account, which totalled US$1.6bn in the second quarter compared with US$2.7bn in the first, thanks to higher levels of international reserves. Travel

Imports reflect globalisation of Brazilian industry

Trade surplus bolstered second quarter current account

34 Brazil


expenses remained stable, with the greater contribution of expenditure on services attributable to transportation costs. With freight rates and trade volumes rising, expenditure on transport is expected to rise materially, although not to the extent that could destabilise the current account, given forecast trends in the merchandise trade balance. In July the current account booked a deficit of US$700m, taking the 12-month trailing current-account surplus down to 1% of GDP, primarily reflecting seasonal travel expenses during winter vacations, which were boosted by the strength of the currency.

Current account (US$ bn unless otherwise indicated)

2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrCurrent-account balance 5.8 3.2 1.6 1.2 7.5 3.3 1.7 2.7 % of GDPa 1.8 1.8 1.6 1.3 1.5 1.4 1.2 1.3Trade balance (fob) 13.0 12.1 9.3 10.1 14.6 12.1 8.7 11.9Services (net) -2.1 -2.5 -1.7 -2.4 -2.8 -2.6 -2.2 -3.3 Credit 3.9 4.7 4.8 4.4 4.8 5.5 5.7 5.2 Debit -6.0 -7.1 -6.4 -6.8 -7.6 -8.0 -7.9 -8.5Income (net) -6.0 -7.4 -6.9 -7.6 -5.5 -7.4 -5.8 -7.0 Credit 0.8 0.8 1.3 2.3 1.4 1.5 2.1 3.0 Debit -6.8 -8.3 -8.3 -10.0 -6.9 -8.8 -7.9 -9.9Current transfers (net) 0.9 1.0 0.9 1.1 2.3 1.1 1.0 1.0

a 12-month current-account balance.


Strong capital markets activity was reflected in a very large inflow into the financial account of the balance of payments in the second quarter. Purchases of debt and equity, both as direct or portfolio investments, underpinned a record surplus of US$37.6bn. Assets purchased were wide-ranging, including public and private equity, asset-backed securities linked to loans to both individuals and companies, pre-IPO financing and local bonds. Faced with such large inflows, in order to avert a major appreciation of the exchange rate, the Banco Central do Brasil (BCB, the central bank) purchased US$38.2bn in foreign-currency reserves in the second quarter, after having purchased US$23.4bn in the first. By mid-September, reserves totalled US$162bn, equivalent to over 80% of Brazil!s total external debt. A cushion of this magnitude helped Brazil to weather the recent liquidity crisis in international capital markets without major disruption to financial flows. Not only was there no significant outflow in either July or August, but the BCB purchased a further US$10bn in reserves during these two months. Nevertheless, in response to much more volatile market environment, the central bank has not resumed reserves purchases since mid-August.

Inflows into the capital account have been very strong

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