1

Brazil Economic Outlook

Alexandre Bassoli

May, 2007

2

This presentation

What are the drivers of the exchange rate appreciation? What explains the resilience of exports?

New GDP methodology has important implications for risk perception and the economic activity outlook

Domestic demand is pushing economic growth

Interest rates, albeit still high, are converging to unthinkable levels

Fiscal policy: expenditures continue to soar, but the public debt dynamics remain healthy

Investment grade may be achieved in 2008

3

In spite of the BRL strengthening, trade surpluses are approximately constant at USD 47bn

12-month trade balance

-10.000

10.000

30.000

50.000

70.000

90.000

110.000

130.000

150.000

jan/90

set/90

mai/9

1

jan/92

set/92

mai/9

3

jan/94

set/94

mai/9

5

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set/96

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set/98

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9

jan/00

set/00

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set/06

US

D m

illio

n

Exports

Imports

Trade balance

4

Terms of trade gains explain the resilience of exports

Mainly as a result of soaring commodity prices, export prices accumulate an increase of 57% since Dec-02

The nominal exchange rate moved from 2.13 to 2.03 BRL/USD between Apr-06 and Apr-07, but the profitability of exports actually increased 1.0%

The increase of export prices has two important implications:– More Dollars for a given volume of exports

– Since the profitability is improving, there are incentives to increase, not reduce, the export volume

EXPORT PRICES

75

80

85

90

95

100

105

110

115

120

jan/9

3

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199

6 =

100

Real exchange rate and export profitability index

40

60

80

100

120

140

160

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6

RER

EPI

5

The improvement of sovereign risk boosts capital inflows

Embi Brasil / Embi +

0,8

1,0

1,2

1,4

1,6

1,8

2,0

2,2

2,4

2,6

2,8

26/8

/200

2

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1/20

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/200

3

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/200

3

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/200

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/200

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/200

6

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/200

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/200

6

26/1

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06

26/2

/200

7

6

Strong BRL is here to stay

Currency appreciation does not seem to reflect a bubble

Brazil has largely mitigated its sources of external vulnerability

Exchange rate volatility was structurally reduced

We forecast 1.95 BRL/USD in Dec-07

Real exchange rate

1,05

1,30

1,551,80

2,05

2,30

2,55

2,803,05

3,30

3,55

3,80

4,054,30

jan/8

0

jan/8

1

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2

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3

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7B

RL

of

Ma

y 2

00

7

.

7

New GDP methodology brought two fundamental changes

The GDP level is 11% higher than we previously thought

Average GDP growth is the last six years was 2.9%, while the previous methodology indicated 2.3%

2006 GDP level (BRL mn) - old vs new methodology

1900

1950

2000

2050

2100

2150

2200

Old New

Average GDP growth (2001-2006) - old vs new methodology

2,9%

2,3%

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

New Old

8

Growth is gaining momentum pushed by domestic demand…

GDP growth: contribution of domestic absorption and net exports

-3,0%

-2,0%

-1,0%

0,0%

1,0%

2,0%

3,0%

4,0%

5,0%

6,0%

7,0%

1996

- I

1996

- III

1997

- I

1997

- III

1998

-I19

98-II

I19

99 -

I19

99 -

III20

00 -

I20

00 -

III20

01 -

I20

01 -

III20

02 -

I20

02 -

III20

03 -

I20

03 -

III20

04 -

I20

04 -

III20

05 -

I20

05 -

III20

06 -

I20

06 -

III

Net exports

Domestic Absorption

GDP

9

…and this process will continue

1-year ex ante real interest rate

9,0

12,0

15,0

18,0

21,0

24,0

27,0

30,0

33,0

jan

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/07

mai

/07

Real growth of total wages (YoY)

-11,0%

-9,0%

-7,0%

-5,0%

-3,0%

-1,0%

1,0%

3,0%

5,0%

7,0%

9,0%

mar

/03

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set/0

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/07

10

The good news is that investments are growing…

Annual growth of gross fixed capital formation

-10,0%

-5,0%

0,0%

5,0%

10,0%

15,0%

20,0%

25,0%

Q4 19

92

Q3 19

93

Q2 19

94

Q1 19

95

Q4 19

95

Q3 19

96

Q2 19

97

Q1 19

98

Q4 19

98

Q3 19

99

Q2 20

00

Q1 20

01

Q4 20

01

Q3 20

02

Q2 20

03

Q1 20

04

Q4 20

04

Q3 20

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Q2 20

06

11

…but the expansion is likely to exceed potential growth in 2007

Industrial capacity utilization

77%

78%

79%

80%

81%

82%

83%

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6

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/07

mar

/07

Unemployment rate (s.a.)

9,0%

9,5%

10,0%

10,5%

11,0%

11,5%

12,0%

12,5%

13,0%

mai/

02

ago/

02

nov/0

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ago/

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7

12

Inflation remains very well behaved, thanks to the BRL appreciation and the deceleration of administered prices

IPCA - tradables and non-tradables

-1%

4%

9%

14%

19%

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8jul

/98

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/99

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7

Tradables

Non-Tradables

Regulated prices

0,0%

5,0%

10,0%

15,0%

20,0%

25,0%

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6

13

Interest rates, albeit still high, are converging to uncharted territory

Several factors point towards lower rates in upcoming quarters– A more robust balance of payments implies a lower sovereign risk and a less volatile currency

– Administered prices now represent a positive shock

– The BRL appreciation keeps tradable inflation under control

– Terms of trade gains allow a fast increase of imports without damaging the current account surplus

Even after achieving the investment grade, however, it is not clear that interest rates will converge to levels observed in other countries such as Chile and Mexico (3.5%-4.0% in real terms)

The bad quality of fiscal policy implies, in our view a higher level of neutral interest rates and a lower level of potential growth

We expect nominal rates to stabilize at 11.0-11.25% in nominal terms

If terms of trade gains intensify, however, rates may stay below the equilibrium for a while

14

Fiscal policy: more of the same

Public expenditures continue to grow at an extremely vigorous pace

The tax collection expansion is also outperforming GDP growth

Real annual growth - central government expenditures

-6,0%

-4,0%

-2,0%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

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9

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ago/

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Real annual growth - central government revenues

-4,0%

-2,0%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

14,0%

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9

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15

The primary surplus will fall, but the nominal deficit is likely to drop as well, thanks to lower interest rates

12-month nominal deficit as a % of GDP

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

14,0%

jan/9

7jul

/97

jan/9

8jul

/98

jan/9

9jul

/99

jan/0

0jul

/00

jan/0

1jul

/01

jan/0

2jul

/02

jan/0

3jul

/03

jan/0

4jul

/04

jan/0

5jul

/05

jan/0

6jul

/06

jan/0

7

16

From a solvency perspective, fiscal policy looks OK, but…

It has as expansionary impact on domestic demand and negative implications for potential growth

The bad quality of fiscal policy may imply higher interest rates in comparison to investment grade countries

Net public debt/GDP ratio

27%

32%

37%

42%

47%

52%

57%

jan/9

1

jan/9

2

jan/9

3

jan/9

4

jan/9

5

jan/9

6

jan/9

7

jan/9

8

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9

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0

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17

Conclusions

Brazil continues to benefit from terms of trade gains

We think that a stronger (and less volatile) BRL is here to stay

Thanks to the positive shocks, the expansion of domestic demand may outperform output growth

Due to stronger fundamentals and positive shocks, interest rates are converging to uncharted territory

Even after the investment grade , however, we think that interest rates will be above the average of our peers

From a solvency perspective, fiscal policy is OK, but its poor quality has negative implications for potential growth and interest rates

Thanks to extraordinarily benign external conditions and the new GDP methodology, the investment grade is likely to be achieved in 2008

18

Macroeconomic forecasts

External accounts (USD bn) 2002 2003 2004 2005 2006 2007

Exports 60,4 73,1 96,5 118,3 137,5 151,0Imports 47,2 48,3 62,8 73,5 91,4 107,0Trade balance 13,2 24,8 33,7 44,8 46,1 44,0Current account -7,6 4,0 11,6 14,3 13,5 11,7Medium and long term amortizations -29,7 -27,8 -33,3 -32,8 -44,1 -31,0External sector borrowing requirement -37,3 -23,8 -21,7 -18,5 -30,6 -19,3Net direct investment 14,1 9,9 8,7 12,6 -8,5 14,0

Economic activity

GDP 2,7% 1,1% 5,7% 2,9% 3,7% 4,3%Industrial production (IBGE) 2,7% 0,1% 8,3% 3,1% 2,8% 4,8%

Inflation

IPCA 12,5% 9,3% 7,6% 5,7% 3,1% 3,5%IGP-M 25,3% 8,7% 12,4% 1,2% 3,8% 2,9%

Public sector

Public sector primary surplus (% of GDP) 3,6% 3,9% 4,2% 4,4% 3,9% 3,6%Public sector nominal deficit (% of GDP) 4,2% 4,7% 2,4% 3,0% 3,0% 1,9%Debt to GDP ratio 50,5% 52,4% 47,0% 46,5% 44,9% 43,9%

Interest rate and exchange rate

FX (average of period, BRL/USD) 2,92 3,07 2,93 2,43 2,18 1,99FX (end of period, BRL/USD) 3,53 2,90 2,65 2,34 2,14 1,95SELIC interest rate (average) 19,5% 23,3% 16,3% 19,0% 15,2% 12,2%SELIC interest rate (end of period) 25,0% 16,5% 17,8% 18,0% 13,3% 11,25%