Cablegate: Brazil: Public Banks' Rising Influence Brings Increased

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RHEHNSC/NATIONAL SECURITY COUNCIL WASHDC

UNCLAS SECTION 01 OF 02 SAO PAULO 000549

SIPDIS
SENSITIVE

E.O. 12958: N/A
TAGS: ECON EFIN ETRD EINV BR
SUBJECT: BRAZIL: PUBLIC BANKS' RISING INFLUENCE BRINGS INCREASED
RISKS TO FINANCIAL SECTOR

REF: (A) SAO PAULO 531; (B)SAO PAULO 320; (C) BRASILIA 950

SENSITIVE BUT UNCLASSIFIED--PLEASE PROTECT ACCORDINGLY

1. (SBU) SUMMARY: Public bank growth in Brazil has played a positive
counter-cyclical role against the impact of the global financial
crisis, but has also raised concerns. In the near-term, continued
growth in public bank lending could accelerate inflation. Over the
longer term, public banks may begin to crowd out private lending.
As Brazil's lending market matures, crowding out effects could
intensify and impose larger efficiency costs on Brazil's financial
system. Despite these risks, attempts to downsize the public banking
sector, given the recognition it has received for bolstering the
Brazilian economy through the crisis, will be politically difficult.
END SUMMARY.

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Lower Rates & Increased Lending Bolster Economy
--------------------------------------------- ---

2. (SBU) Large public banks such as Brazil's Development Bank
(BNDES), Banco do Brasil, and Caixa Economica have helped stabilize
Brazil's economy in recent months by boosting credit flows and
serving as a quasi-lender of last resort for the hardest-hit
industries. The substantial increase in public bank lending is a
result of significant pressure applied by President Lula at the
outset of the global financial crisis in late 2008. BNDES lending
rose sharply for capital goods purchases, SMEs, and trade finance,
while Banco do Brasil boosted agricultural lending and Caixa
Economica supported Brazil's housing sector. The GoB also
instructed public banks to reduce loan rates. Rates on working
capital loans, among the most important loan categories, for example
are 5 to 10 percentage points below private bank rates. Banco do
Brazil for example charges about 17 percent compared to Bradesco's
23 percent, according to the Central Bank.

3. (SBU) Increased lending by Brazil's public banks provided a key
source of monetary stimulus, arguably even more important than the
Central Bank's reductions in its benchmark Selic rate since bank
lending injected credit directly into the economy rather than
indirectly via price signals. Over the past year, total credit
expanded nearly 20 percent while BNDES lending alone rose almost 40
percent.

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Advantages Over Private Banks Fuel Growth
-----------------------------------------

4. (SBU) Public banks' in Brazil enjoy several market advantages
over private banks. First, a significant portion of the public
banks' funding comes from payroll taxation (FAT), which provides a
low cost and captive source of funds. While estimates vary, the
cost advantage that FAT funding provides is substantial. Private
bankers have told Treasury's financial attache that they simply
cannot compete for longer-run funding against the large public
banks. Public banks also have access to additional funding directly
from Brazil's Finance Ministry. Last December, for example, BNDES
obtained a $55 billion loan at a time when private inter-bank
markets were completely frozen. The funding source provides public
banks stronger implicit deposit guarantees than private banks.
Finally, some of the liability advantages that public banks have
allow them to take greater risk with their loan portfolios and other
assets. For example, Banco do Brasil and Caixa Economica lend
disproportionately to Brazil's highest-risk sectors and BNDES is
Brazil's second-largest holder of equities -- a large degree of
asset risk that private banks are less able to absorb.

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Rising Inflationary Risks
-------------------------

5. (SBU) As the economy recovers, continued growth in public bank
credit could generate short-term inflationary problems, as private
credit is likely to rebound. In a worst-case scenario, 2010
inflation could approach the central bank's 6.5 percent upper
boundary target, a large but not catastrophic jump from the current
4.5 percent level. Adding to potential inflation risk, leadership
succession at Brazil's Central Bank remains uncertain following
Central Bank president Henrique Meirelles' expected resignation in

SAO PAULO 00000549 002 OF 002

the near future. Additionally, according to a contact from a major
private bank, Mario Mesquita and Mario Toros, respected members of
the Bank's interest rate committee (COPOM) are likely to step down
later this year, although neither has publicly admitted this
information. Fiscal policy is likely to remain expansionary over
the next year as President Lula seeks to support his Chief of Staff,
Dilma Rousseff's, presidential bid.

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Crowding Out Private Lending
----------------------------

6. (SBU) Since Brazil's current credit ratio is only 50 percent of
GDP, all banks, including private banks, are likely to continue
growing their loan books rapidly and remain highly profitable over
the near-term. Sustained increases in public bank lending over the
long-term could, however, eventually crowd out private lenders and
become a structural drag on future bank competition. As crowding
out effects rise, the subsidy and guarantee advantages that public
banks receive could increase distortions and impose larger
efficiency costs on Brazil's financial system and private sector
customers.

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COMMENT
-------

7. (SBU) As Brazil's economy recovers, lending will continue to
grow. Public banks are eager to expand and many borrowers support
public bank lending because the rates they pay are effectively
subsidized by Brazilian taxpayers. Many Brazilians, including
President Lula, credit Brazil's stable, if inefficient, banking
system for helping Brazil successfully withstand the global
downturn. President Lula has actually suggested publicly that a key
weakness in the U.S. financial system is its absence of large public
banks. This popularity makes any reform of the public banking
sector politically difficult. Nevertheless, the growth of public
bank lending does pose limited, but important, costs on the country
that will rise in coming years as Brazil's loan market saturates.
At that point restraining Brazil's public banks may be even more
difficult. End Comment.

8. (U) This cable has been coordinated with Sao Paulo Treasury
Attache.

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