Cablegate: Brazil's Public-Debt Vulnerability Lessens, for Now

Published: Sun 29 Feb 2004 01:11 PM
This record is a partial extract of the original cable. The full text of the original cable is not available.
E.O. 12958: N/A
REF: (A) 03 BRASILIA 3682, (B) 03 BRASILIA 3911
1. (U) Brazil's nominal net public debt and debt/GDP
ratio both continued to rise in 2003, but there are grounds
for guarded hope that the debt burden is not now the
imminent threat it has been in recent years. The debt/GDP
ratio (58.2% end-December) is far down from its brief late-
2002 spike of 64% and is forecast to decline year-on-year in
2004 -- a first since 1993. The GoB has worked well to
reduce the debt's exchange-rate vulnerability: foreign
public debt grew fractionally in 2003, but the dollar-linked
component of domestic debt was steeply down, to 10% of the
total (20.5%, including swap exposure) from end-2002's 20.3%
(53.5%, including swap exposure). The Real's appreciation
since late 2002 from almost four to under three per USD has
in itself greatly eased service of the debt's foreign-
currency component. And Brazil's soaring exports have added
a new shock-absorber against sudden depreciation of the Real
and consequent surges in dollar-linked debt.
2. (U) Eighty percent of the total debt is domestic, i.e.,
denominated in Reals. Half of that 80% is tied to the
Central Bank's benchmark SELIC interest rate. Thus, the
SELIC's drop from 26.5 to 16.5% since June 2003, if
continued, means future-year savings in interest payments of
1.5-3.0% of GDP, as the GoB replaces or retires old debt
issued at high SELIC rates. In a "virtuous-circle" effect,
the return of market confidence during Lula's first year has
allowed the GoB to improve the composition of its
securitized debt by issuing more fixed-rate paper, as well
as (since August) lengthening maturities. GoB optimists
speak of cutting debt-service costs enough to achieve
nominal/nominal balanced budgets by 2008, paving the way for
debt/GDP to decline to the low 40% range within the decade.
3. (SBU) Yet Brazil's public debt remains far too close
for comfort to a macroeconomic knife's edge. The Lula
government's hard-won primary surplus of 4.32% of GDP in
2003 still covered less than half of the interest payment
(9.49%) on its debt stock. The overall nominal debt and
debt ratio each thus still grew by around three percent.
(The Real's appreciation partly counteracted the nominal-
deficit effect, by shrinking the valuation in Reals of
foreign-exchange-linked debt.) For 2004, the GoB itself
projects only a modest reduction in the ratio, to 57.3% --
even assuming 3.5% GDP growth. Domestic and/or external
shocks could reverse recent positive trends. Meanwhile, the
huge costs of debt-service sap the GoB's ability to make
investments needed for growth, without which the debt burden
will become more intractable. Bottom line: Lula's team in
its first year made more progress in managing the public
debt than even they might have dreamed possible -- but the
debt worry looks sure to remain, hovering like a ghost over
his entire term. END SUMMARY.
Scope and Structure
4. (U) Brazil's net public-sector debt rose in 2003 from 881
to 913 billion Reals (from 55.5 to 58.2% of year-end GDP).
Converted at the then-exchange-rate of Reals 2.89 per USD,
the end-2003 total amounted to $316.1 billion. That dollar
figure may mislead, however. Net public foreign debt
constituted just USD 64.6 billion, or 20.4% of the total.
The other four-fifths was domestic and denominated in Reals.
Thus, the GoB can finance itself almost entirely on the
local market. About 90% of new debt issued is domestic;
recent modest external issues have involved simply rolling
over foreign-exchange debt. The domestic debt admittedly
includes foreign-exchange exposure of about USD 55.8 billion
in the form of domestic securities tied to the exchange rate
or currency swaps issued in parallel with those securities.
The total foreign-exchange-rate exposure of Brazil's public
debt thus amounts to roughly USD 121 billion, 30.4% of the
total (40.9% including swaps).
5. (U) FOREIGN-DEBT NOTE: The GoB (and IMF-approved) figure
for Brazil's foreign public-debt total is net/net of
official gross/gross reserves. The latter at end-2003 were
below USD 60 billion, of which over USD 38 billion
represented IMF loans. Net reserves then were under 20
billion, a small fraction of their average since the early
1980s. The GoB has since increased its net reserves by over
two billion dollars via open-market purchases, an ongoing
process. END NOTE.
Table 1
Brazil's Consolidated Net Public Sector Debt
(1998-2003, End-Year), Billion Reals
1998 1999 2000 2001 2002 2003
Net Debt 385.9 516.6 563.2 660.8 881.1 913.1
(% of GDP) 41.7 48.7 48.7 52.6 55.5 58.2
Foreign 1/ 57.2 108.8 111.3 130.8 226.8 186.4
(in dollars) 47.3 60.8 57.0 56.4 64.2 64.6
(% of GDP) 6.2 10.3 9.6 10.4 14.3 11.9
Net Domestic 328.7 407.8 451.8 530.0 654.3 726.7
(% of GDP) 35.5 38.4 39.1 42.2 41.2 46.3
-1/ Net of Central Bank foreign exchange-denominated assets
including gross reserves; converted at contemporary exchange-
Sources: Central Bank and Finance Ministry.
Table 2
Breakdown of Public-Sector Debt
Billions of Reals
December 2003
Gross Debt 1,344.6
- Federal Government 940.0
- Central Bank 312.4
- State Governments 21.9
- Municipal Governments 5.2
- Federal para-statals 51.2
- State para-statals 13.9
- Municipal para-statals 0.3
Assets netted out -431.5
- Federal Government -203.3
(primarily domestic assets of the Workers' Guarantee
Fund, assets of similar domestic funds and renegotiated
state debts to federal government)
- Central Bank -161.5
(primarily international reserves)
- State Governments -11.3
- Municipal Governments -2.5
- Federal para-statals -52.6
(includes foreign exchange deposits, renegotiated debt,
other credits)
- State para-statals -0.3
- municipal para-statals -0.1
Source: Central Bank
6. NOTE: To avoid confusion amongst specialist followers
of Brazilian finances, it should be noted that Brazil's net
public domestic debt ("divida liquida") is not the same as
its Federal Domestic Securitized Debt (FDSD -- "divida
mobiliaria"). The latter includes some GoB paper which does
not reflect net debt, e.g., extra issuances to sterilize the
CB's open-market purchases of dollars to boost reserves, or
other monetary-policy operations. FDSD thus is sometimes
greater, sometimes less, than net domestic debt, as a
comparison of Table 1 above with Table 3 displays.
Table 3
Federal Domestic Securitized Debt
(1998-2003), Billion Reals
1998 1999 2000 2001 2002 2003
Stock 323.9 414.4 510.7 624.1 623.2 731.4
-(% of GDP) 35.0 39.1 44.2 49.7 39.2 46.1
Source: Central Bank and Finance Ministry
How Did We Get Here?
7. (U) Multiple dynamics raised Brazil's federal debt/GDP
level from 1994's 30% to the current 58+%. The key drivers
have been: a) high nominal deficits (and, before 1998,
primary deficits), generated fundamentally by the high
interest rates to which successive GoBs have resorted to
stabilize the currency and fight inflation in the face of
various shocks; b) centralization of state, municipal and
other liabilities at the federal level after the mid-1990s;
c) currency devaluation since 1998; and d) stubbornly low
GDP growth.
High, Interest-Driven Deficits
8. (U) Before the 1997-99 emerging-market financial crisis,
the GoB ran not just nominal but primary consolidated budget
deficits. The Cardoso government of that era maintained an
overvalued exchange rate by means of high interest rates.
When forced to float the Real in 1999, it raised interest
rates still further to control inflation. These factors
help explain how interest costs of what was initially a
relatively modest stock of debt have for years been so high.
9. (U) The years since 1998 have seen primary-budget
surpluses of 3.2% of GDP or better. However, in those same
years debt service has grown to 7-9% of GDP in interest
payments alone. This tremendous expense soaks up as much as
a quarter of government revenues (federal and state.) It
has been the primary agent behind Brazil's fiscal deficits
since the Plano Real in 1994. To illustrate: the Lula
government's hard-won 4.32% of GDP primary surplus covered
less than half its interest expenditures (9.49% of GDP) in
2003. Result: a nominal deficit of 5.16% of GDP. Table 4
illustrates the impact of debt service on Brazil's fiscal
accounts over the last half-decade.
Interest Payments Drive Fiscal Deficits
(In Billions of Reals and Percent of GDP)
Year 1998 1999 2000 2001 2002 2003
Interest 68.3 87.4 78.0 86.4 114.0 145.2
-% GDP 7.5 9.0 7.1 7.2 8.6 9.5
(accrual basis)
Surplus 0.1 31.1 38.2 43.7 52.4 66.2
-Pct of GDP 0.0 3.2 3.5 3.6 4.0 4.3
Deficit 68.2 56.3 39.8 42.7 61.6 79.0
-Pct of GDP 7.5 5.8 3.6 3.6 4.6 5.16
Source: Ministry of Finance and Central Bank
10. (SBU) NOTE: Unibanco's chief economist once lamented to
Econoff that his former employer, the World Bank, had ever
convinced the IMF to fix primary surpluses instead of actual
deficits as program benchmarks. This policy, he said, masks
the extent of a country's fiscal problems. In Brazil's
case, even the current 4.3% of GDP primary surplus is not
enough to bring down the debt-to-GDP ratio, he argued. END
11. (U) The Cardoso administration's responsible process
through the late-1990s of acknowledging bad state, municipal
and parastatal debt, plus some other liabilities, has also
driven up the official GoB debt level. Much of these debts,
commonly referred to as "skeletons", have been centralized
in the federal government. "Skeletons" added an officially
estimated 8.62% of GDP to the stock of federal public debt
in the eight years to December 2003. Pessimists opine that
more skeletons remain to be unearthed, perhaps another 5-8%
of GDP, but this upper figure seems increasingly unlikely.
Currency Depreciation
12. (U) Since 1998, the dominant factor in worsening the
debt/GDP ratio has been the exchange rate. This was
reflected by the jump in the ratio after the GoB was forced
to float the Real in early 1999. From 41.7% in 1998, the
ratio leapt to 48.7% at the end of 1999. (The particularly
high interest rates briefly imposed in 1999 were also a
factor, but those rates themselves stemmed from the need to
staunch capital flight and inflationary effects arising from
the devaluation.) The Real's renewed plunge from April into
October 2002 -- combined with the effects of high interest
rates employed to combat inflation and restore market
confidence during the presidential campaign -- likewise took
a toll, causing the brief spike at 64%.
13. (U) A CSFB study gave as the rule-of-thumb for the
second half of 2002 (with the Real in the 3.50-4.0/dollar
zone) that a 10% currency devaluation translated to a 2
percent rise in Brazil's debt/GDP. At its worst, in
November 2002, it meant a 3.4% increase. This effect was
not mainly due to Brazil's relatively modest foreign public
debt. Rather, it was driven by the then-burgeoning level of
the dollar-linked portion of domestic public debt. That, in
turn, was generated by the GoB's practice, adopted out of
necessity, of holding down interest rates on its new debt by
increasing issuance of dollar-linked instruments. As part
of this process, starting in April 2002 the Central Bank
also began issuing dozens of billions of dollars' worth of
swaps in parallel with new Treasury SELIC issuances. (IMF
rules forbid Treasury from selling swaps or other
14. (U) Lula's GOB has assiduously reduced this exposure to
exchange-rate volatility. As market confidence in his
financial team has grown, the latter has been able to
retire, rather than roll over, massive portions of dollar-
linked debt coming due, replacing them with non-dollar-
linked debt. In 2003, it retired from the market over $20
billion in dollar-linked debt and debt-related swaps. By
year's-end, the dollar-linked part of the domestic debt had
halved, from 20.3 to 10.0%, year-on-year. Including swaps,
the drop was from 33.5 to 20.5%. The process has
accelerated since, with a total of $7.6 billion more in
dollar-denominated debt retired in the first two months of
2004, according to the latest GoB figures.
Table 5
End-2002 Sept.'03 End-2003
-------- -------- --------
Fixed-interest 1.5% 6.9% 9.5%
Floating-interest 42.4% 48.9% 46.5%
Inflation linked 9.2% 9.8% 10.3%
Total Dollar and
Dollar-linked 45.8% 33.0% 32.4%
Others 1.6% 1.4% 1.4%
Source: Central Bank and Finance Ministry
15. (U) As the debt's foreign-exchange component has shrunk,
its interest-rate component has grown. Half the domestic
debt is floating-rate, linked to the Central Bank's discount
(SELIC) rate. To illustrate the potential downside of this
factor: the Central Bank's interest-rate hikes in response
to the crisis of confidence in 2002 increased average
interest on Brazil's domestic public securitized debt to a
peak of 31.7% in November 2002.
16. (U) The GoB has begun to turn the tide in this area, as
seen in Table 6. New financial-market confidence has
allowed it to reduce interest rates, increase issues of
fixed-rate debt (from under two to over twelve percent of
the total, year-on-year by end-2003) and, beginning in
August 2003, also to lengthen maturities. By December 2003,
the SELIC had dropped to 16.5% from 26.5% in mid-2003, and
the average interest rate on domestic debt was down to
around 22%. This, to be sure, still left the real rate well
in the double-digit range. As for foreign-debt service: by
January 2004, the GoB was able to launch a 30-year Eurobond
with a spread of 377 basis points above U.S. Treasuries --
quite remarkable after the spreads of 24% above U.S.
Treasuries little more than a year before.
End 2002 Sept 03 Dec 03
Ave. maturity
(months) 33.20 31.20 31.34
- fixed rate 3.06 6.64 6.50
- SELIC linked 21.83 22.38 22.74
- Dollar linked 35.47 40.82 40.51
- inflation link 79.18 75.29 77.88
Duration (months) 20.0 15.2
Percent maturing within one year
(total) 38.9 32.1 33.4
- fixed rate 96.8 86.9 85.9
- SELIC linked 48.8 30.9 28.9
- Dollar linked 31.1 33.5 42.7
- inflation link 1.3 1.7 1.4
Average Interest Rate
- w/swap exposure 20.9 18.6
- w/out swaps 29.1 21.2
Exchange-Rate Exposure (Billions of Reals)
- Dollar-linked 139.47 83.24 78.67
- Swaps 91.10 103.37 82.72
- Total 230.57 186.62 161.39
1/ Federal domestic debt in the form of securities
held by the public
Source: Ministry of Finance and Central Bank
GDP: The Stagnant Variable
17. (U) The final variable in the debt/GDP equation is GDP
itself. Brazil's anemic growth over the last several years
has exacerbated the ratio's increase. Growth in 2004 is
widely forecast to recover to 3.5%. But even if that
scenario is borne out, along with market expectations of
relative exchange-rate stability (3.1-3.2 Reals/$) plus a
further decline in the SELIC interest rate to 13.5% at end-
year, private-sector specialists calculate debt/GDP at end-
2004 will still be 58%. The GoB itself forecasts just a
modest fall, to 57.2%.
18. (U) After 2004, projections of declining debt/GDP levels
depend critically on sustained growth rates of at least 3.5
to 4%. Indeed, the public debt will only be payable to the
extent that Brazil solves its longer-term growth problem.
That solution, in turn, hinges on the raft of microeconomic
reforms necessary to increase economic efficiency and
promote investment (Ref A.)
19. (U) Meanwhile, Brazil's debt level in itself stymies
longer-term growth. Most GoB borrowing is to roll over
maturing debt and to pay current fiscal deficits. Public
investment has dried up, squeezed both by debt service and
constitutional spending earmarks which leave only about 9%
of the federal budget as discretionary spending.
20. (SBU) Financial-market enthusiasm for Brazil debt-paper
seems ready for the long-haul. Certainly Brazil has come a
good way from the "vicious circle" near-panic induced by the
presidential campaign of 2002, with that period's plummeting
exchange rate, interest-rate hikes, and extreme difficulty
in debt-rollover. But, for all the debt-management skill
and progress of Lula's first year, Brazil's public-debt
profile could quite easily again fall prey to negative turns
of market mood if, e.g., local interest-rate or global risk-
capital trends take a bad turn, and/or domestic growth in
the real economy continues not to materialize.
21. (SBU) Beyond keeping its fingers crossed against
external and domestic shocks, the GoB can now best improve
its debt sustainability by enacting structural and
microeconomic reforms to attract investment and boost
growth. Unfortunately, the early results of its efforts to
reform the tax, pension and regulatory systems have been
economically underwhelming, however politically resolute.
The phantoms of doubt about Brazil's debt have withdrawn to
the wings for now, but will surely hang around, ready again
to haunt the GoB, through Lula's term.
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