FOR IMMEDIATE RELEASE: Contact: Sueli Bonaparte Company Name: Brazilian-American Chamber of Commerce, Inc. Telephone Number: 212.751.4691 Fax Number: 212.751.7692 Email Address: sueli@brazilcham.com Web site address: www.brazilcham.com Brazil’s Economic Outlook Stable Following Lula Reelection but Fiscal Reform Needed for Higher GDP Growth New York, NY (November 1, 2006) — During a breakfast seminar on October 31 at the University Club in midtown Manhattan, a distinguished panel of speakers analyzed Brazil’s political and economic outlook for 2007 in the aftermath of Lula’s victory in the presidential runoff. The event was organized by the Programs Committee of the Brazilian-American Chamber of Commerce, Inc. Paulo Leme, Programs Committee Chair and Director of Emerging Markets Research at Goldman, Sachs & Co., served as the moderator of the event. Drausio Giacomelli, a Vice President at JPMorgan, highlighted the Lula administration’s need to develop a more effective and participatory coalition government during his second mandate. “Coalition parties were not sufficiently represented in Lula’s first administration,” he said. Only one-third of ministerial posts were occupied by coalition parties in Lula’s first term. Conversely, representatives of coalition parties accounted for two-thirds of ministerial positions during Fernando Henrique Cardoso’s first administration. While forging a strong coalition government will not be an easy task for Lula, Giacomelli underscored that even opposition parties have a strong stake in Brazil’s ongoing stability and growth, particularly as they look forward to the 2010 elections. Giacomelli believes Lula has a two-year window to pursue reforms and improve the nation’s fiscal dynamics before he becomes a lame duck president. Lula will also need to focus on rebuilding the PT as a result of the corruption scandals that have damaged the party in recent years. On the macroeconomic front, Giacomelli highlighted that while Brazilian exports are not growing in volume, they are growing in value. In 2006, export prices have risen 6% and are outpacing increases in import prices. Although Giacomelli maintains that the Real is overvalued at present, he does not foresee a large-scale depreciation in the near future. The nation’s strong trade surplus, capital market growth and direct investments should more than compensate for amortization payments, remittances and other forms of capital flight, giving rise to a net inflow into the FX market of US$10 billion in 2007. And if the Central Bank is able to cut interest rates at an even faster pace, Giacomelli says the nation’s equity markets will no doubt experience a boom, attracting more portfolio inflows. On a more somber note, Giacomelli says “Brazil’s fiscal accounts are lousy.” The nation has a 4.3% primary surplus, but roughly 90% of all revenue is earmarked for non-discretionary spending. This means that the nation’s fiscal accounts are extremely rigid, offering little room to curb expenditures. “We would clearly like to see lower spending levels and smaller government,” he said. While the administration has expressed its commitment to putting the fiscal house in order during Lula’s second term, it will likely happen at a glacial pace. As for interest rates, while most Latin American markets have converged towards prevailing international rates, Brazil has lagged behind. Giacomelli says Brazil will likely continue to cut rates at a gradual pace, slowly improving the nation’s interest rate dynamics and their impact on the fiscal accounts. In the public sector, Brazil is still borrowing at very high rates. Giacomelli says hedge funds in Europe and the US are willing to securitize Brazilian loans and offer cheaper credit, but still at a very hefty premium. In the consumer market, meanwhile, he says analysts should see a stronger focus on consumer credit and the housing sector, given the extremely low ratio of mortgages to GDP in Brazil in comparison to other markets. Lisa Schineller, Director of Sovereign Ratings at Standard & Poor's, focused first and foremost on Brazil’s investment rating. In order to achieve investment-grade status, Schineller says the new administration must improve Brazil’s fiscal fundamentals and growth prospects. She believes the government must articulate a clear and actionable policy agenda, while also working to build a strong political coalition capable of pushing such reforms through Congress. In particular, she believes the Lula government must work with the PMDB to share power and advance critical reforms, given that party’s increasing dominance. Schineller highlighted some key fiscal measures, stopping short of calling them reforms, that are needed to keep the fiscals accounts moving forward in a prudent manner. These include extending the DRU de-earmarking provision and the CPMF financial transaction tax, both of which expire in 2007. Schineller expects a continuation of Brazil’s prudent fiscal and monetary policies as well as incremental reforms in 2007. Because of Brazil’s extended track record of solid policy implementation, Schineller believes the nation is better poised for consistent growth. However, to grow at more robust rates, she believes the nation must focus on the fiscal picture and a combination of micro and macro measures. In her view, Brazil must reduce the size of the government, improve the composition and level of the tax burden, improve the composition and level of spending as well as reduce the debt ratios. She says the pattern of increasing taxes and spending can no longer be maintained. Rather, she argues that the administration must solidify a strong fiscal outcome based on lower spending. Schineller sees the social security system as a particularly acute problem. The private sector regime, INSS, has seen its deficit double since the late 1990s. That, combined with the public system’s shortfalls, has led to an overall social security deficit of 4.5% of GDP, higher than the primary surplus target. She says the administration will have to balance political pressures with the need to get something done on this issue. In addition to extending the DRU and CPMF, ICMS reform is also being discussed. Schineller believes this will be a particularly difficult reform to achieve, as it involves taking away tax revenue from certain states and giving it to others. However, if progress is made, analysts would certainly consider it to be a positive development that would improve the efficiency and structure of the tax system. As for the nation’s rating trajectory, Schineller balked at estimating when and if Brazil will achieve investment-grade status. She did, however, underscore that maintaining a sufficiently high fiscal surplus will be of critical importance. Brazil’s net government debt is 49% of GDP, compared with 38% for the BB rating median and 30% for economies with BBB- status (a low investment grade rating). While she concedes the debt has come down, it is still very high. In her view, Brazil will need a high primary surplus to continue decreasing the debt burden. Enhancing fiscal flexibility, slowing spending growth, improving the composition of spending and improving the tax structure would all contribute to a more positive dynamic and a more credible and sustainable fiscal policy. Such progress would, in turn, help reduce real interest rates at a faster pace and bring the entire debt burden down more quickly over time. Schineller highlighted that other markets have made the move from a BB stable rating to BBB- (low investment grade) over a period of 5-7 years. For Brazil, the exact timing depends on the pace at which policy improvements can move forward. According to Rogério Chequer, Managing Director of Discovery Fund Services, Lula has emerged from the run-off election with a great deal of political strength. The PT not only won the presidency – with overwhelming support from the North and Northeast – but also a large share of the gubernatorial races. This bodes well for Lula’s legislative reform prospects, given the substantial influence of state governments and governors on their delegations in Congress. Chequer believes the political climate in Brazil will be decidedly moderate in the aftermath of the election. Lula was reelected on a middle-of-the-road policy platform, and there is very little incentive for anyone to try and do something radically different in the next four to eight years. “I believe this more moderate approach will now be consolidated for a longer period of time given Lula’s success in this election cycle,” he said. Chequer also reiterated the importance of fiscal reform. He says the primary question is what kind of fiscal adjustments a second Lula administration will pursue. One option is gradual reform - extending the DRU and the CPMF, linking the minimum wage to per capita GDP and limiting expenditures. Another is a more profound fiscal adjustment – increasing the fiscal surplus target to 6.5% in 2007 in order to signal that the administration is aiming for a zero nominal deficit. Such a move would allow for a more relaxed fiscal primary in the following years, attract more capital and investment and bring interest rates down. Chequer, for his part, believes the ideal solution is somewhere between these two options. Another point of concern for Chequer is Brazil’s low investment levels at present. He says weak investment levels are making it extremely difficult to improve the nation’s productive capacity and output. Paulo Leme closed the event by highlighting the fact that Brazil’s stability – while a necessary precondition for the nation’s ongoing macroeconomic health, in no way ensures that the economy will grow at a more robust rate in the near future. Unless some very unpopular decisions are made in the fiscal arena, Leme does not believe the Brazilian economy can grow at a much faster pace than its current trajectory of 3-3.5% per annum. If such tough decisions are not made, Brazil is unlikely to live up to its full growth potential. ### For additional information, contact Sueli Bonaparte at sueli@brazilcham.com or 212.751,4691.