Speech by the Governor of the Central Bank of Brazil, Henrique Meirelles, at the Brazilian Chamber of Commerce in Great Britain luncheon — London, 23 June 2008.

Ladies and Gentlemen,

I would like to thank the Brazilian Chamber of Commerce and the Brazilian Embassy in the UK for organizing this luncheon and inviting me to speak to you this afternoon.

Brazilian macroeconomic fundamentals have improved considerably in the last few years, and the results are materializing in higher GDP growth, a solid balance of payments performance, inflation within the target range, and a falling public debt-to-GDP ratio.

With regard to GDP, the Brazilian economy grew by 5.8% year-on-year in the first quarter of 2008, after having grown by 6.2% in the final quarter of 2007. The current expansion is already the longest since a short-lived episode in the mid-90s, and the longest since the 70s.

The current growth path is explained by domestic demand. Household consumption registered a 6.6% expansion year-on-year, while fixed-capital investment grew 15.2% on the same comparison basis. In other words it is domestic demand that is supporting the current expansion. Consistent with this fact, both consumer and business confidence currently stand at record highs.

Brazilian asset prices have reflected the consolidation of the stable economic environment in Brazil, and have been leveraged in recent years by a global environment of historically low risk aversion and low real interest rates. Global financial turmoil means this period might now be over. In this new, less risk-tolerant environment, Brazilian asset prices have reflected the improvement in macroeconomic fundamentals. The BOVESPA index records the best performance among major stock exchanges, having risen substantially since the sub-prime crises erupted, compared with the decline in major indexes. Brazilian risk and credit default swaps increased only slightly since the sub-prime crisis, well below rises seen for other emerging markets.

The global economy faces trying times, and these carry risks for the Brazilian macroeconomic outlook. But it is important to place issues in perspective: domestic demand is leading GDP growth in Brazil. The country shows an increasing diversification of exports, both in terms of products and markets. Therefore, if the consensus view of a moderate global slowdown prevails, the direct demand channel is likely to have somewhat limited impact on Brazil's short-term growth prospects.

A second channel of transmission could in theory take place through financing. Equity issuance was low at the beginning of 2008, but has recovered recently. While Brazilian banks have not been directly exposed to the US sub-prime market, there was anecdotal evidence that they might have felt some of the global trend towards rising funding costs. Finally, Brazilian non-financial corporations retained access to external funding, but possibly at a higher cost.

The financial channel has changed for the better after the promotion of the Brazilian sovereign rating to investment grade. There is new equity issuance, and both financial and non-financial corporations benefited directly from the reduction in sovereign premiums after the achievement of investment grade. Thus, although the financial channel seemed to be operating at some stages of the crises, investment grade status might have eased major concerns. And as I mentioned before, GDP growth in Brazil is being led by domestic demand, which is being fuelled by raising employment, income and credit. This is a result of the stabilization of the Brazilian economy.

Inflation has increased in Brazil in the recent past, as almost everywhere else, rising from 3.0% at the end of 2006 to 5.6% last May – above the central target of 4.5% but still within the target range of 2 percentage points. Commodity price increases have a dual effect in the Brazilian economy, as on one hand they reduce the real income of certain segments of the population, while on the other, as Brazil is a net exporter of commodities, they increase the incomes of other segments. At the same time they boost the country's capacity to import. We also have domestic factors that have increased inflation, related to very strong domestic demand.

The Central Bank has shown that it is committed to inflation targeting and prepared to act to safeguard price stability, which is a pre-condition for sustainable growth. In fact, monetary conditions have tightened since the beginning of the year, and the results will be clearer in due course, considering the usual lags of monetary transmission to prices. Thus, inflation expectations converge on the central inflation target in 2009 and 2010, and are indeed below the central target for 2011 and 2012.

About half of Brazilian exports have an important commodity component, and the country is a major player in the markets for metal and agricultural commodities. Lately, in fact, it appears the correlation between the Brazilian real and so-called 'commodity currencies' has strengthened. Rising commodity prices imply positive shifts in Brazil's terms of trade, raising income and demand levels as well as the economy's ability to expand imports (which grew 40% in value in the twelve months up to May this year) without excessive deterioration in its external accounts.

Brazil is currently in an unique position. It is possibly one of the few countries in the world that has the capacity to increase food production, having a large area of unused arable land that can be incorporated into regular production to respond to the growing demand for food worldwide. The Brazilian agribusiness sector has the technology, know-how and resources to meet the challenge. The recent discovery of oil reserves in deep waters will contribute to shifting Brazil from the position of net importer of oil, as had been the case before 2006, to that of net exporter in the next decade. Brazil is also in a unique position in terms of the use of renewable energy sources, with ethanol playing a significant role. While the global use of renewable energy sources is around 12%, and even less for advanced economies, the Brazil's use of energy is relatively well balanced between non-renewables and renewables, particularly hydroelectric power and ethanol.

The economy has become more resilient to external shocks. Brazil today has a floating exchange rate regime, one that is best suited to act as a buffer against external shocks. Second, the Brazilian Central Bank has accumulated almost $200 billion dollars of external reserves. Third, the economy has de-leveraged in foreign currency terms, and since January this year Brazil has been a net international creditor – a status the public sector has actually enjoyed since June 2006. Fourth, while Brazil is likely to post a current account deficit this year, net foreign direct investment is well in excess of the deficit. Brazil's overall external exposure has shifted from debt to a larger equity component. This means that remittances and external obligations are more correlated to the Brazilian business cycle than when the country had major external debt and thus major fixed debt service outlays. In addition, the public sector is showing consistent primary surpluses and the Central Bank is committed to the inflation target. All of this, together with domestic demand-driven GDP growth, creates a more resilient economic environment.

More resilient does not mean totally immune. Brazil is of course fully integrated in the world economy and would inevitably suffer some of the consequences of a severe slowdown, but probably in a much milder form than used to be the case. In fact, the global deceleration is why we expect GDP growth to slow down, from the 5.8% recorded over the last four quarters to 4.8% at the close of the year.

In a nutshell, Brazil has taken steps in the last few years to increase the economy's resilience to external shocks and, judged from what has happened, and especially from what has not happened to the Brazilian economy since turmoil erupted in major financial markets by mid-2007, we have reason to believe that even taking into consideration the economic cycles and the present challenges, Brazil is now on a sustainable growth path rather than the 'stop and go' paths of the past.

Thank you very much.