U.S. investors’ inquiries should be directed to Santander Investment Securities at (212) 350-0707.

Latin American Economics Research Economics Research

Ernest W. (Chip) Brown, Head212-583-4663 ebrown@schny.com

September 15, 2006

STRICTLY MACRO

OVERVIEW THE IMF AND THE WANING DAYS OF THE GOLDILOCKS ERA

ARGENTINA REELECTION AND ROBUST GROWTH SUPPORTED BY MISALIGNING PRICES

BRAZIL BENIGN SCENARIO IN 2007, BUT COMPLACENCY AHEAD

CHILE 2007 FISCAL BUDGET: HOW MUCH IS TOO MUCH?

MEXICO STRONG EXTERNAL ACCOUNTS CONFIRM ECONOMIC STABILITY

VENEZUELA REVISING OUR 2006-2007 FORECAST

CONTENTS

OVERVIEW

THE IMF AND THE WANING DAYS OF THE GOLDILOCKS ERA.............................2

ARGENTINA

REELECTION AND ROBUST GROWTH SUPPORTED BY MISALIGNING PRICES ..................................................................4

BRAZIL

BENIGN SCENARIO IN 2007, BUT COMPLACENCY AHEAD ..................................7

CHILE

2007 FISCAL BUDGET: HOW MUCH IS TOO MUCH?.............................................12

MEXICO

STRONG EXTERNAL ACCOUNTS CONFIRM ECONOMIC STABILITY .................16

VENEZUELA

REVISING OUR 2006-2007 FORECAST...................................................................21

Strictly Macro – September 15, 2006

2

OVERVIEW: THE IMF AND THE WANING DAYS OF THE GOLDILOCKS ERA

For a very long time we have been forecasting a Goldilocks global scenario for Latin America: buoyant global demand, low interest rates internationally, and sufficient political good will at home to keep monetary policy in check and preserve fiscal balances, strengthening external balances. The result for the region hasn’t been porridge of just the right temperature, but a tepid meal of regional economic growth that at a projected 4.4% for 2007 is far short of the best growth to be found in the emerging world.

There is now a sense that change of a more lasting nature is in the air, and that we may be in the waning days of the Goldilocks era. This has been perhaps best exemplified by a warning last week by the International Monetary Fund research team that commodity price declines in coming years could be significant. This was followed by additional warnings from the Fund that the U.S. twin deficits and housing markets were untenable in the long term.

We’re not as convinced as the IMF that the world, at least as far as it extends to Latin America, is changing that quickly. The IMF itself is talking about modest reduction of global growth, not recession, and certainly not collapse of the Asian growth story, which is crucial to the Latin American growth outlook. Supply problems among copper producers (including Chile) may keep copper prices high in 2007, perhaps beyond. The IMF’s view of Latin America, as reported by the press, is more pessimistic about growth in Mexico and more optimistic about growth in Brazil than we are for 2007-08.

We are gradually unveiling our view of 2008 beginning with our team from Argentina, looking beyond the election year of 2007. The rest of our team will present their initial forecasts for 2008 in the October issue of Inside Latin America.

Our view of Latin America in this Strictly Macro reflects our skepticism about major changes being afoot, and focuses more on how local changes can affect the local story over the next year or so. On the most aggregated level, we still see 4.4% growth in 2007, slightly down from 4.5% this year and substantially higher than the 3.9% we were forecasting for the year this past January. Similarly, inflation remains around 5%, the regional current surplus has grown to 1.3% of GDP for next year from 0.3% early this year, and fiscal balance is maintained. There’s no pride of place in the current account surplus; all it really means is that the rest of the world is accelerating its growth and consumption of exportable products from Latin America at a faster clip, another sign of the regional growth numbers, which are decent but disappointing.

The highest growth in the region in recent years has been found in countries in Latin America that willfully fracture all the neoclassical rules of sound economic management, specifically Argentina and Venezuela. It is our view that this heterodoxy is unlikely to spread to the major economies of the region. We don’t think that Kirchnesian economic policy (as our Juan Arranz in Buenos Aires refers to it) is easily transferable elsewhere because there are few leaders in the region who have been as popular as Mr. Nestor Kirchner has been, and his personal credibility is the mainstay of the price acuerdos in Argentina. By the same token, none of the Latin leaders has the wherewithal from high petroleum prices that Venezuelan President Hugo Chávez enjoys, and none is as willing to commandeer petrodollars for political advantage as is Mr. Chávez.

Chile enjoys a similar export revenue windfall from state-owned Codelco and reports growth that is at near-Argentine levels, but Chile has been focusing on restocking a contingency fund and is far more cognizant of the need to keep monetary aggregates under control in a market economy.

In Argentina, our Juan Arranz focuses on economic growth in an environment of misaligned, distorted prices. Presidential elections are over a year away, but President Kirchner’s chances of being reelected are very high indeed. Our team does see economic growth slowing in Argentina, but expansion at 6% next year is sufficient to do the job of seeing the president reelected. We are worried about the energy sector in Argentina, as frozen public utility rates have led to deferral of maintenance and cancellation of new investment in the sector. (Of course, we are also concerned about the possible impact on neighboring Chile of shortages of imported gas from Argentina.) We see the ad hoc system of price controls in Argentina gradually becoming less workable and leading eventually to higher inflation, but not before Mr. Kirchner is easily installed for a second term in 2007. Meanwhile, by artificially raising real purchasing power, the price acuerdos are contributing to strong domestic consumption spending and spending on real estate.

3

Our Brazil team focuses on the juxtaposition of a benign growth and re-election scenario for President Lula and the tough economic policy decisions ahead, a theme that should be familiar to regular readers of our research. Once again, we point out that the inflation battle has been all but won and the next challenge will be to persevere with legislative changes needed to preserve fiscal balance. Brazilian government spending continues to support wages and pensions at the expense of investment, sacrificing future growth for current growth. Weighed in the balance, at least for 2007, the good inflation news trumps misgivings about the future course of fiscal policy.

Our Chilean team points out a fiscal dynamic that will seem familiar to others: how much of a fiscal windfall should be squirreled away for future need, how much spent today for urgently needed social programs? Our Pablo Correa notes that 70% of spending is in the form of social transfers, which affect private consumption spending and prices of goods such as housing and services. Accordingly, the decision to spend more of a windfall has repercussions for fiscal policy, inflation, and economic growth. In Chile there are competing calls for tax relief and for more spending on infrastructure and social programs. The Bachelet government, new this year, prepares its first budget for fiscal 2007, within which we expect a “controlled expansionary” spending policy with one eye firmly on the long-term level of copper income, not the near-term trend. Our ideal: no more than an 8% expansion in government spending, adjusted for inflation.

Our Mexico City-based team focuses on the long-term trend of falling deficits in the current account and the trade account in the balance of payments. Oil is, of course, a major part of this picture (exports up 44% in 1H06), but so is strong growth of manufacturing exports, up 18% over 2005 in the first half of this year, both well outstripping growth in imports. Remittances by Mexicans working abroad will likely total US$24 billion, the equivalent of 60% of oil revenues. Strong inflows in the balance of payments have encouraged the Ministry of Finance to issue local bonds, using the proceeds to pay external debt, which will likely equal no more than US$50 billion at the end of the year after a reduction of nearly US$27 billion during the Fox administration.

Finally, our Caracas-based team of economists has realigned its macro numbers to try to fully factor in the positive effects from this year’s higher-than-expected oil prices. The highlight: Economic growth in 2006 will now likely be up 9.6%, compared with our prior estimate of 7.5%. Growth next year will likely be 7.2%, an upward revision of roughly the same magnitude as in 2006. Despite sharp increases in spending this year, likely continuing through next year, this year’s finances will probably result in a slight surplus (0.7% of GDP) instead of the deficit (0.6%) we’d previously forecasted, and the surplus in Venezuela’s public balance is likely to grow next year to 1.5% of GDP compared with a 0.8% surplus we forecast six months ago. The country’s capital account in the balance of payments is in deficit in part due to external debt buybacks and transfers of reserves from the central bank to FONDEN, the government’s development bank. The country still has to deal with the local liquidity impact of the flood of petrodollars in a world of tight exchange controls, which has produced the highest inflation numbers currently being recorded in Latin America.

More growth and less inflation, continuing fiscal balance in 2007

5.8

1.2

-0.9

4.1

5.6

1.8

4.8 4.7

1.7

-0.7

4.45.0

1.3

-0.6

6.8

-0.9

-3.0

-1.0

1.0

3.0

5.0

7.0

9.0

Regional GDP Growth CPI Inflation Current Account Balance (% of GDP)

Fiscal Balance (% of GDP)

2004 2005E 2006 P 2007 P

Source: Santander Investment.

Ernest W. (Chip) Brown (212) 583 4663

Strictly Macro – September 15, 2006

4

ARGENTINA

REELECTION AND ROBUST GROWTH SUPPORTED BY MISALIGNING PRICES

• Although there are more than 13 months to go before the presidential election, Néstor Kirchner seems likely to be reelected in the first round. We expect the Argentine economy to expand by 6% in 2007, taking into account the 3.9% statistical drag already recorded.

• Despite encouraging growth, the energy sector outlook could affect macroeconomic fundamentals. The story of the twin surpluses as anchors for long-term economic stability is less persuasive now.

• Should Kirchner’s reelection and robust 2007 growth materialize, attention will be then focused on the maintenance of an economic model of distorted prices. Alternatively, the government could turn toward economic orthodoxy.

President Kirchner is likely to be reelected in the first round of next year’s presidential election, according to polls conducted by Ipsos-Mora y Araujo, among others. Although the election is more than 13 months away, it is difficult to envision a scenario that excludes Kirchner from the center of the political scene in the years to come. However, the maintenance of the Kirchnesian economic model aimed at maximizing output and employment amid distorted relative prices is also, apparently, out of question.

When voters are asked about how they would vote if the election were held now, President Kirchner leads with 46% of responses, followed well behind by Mauricio Macri with a meager 9% support, Elisa Carrió with 7%, and Roberto Lavagna (former Economy minister under President Kirchner) with only 5%. Any other potential candidate received less than 2% support. According to the Constitution, a candidate with 45% of the total votes and a difference of more than 10% compared with the runner-up wins the presidency in the first round. Thus, the most likely scenario is that President Kirchner would be reelected if he runs for a second term. Thus, by the end of 2007 attention would be focused on the maintenance of the Kirchnesian economic model of distorted prices, or, alternatively, the government could turn toward orthodoxy.

For 2007 we expect the Argentine economy to expand by 6%, taking into account the 3.9% statistical drag already recorded. Next year’s expansion rate should show some deceleration compared with the 7.5% expected GDP growth for 2006. By the end of 2007, we expect GDP to have expanded by 48% since the minimum of 2002, surpassing by 20% the peak of the previous business cycle recorded in 1998. We expect both private and public consumption to continue being the main drivers of next year’s growth. As real salaries continue to improve, and with the consolidated primary surplus likely to fall during an election year, consumer spending is set to continue as the engine of the economic expansion.

Despite such encouraging growth, the energy sector is a source of worry. Setting aside the discussion of whether Argentina is already facing an energy crisis, it’s clear that the maintenance of public utility rates for household consumers, frozen since early 2002, has affected long-term investment decisions and corporate earnings as well. Investment delays, inefficient investment decisions at higher costs, or the abandonment of otherwise profitable projects are likely to persist throughout next year, barring a scenario of energy price increases for households, which we believe is unlikely.

The energy issue is also affecting macroeconomic fundamentals. The twin current account and fiscal surplus has functioned as an anchor for long-term economic stability, but it may not be possible to continue depending on it. The decline in net energy exports, thus far responsible for more than 50% of the trade surplus, and a lower primary surplus resulting from lower export tax receipts and higher subsidies on transport and fuels, affects both the current account and the fiscal surpluses. Meanwhile, investment is likely to slow based on an uncertain business climate resulting from a political year and the questions surrounding the maintenance of the current price policy after the October 2007 election.

The other main concern for 2007 is the government’s approach to inflation – an extremely sensitive variable for a country with important inflationary memory and 34% of its population below the poverty line that would be devastated if inflation accelerates above the 15% to 20% range. We expect the unorthodox Kirchnesian

5

approach against inflation to be maintained. Price agreements might be tougher should growing aggregate demand not accompany aggregate supply, putting further upward pressure on prices. Although this approach has proved successful by slowing annual CPI inflation to 10.6% in August from 12.3% in December 2005, relative price structure is becoming increasingly rigid. As a result the economy is not allocating resources efficiently, with the energy sector the clearest example. According to our calculations, the ratio between free prices and residential public utility rates is 8% above the level observed in December 2005 but 55% higher than the reading obtained at the end of 2001. At the same time, the ratio between free and agreed prices is 5% higher than in December 2005, when the official price agreements policy was launched, but 7% below the figure observed in late 2001.

MAIN CONCLUSION

We believe President Kirchner will be reelected in the first round of next year’s election. On the economic front, a high 6% growth should once again place the country among the faster growing economies in Latin America. However, the energy sector could also affect macroeconomic fundamentals. The twin current account and fiscal surplus is being hit by weakening energy performance. Entering 2008, attention will be focused on the maintenance of an economic model of distorted prices or, alternatively, a government move toward orthodoxy.

Martín Mansur and Rodrigo Sebastián Park (5411) 4341-1096/1080

Strictly Macro – September 15, 2006

6

Argentina – Economic Projections, 2003-2008F Structure % GDP 2003 2004 2005 2006E 2007F 2008F

National Accounts Real GDP (∆% YoY) 8.8 9.0 9.1 7.5 6.0 4.6 Consumption (∆% YoY) 80.9 7.5 7.6 8.0 6.7 5.9 4.0 Private (∆% YoY) 66.5 8.2 9.4 8.8 7.1 6.5 4.8 Public (∆% YoY) 14.4 1.5 2.7 3.0 2.4 2.5 1.0 Investment (∆% YoY) 11.3 38.2 34.5 21.4 15.0 8.0 3.0 Private n.a. NA NA NA NA NA NA Public n.a. NA NA NA NA NA NA Exports (Local currency) (∆% YoY) 14.1 6.0 8.2 12.6 5.2 5.0 4.0 Imports (Local Currency) (∆% YoY) -6.3 37.6 39.8 19.4 12.7 8.0 7.0 GDP (US$bn) 128.1 152.1 182.8 209.8 242.0 275.9 GDP Per Capita (US$) 3,459 4,063 4,833 5,487 6,264 7,074 Population (Mn) 37.0 37.4 37.8 38.2 38.6 39.0 Monetary and Exchange Rate Indicators CPI Inflation, Dec Cumulative (%) 3.7 6.1 12.3 10.0 11.0 11.0 WPI Inflation, Dec Cumulative (%) 2.0 7.8 10.6 12.8 12.0 12 US$ Exchange Rate (Year-End) 2.96 2.98 2.99 3.12 3.18 3.29 US$ Exchange Rate (Avg) 2.87 2.96 2.92 3.10 3.18 3.24 30 day, local currency prime lending rate (Year-End) 2.8 4.1 4.8 7.7 9.0 10.0 30 day, local currency prime lending rate (Avg) 9.7 3.1 3.6 6.5 8.9 10.0 Monetary Aggregate M3-end of period (US$bn) 34.0 42.5 52.4 60.3 68.5 74.2 Monetary Aggregate M3-end of period (∆% YoY) 36.9 24.9 23.3 15.1 11.1 10.7 Fiscal Policy Indicators Fiscal Balance (% of GDP) 0.5 2.7 1.8 2.1 2.0 1.7 Primary Balance (% of GDP) 2.3 3.9 3.7 3.5 3.5 2.7 Government Financial Needs a (Peso Billion) 12.1 -3.2 16.2 10.7 8.8 7.1 Gross Total Government Debt (US$bn) 179.0 182.0 128.6 124.5 119.1 120.9 Local Currency (US$bn) NA NA 62.1 61.2 60.0 62.0 Foreign Currency (US$bn) NA NA 66.5 63.3 59.1 58.9 Balance of Payments Trade Balance 15.8 13.3 11.3 11.4 11.6 11.0 Merchandise Exports fob (US$bn) 29.6 34.5 40.0 45.0 49.6 51.0 Merchandise Imports cif (US$bn) (13.8) (21.2) (28.7) (33.6) (38.0) (40.0) Services and Income Receipts (US$bn) 6.7 8.0 9.5 9.4 10.5 11.0 Services and Income Payments (US$bn) (10.1) (18.7) (16.2) (16.8) (17.5) (17.0) Transfers (US$bn) 0.6 0.7 0.7 0.8 0.8 0.8 Current Account (US$bn) 13.0 3.3 5.3 4.8 5.4 5.8 Current Account (% of GDP) 10.1 2.2 2.9 2.3 2.2 2.1 Gross Foreign Direct Investment (US$bn) 0.0 0.2 2.5 3.0 3.0 3.1 Debt Profile International Reserves (US$bn) 14.1 19.6 28.0 30.0 32.8 35.8 Total Internal Government and Central Bank Debt (US$bn) 73.0 72.0 75.6 75.0 73.6 72.5 Short Term (less than 12 months) (US$bn) NA NA NA NA NA NA Long Term (over 12 months) (US$bn) NA NA NA NA NA NA Total Internal Govt. And Central Bank Debt (% of GDP) 57.0 47.3 41.4 35.8 30.4 26.3 Total External Debt (US$bn) 140.6 165.0 64.3 63.0 61.0 61.9 Short Term (less than 12 months) (US$bn) NA NA NA NA NA NA Long Term (over 12 months) (US$bn) NA NA NA NA NA NA Total External Debt (% of GDP) 109.8 108.5 35.2 30.0 25.2 22.4 Total External Debt (% of Exports of Goods & Services) 387.8 388.1 129.9 115.8 101.5 99.8 Debt Service Ratio b NA NA 24.7 20.3 20.3 20.2 Labor Markets Real Salary Index (% chg, Dec cumulative) 8.1 10.8 15.0 13.0 12.0 12.0 Unemployment Rate (year-end, % of EAP) ( c ) 19.7 16.4 10.1 10.6 9.5 9.5 Total Payroll in the formal sector (% chg, real Dec cum.) 18.6 16.0 13.0 11.0 10.0 5.0

(a) (Amort + Fiscal Deficit). (b) (Amort+Interest Ext Debt)/Export Good & Services. (c) Excluding social plans. E Santander Investment estimate. F Santander Investment forecast. Sources: Economy Ministry, Central Bank, and Santander Investment estimates.

7

BRAZIL

BENIGN SCENARIO IN 2007, BUT COMPLACENCY AHEAD

• We are very optimistic about the inflation outlook in Brazil going forward, which we believe will enable the Central Bank to continue to ease the benchmark Selic rate to levels lower than what the market now expects.

• In our view, with the real interest rate falling comfortably below the 10% mark, perceptions regarding the solvency of the public sector will keep Brazilian assets attractive in 2007.

• However, this benign environment may lead to complacency regarding the deterioration of the fiscal accounts. Basically, if interest rates fall, all is well. But this may lead to a less favorable macroeconomic scenario for 2008.

If there is some consolation to be found in the worse-than-expected 2Q06 GDP figures, it is that they reinforce perceptions that there is still substantial room for the reduction of the Selic target rate. In our view, the key to success is inflation, which ultimately determines the trajectory of the Selic. With the inertial component of inflation declining very rapidly (the 2006 IPCA will be close to the floor of the inflation target) and commodity prices expected to retreat in response to a slowdown in global growth, the risks for inflation in 2007 are rapidly declining.

Real interest rates of less than 10% help explain the resilience of asset prices to the deterioration of important economic fundamentals. In particular, the negative effect of currency strength on industry and agriculture is becoming increasingly noticeable. Additionally, there has been a deterioration of some institutional aspects of the Brazilian economy, including failure to strengthen the regulatory agencies and the effects of the political crisis on Congress (particularly on the approval of the 2007 budget). On top of that, government programs are leading to the deterioration of the fiscal accounts, making it more difficult for a decline in real interest rates to be translated into a reduction in the public debt to GDP ratio (which would help improve confidence regarding debt solvency, making additional reductions of real interest rates possible).

Change in net public debt/GDP under different scenarios for the primary fiscal surplus and real interest rates Real interest rate Primary fiscal surplus

3.5% 3.75% 4.0% 4.25%

10% -0.25% -0.5% -0.75% -1.0%

9% -0.75% -1.0% -1.25% -1.5%

8% -1.25% -1.5% -1.75% -2.0%

7% -1.75% -2.0% -2.25% -2.5%

Real GDP growth assumed to be 3.5%. Source: Santander Investment.

If the cost of debt is lower, there would be more resources available for social spending and public investment. But the choice faced by the government is whether to lower the public debt faster, to reduce the tax burden, to spend more on income redistribution schemes, or to invest in infrastructure. The options are in a sense ideological in nature. With at least some attention paid to ensuring the stability of the public debt stock, there is room for expenditures that may be somewhat inefficient economically but very efficient in political terms. However, we cannot conclude that anything goes if interest rates fall.

The deterioration of the fiscal accounts is not exactly news, but the deterioration in the quality of public spending will restrict investment, and therefore growth. In quantitative terms, the government is likely to find it increasingly difficult to keep the primary fiscal surplus at 4.25% of GDP. But with interest rates on a downward trajectory, at some point there will be a growing incentive for the government to argue that there is no need to generate such a high primary surplus.

Next year the new administration will begin facing considerable fiscal challenges. For one, the government will face a BRL6 billion loss in revenues resulting from the Supreme Court ruling regarding the way certain taxes are calculated. In addition, an increase in civil servants’ salaries will increase payroll spending (which

Strictly Macro – September 15, 2006

8

has remained more or less stable over the last few years) by about 0.5% of GDP. Moreover, the 2007 budget is based on the assumption of real GDP growth of 4.75%, overestimating fiscal revenues by some BRL10 billion. The bottom line: The government will start 2007 with a hole in the budget of around BRL25 billion.

Federal budget (% GDP) Avg 2002-2003 2006 (estimate) 2007 (budget)

“Social” current expenditures 1.95

Other current expenditures 5.55 8.45 8.3

INSS (soc. sec. benefits for private sector workers) 6.7 7.8 7.9

Public sector worker pension benefits 2.4 2.3 2.3

Federal government investment 0.75 0.8 0.85

TOTAL PRIMARY SPENDING 17.35 19.35 19.35

PRIMARY SPENDING (x-investment) 16.6 18.55 18.5

FEDERAL GOVT REVENUES (net of transfers) 19.47 21.8 21.8

PRIMARY SURPLUS (federal govt.) 2.12 2.45 2.45

Local govt. entities & SOEs 1.96 1.8 1.8

PRIMARY SURPLUS CONS. PUBLIC SECTOR 4.07 4.25 4.25

Sources: Giambiagi, Mansueto & Pessoa, and Treasury.

On top of this, there is an urgent need to approve the renewal of the CPMF tax and the DRU (which expands government discretion in public spending) in order to avoid a shortfall in revenues of about BRL30 billion in 2008. All of this is likely to be voted upon amid a rougher political environment for the government, given the fallout of the political crisis of the last two years, even if the government secures the support of the PMDB.

Breakdown of Congress Senate (81 seats)

Elected in 2002 Inaugurated in 2003 Current 2006 Election (forecast)

PMDB 19 20 22 23

PSDB 11 12 15 15

PFL 19 18 16 18

PT 14 14 12 13

PP, PTB, PL, PRB 8 7 8 6

PSB, PDT, PPS, PV, PC do B 10 10 7 6

Other 0 0 1 0

House (513 seats)

Elected in 2002 Inaugurated in 2003 Current 2006 Election (forecast)

PMDB 74 70 83 100

PSDB 71 63 57 75

PFL 84 76 65 75

PT 91 91 81 65

PP, PTB, PL, PRB 101 118 126 95

PSB, PDT, PPS, PV, PC do B 75 85 83 85

Other 17 10 18 18

Source: Santander Investment.

9

THE REFORM AGENDA FOR 2007 AND BEYOND

The DRU & CPMF. Strictly speaking, these are not economic reforms. However, their renewal will require the passage of constitutional amendments (requiring the support of three-fifths of both the House and the Senate), and failure to pass either would cause a significant fiscal problem.

The DRU originated in the Real Plan as the Social Emergency Fund, later renamed the Fiscal Stabilization Fund. Originally, the fund set aside 20% of fiscal revenues, which were not subject to the mandatory transfer/spending rules and over which the federal government had full discretion. In its latest form, the DRU does not exclude transfers to state and municipal governments, but enables the federal government to use 20% of these revenues toward the primary surplus instead of spending 100% of the “social” contributions.

Regarding the CPMF, the government has signaled its intention to gradually lower the tax rate from the current 0.38% of financial transactions to a level that would be economically irrelevant and whose only function would be to make it easier for the Federal Revenue Service to compare tax statements with the volume of financial transactions going through the bank accounts of individuals and companies. In the short term, however, this is not viable, as CPFM tax revenues currently total about 1.5% of GDP.

Both pieces of legislation will probably be approved sometime in 1H07, but considering the increasing popular aversion to the high tax burden, we expect the government to face some resistance. It would be no surprise if, in exchange for support, the government were to include a gradual phasing-out of one or both of the taxes.

The increase of the INSS deficit over the last few years suggests that another round of social security reform is an absolute necessity. The reform implemented at the beginning of the Lula administration dealt mostly with pension benefits of public sector workers. This new round would deal with pension benefits paid out to private sector workers. Two key aspects will be the minimum wage and the decoupling of INSS benefits from increases in the minimum wage. In an attempt to make the system more transparent, the government may also remove certain types of social benefits from the INSS system. All pension benefits paid out to persons who never contributed to the INSS system could be paid directly from the budget (an example would be the so-called rural retirement benefit). The catch is that reducing the “official” deficit of the INSS may result in a diminished drive to reform the system (which, however, remains insolvent). As usual, attempts to reform the social security system will face fierce opposition, and the approval of an effective reform by Congress cannot be taken for granted. In addition, the government must still pass complementary legislation needed to implement the social security reform passed at the beginning of the Lula administration, including the creation of complementary pension funds for public workers. Because these do not require the approval of constitutional amendments, however, they may be dealt with separately.

Other items that may be included in the congressional agenda over the next few years include labor reform, political reform, and tax reform.

Political reform will certainly be a priority of the new administration in response to the political crisis of the last few years. Note that the major parties will probably increase in size at the beginning of the next legislature as those deputies elected from parties that fall below the so-called “barrier clause” (and which will therefore not be entitled to funds from the Political Party Fund or to representation on committees) move to bigger organizations. The major parties will thus have an incentive to pass legislation that protects them from losing these new members and that strengthens party discipline.

The Holy Grail of tax reform is still the unification of the state ICMS tax into a single national VAT and the conversion of the taxes that are still levied on gross corporate revenues into value-added taxes. One of the main obstacles appears to have been overcome now that the state of São Paulo signaled that it would be prepared to accept the principle that the ICMS tax should be collected where goods are consumed rather than where they are produced. Nevertheless, considering the influence of state governors in Congress and the conflict of interest between the various levels of government that are involved, passing tax reform will undoubtedly be very difficult. We are not optimistic.

Finally, the Lula administration has signaled its intention to work toward passing a labor reform that reduces payroll taxes as an incentive for formal employment and to increase competitiveness. Considering that the government will have little flexibility in the fiscal accounts, lowering taxes on one side will probably require higher taxes somewhere else. The resistance to tax increases means that any such move will face formidable opposition. Therefore, we would not bank on much progress on this issue.

Strictly Macro – September 15, 2006

10

Lower commodity prices (as a result of a slower global economy), meanwhile, could also put a dent in the trade balance following a reversal in the country’s terms of trade and slow growth in export quantities. Considering that the trade account is starting from a very comfortable position to begin with, and that risk perceptions should ensure comfortable external financing conditions, it will take some time for this reversal to kick in. However, we could see a weaker exchange rate toward 2H07 or 2008.

Volume of exports and imports (six-month moving average)

80

90

100

110

120

130

140

150

160

170

180

Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06

Export Volume (6moma - sa) -Jan '02=100

Import Volume (6moma sa) - Jan ' 02=100

Source: Funcex.

Terms of trade and real exchange rate

60

65

70

75

80

85

90

95

100

105

Jan-91 Jul-92 Jan-94 Jul-95 Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06-

50

100

150

200

250

Price Exports / Imports Real FX (BRL/USD)

Terms of Trade Real Exchange Rate

Sources: Santander Investment and Funcex.

MAIN CONCLUSION

We believe that the current scenario points toward a more difficult political environment and some deterioration of the fiscal accounts, although the initial impact of this on overall risk aversion will likely be more than offset by the favorable dynamics of inflation in 2007. In particular, the fact that there will be room for the Central Bank to continue to lower the Selic target rate will support market optimism in 2007. However, we may also see a gradual weakening of the BRL next year, resulting in a less favorable inflation environment in 2008. Both would be results of the failure to pass structural reforms and a certain degree of fiscal complacency on the part of the administration.

André Loes, Constantin Jancsó & Mauricio Molan (5511) 3012-5724

11

Brazil – Economic Projections, 2002-2007F Structure % GDP 2002 2003 2004 2005E 2006F 2007F

National Accounts Real GDP (∆% YoY) 1.9 0.5 4.9 2.3 3.1 3.6 Supply: Agriculture (∆%YoY) 7.5 5.5 4.5 5.3 0.8 1.6 4.5 Industry (∆% YoY) 35.8 2.6 0.1 6.2 2.5 3.9 4.0 Services (∆% YoY) 56.7 1.6 0.7 3.3 2.0 2.9 2.4 Demand: Private Consumption (YoY%) (2.3) (1.5) 4.1 3.1 3.7 3.4 Public Consumption (YoY%) 6.6 1.3 0.1 1.6 2.2 1.2 Investment (YoY%) (5.0) (5.1) 10.9 1.6 5.2 7.0 Exports (YoY%) 19.4 9.0 18.0 11.6 6.2 9.0 (-) Imports (YoY%) (3.8) (1.7) 14.3 9.5 12.5 12.0 GDP (USD bn) 459.4 506.8 604.0 794.4 961 1,031 GDP Per Capita (US$) 2,604 2,831 3,326 4,311 5,150 5,450 Population (Mn) (1) 176.4 179.0 181.6 184.3 187.0 189.7 Monetary and Exchange Rate Indicators IPCA-IBGE Inflation (Dec Cumulative) (%) 12.6 9.4 7.6 5.7 2.9 4.0 IGP-M Inflation (Dec Cumulative) (%) 25.3 8.7 12.4 1.2 3.0 3.7 US$ Exchange Rate (Year-End) 3.53 2.89 2.65 2.34 2.10 2.25 US$ Exchange Rate (Avg) 2.93 3.07 2.92 2.43 2.16 2.17 Relevant Interest Rate (Overnight – SELIC) (Target - Year-End) 25.0 16.5 17.8 18.0 13.75 12.0 Relevant Interest Rate (Overnight – SELIC) (Effective - Accum) 19.2 23.3 16.2 19.0 15.14 13.1 Monetary Base (BRL bn) 73.3 73.2 88.7 101.2 107.4 115.7 Monetary Base (US$bn) 20.7 25.3 33.4 43.3 51.1 51.4 Monetary Base (∆% YoY in US$) (9.6) 22.2 31.9 24.1 18.2 0.6 Fiscal Policy Indicators Public Sector Borrowing Requirements (harmonized) (% of GDP) (4.6) (5.1) (2.7) (3.3) (3.1) (2.5) Primary Balance (% of GDP) 3.9 4.3 4.6 4.8 4.25 4.25 Public Sector Borrowing Requirements (harmonized) (BRL billion) 61.6 79.0 (47.1) 3.3 3.1 2.5 Gross Total Government Debt (US$bn) (c) 320.6 425.2 502 621 689 688

Internal (US$bn) (c) 240.2 341.7 419 540 630 631 External (US$bn) (c) 80.5 83.6 83 81 59 57

Balance of Payments Trade Balance (US$bn) 13.1 24.8 33.7 44.8 40.3 35.7 Merchandise Exports (US$bn) 60.4 73.1 96.5 118.3 129.0 136.5 Merchandise Imports (US$bn) 47.2 48.2 62.8 73.5 88.7 100.7 Net Income and Services Account (US$bn) (23.2) (23.5) (25.3) (34.1) (33.7) (32.5) Transfers (US$bn) 2.4 2.9 3.3 3.6 3.0 3.0 Current Account (US$bn) (7.6) 4.2 11.6 14.2 9.6 6.2 Current Account (% of GDP) (1.7) 0.8 1.9 1.8 1.0 0.6 Foreign Direct Investment (US$bn) 16.6 10.1 18.2 15.2 16.0 17.0 Debt Profile International Reserves (US$bn) 37.8 49.3 52.9 53.8 72.0 75.0 Federal Government and Central Bank Domestic Securities (US$bn) 176.4 248.1 323.0 428.3 468.3 481.5 Short term (less 12 months) (US$bn) 67.9 82.8 135.5 170.9 178.0 154.1 Short Term (less than 12 months) (%) 41 33 42.0 39.9 38.0 32.0 Total Government Gross Debt / GDP (a) 84 79 71.9 74.8 74.3 73.7 Total External Debt (US$bn) (e) 210.7 214.9 201.4 168.9 142.8 148.0 Short term (maturity of less than 12 months when issued) (US$bn) 23.4 20.2 18.7 18.2 18.0 18.0 Long term debt (maturity of more than 1 year when issued) (US$bn) 187.3 194.7 182.6 150.7 124.8 130.0 Total External Debt (% of GDP) 45.9 42.4 33.3 21.3 14.3 14.2 Total External Debt (% of Exports of goods & services) 301 257 208.7 142.7 111.7 108.5 Debt Service Ratio (e) (f) (1) 73% 66% 47.6 49.3 28.7 26.1 Labor Markets Change in Payroll (∆% YoY) - Seade 0.9 0.4 3.2 3.8 4.0 3.4 Average wages (real % YoY) - Seade (8.2) (6.0) 1.9 (0.6) 0.5 1.0 Unemployment Rate Avg. (% of EAP) - Seade 12.1 12.1 12.7 10.5 9.2 8.9 Aggregate Wages (real % YoY) - Seade (7.3) (5.6) 5.0 3.2 4.5 4.4 (a) GDP used to calculate the ratios is estimated by the Brazil Central Bank at December prices. This is different from the GDP calculated by IBGE, computed at average yearly prices. (b) Excludes the impact of FX variations on nominal interest expenses. (c) Interest payments only, excludes amortization. (d) Estimated by Santander. (e) As defined by the Central Bank of Brazil, excluding inter-company loans, which are classified as FDI. (f) (Gross M/L term debt amortizations including IMF but excluding refinanced amortizations + Gross Interest Payments) / Exports of Goods and Services. (1) Revised series. E Santander Investment estimate. F Santander Investment forecast. Sources: IBGE, Secex, FIPE, FGV, Central Bank, and Santander Investment.

Strictly Macro – September 15, 2006

12

CHILE

2007 FISCAL BUDGET: HOW MUCH IS TOO MUCH?

• During September the government must propose to Congress the 2007 fiscal budget law. Given the importance of copper-related revenues to the fiscal balance, there has been pressure from the main political players to increase government spending as a response to high copper prices. However, so far the Ministry of Finance has strongly defended a prudent fiscal policy framework based on structural or long-term revenues instead of short-term windfalls.

• In our opinion, the final rate of expansion of real fiscal expenditures in 2007 will be a key variable for the performance of the economy. Almost 70% of government expenditures are made in the form of social transfers, affecting private consumption and prices of non-tradable goods. Thus, an expansionary fiscal policy could be reflected in higher inflationary pressures, higher interest rates, and a more appreciated real exchange rate. Our base scenario considers an expansion in real fiscal expenditures of 8.1%, a 2007 year-end inflation rate of 3.0%, and a monetary policy interest rate of 6.0%.

As of 1H06, the central government balance shows a historical surplus of 4.2% of GDP (about US$6 billion), over the 2.8% of GDP posted in 1H05. This is mostly explained by higher copper-related revenues (transfers from Codelco, the state-owned mining company, plus income tax from private copper companies), which grew 97.5% on a real basis to US$6 billion. As a consequence, the central government posted a real increase in its overall revenues of 19.7% (to US$18.3 billion) in 1H06, which compares with 22.1% (US$11.5 billion) in 2005. It is clear to us that these numbers can be explained by the 82.1% increase in the average price of a pound of copper during the first half of 2006 (vs. 20.8% in same period of 2005), so this should not be considered a permanent income increase.

This exceptional situation triggered a strong political discussion regarding how expansive the 2007 fiscal budget should be. Some players inside the government coalition have asked for a two-digit real expansion of fiscal expenditures in order to increase social spending in areas such as education and infrastructure. Meanwhile, representatives of the private sector have called for a reduction of the tax burden, particularly the most distorting taxes such as those on financial transactions. In this report we review the main points that are likely to drive the budget discussion and the potential impact on macroeconomic variables such as inflation, the exchange rate, and interest rates.

Central government effective and structural balance, as % of GDP (1997-2006E)

-3%

-2%

-1%

1%

2%

3%

4%

5%

6%

7%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006E

Effective Structural

Sources: Ministry of Finance and Santander Investment.

13

So far, the fiscal policy followed by the government has been anchored by the so-called structural balance rule. This rule is based on calculating the potential GDP growth rate and the average price that copper should post in the next 10 years. With these two variables, the Ministry of Finance estimates structural revenues and, aiming to achieve a 1% of the GDP surplus, sets spending for the fiscal year. Thus, each year the government

should face a 1%-of-GDP structural surplus, as well as an effective balance, which represents the difference between effective revenues (resulting from the real expansion of GDP and the spot price of copper) and effective expenditures. The rule is intended to stabilize fiscal expenditures and avoid an excessive dependency on copper-related transfers or the GDP cycle – in other words, to conduct a countercyclical fiscal policy.

The previous administration successfully implemented this rule in the 2001-2006 fiscal budgets, and the uncertainty comes from the direction to be taken by the Bachelet administration in the 2007 budget. The government of President Lagos conducted a countercyclical fiscal policy, facing effective fiscal deficits in the first three years of his administration (2001-2003 budgets) when the copper price was lower than its historical average, and the GDP expansion reached a meager 3.2% average annual growth. However, when economic activity recovered and the price of copper started to increase, the government controlled its expenditures, posting large surpluses and reducing the central government’s gross debt to 7.5% of GDP. Thus, by June 2006 the National Treasury had US$7 billion in assets (65% of them invested abroad and 80% in U.S. dollar-denominated instruments), and with an accumulated 73.8% increase in the copper price so far this year and an auspicious forecast for 2007, the spotlight will be on the first fiscal budget of the Bachelet era.

Copper-related revenues over total, as % of GDP (1997-2005)

0%

5%

10%

15%

20%

25%

30%

1997 1998 1999 2000 2001 2002 2003 2004 2005

% G

DP

0.00

0.30

0.60

0.90

1.20

1.50

1.80

US

$ pe

r pou

nd

Total revenues (ex copper) Copper revenues Average copper price (right-axis)

Sources: Ministry of Finance and Santander Investment.

The channels through which copper affects the fiscal balance are basically the income taxes of private mining companies and the transfers by Codelco, the state-owned copper company. Using the new US$1.21 structural price, we broke down the additional revenues coming from (1) Codelco, (2) private mining, and (3) interest from the Copper Stabilization Fund. The results of our estimates indicate that the government would have additional structural revenues of US$1.12 billion, which should be reflected in a real increase in fiscal expenditures of 8.1%, compared with the 6.7% posted in 2005 and the 6.5% estimated for 2006. We can break down these additional resources between the following:

1. Codelco. According to information provided by the company, during 2007 Codelco’s production should reach 1,652 million metric tons (MT) of copper, a 3.5% decrease compared with 2006. If we add the copper bought by Codelco to the output of other mining companies, its sales should reach about 2 million MT, a decrease of 3% compared with 2006. This is the first factor to consider, apart from the potential increase in costs. Between 2005 and 2006 the company is estimated to have a US$0.15 increase in the cost of producing a pound of copper, with almost 75% of that amount due to increased cost of supplies, wages, and an FX effect. For 2007 we are estimating an increase of about 8%, explained by higher labor costs and a higher PPI. Considering all these factors plus the increase in the long-term price of copper from US$0.99 to US$1.21, the additional structural revenues coming from Codelco would reach US$960 million (with total earnings of the company at around US$11.5 billion).

Strictly Macro – September 15, 2006

14

2. Income tax from private mining companies. Considering an average price of copper of US$2.87 per pound for 2007, we estimate that the income tax flowing from private copper companies would amount to between US$330 million and US$410 million, a decrease of between 11% and 13% compared with our forecast for 2006 (revenues in the range of US$380-US$460 million).

3. Interest on the Treasury’s financial assets. We estimate that with an effective surplus of 6.7% of GDP for this fiscal year, the government will have a stock of financial assets of US$15.6 billion (after paying debt amortizations of US$450 million), which would generate interest earnings of about US$470 million in 2007, or 80% more than in 2006.

Real expansion of fiscal expenditures versus GDP growth (1997-2005)

-2%

0%

2%

4%

6%

8%

1997 1998 1999 2000 2001 2002 2003 2004 2005

Real fiscal spending grow th GDP grow th

Sources: Ministry of Finance and Santander Investment.

Therefore, we are expecting an expansionary (but controlled) increase in fiscal expenditures in 2007, in line with the structural balance rule. In our opinion, as copper prices return to normal levels in the medium term, there will be just one source of permanent increases in “structural” revenues: the interest earnings of the financial assets accumulated by the government. Nevertheless, the contribution of interest earnings should not be as significant as the contribution of copper. We believe that the scenario faced by the Central Bank next year should not be significantly different from the one used currently in its monetary policy models, so an 8.1% real increase in fiscal expenditures would be consistent with decelerating inflation and the approaching end of the monetary tightening cycle.

MAIN CONCLUSION

The 2007 fiscal budget will be crucial to determining the development of key variables next year, such as inflation, the real exchange rate, and the monetary policy interest rate. While the copper price increase has given the government huge extra revenues, we think the Ministry of Finance ought to draft a neutral fiscal budget and resist the political pressure to overexpand fiscal expenditures. A two-digit expansion rate of real expenditures (given that most of these are made as social transfers) could trigger an overheating of the non-tradable sector, affecting inflation and, thus, interest rates and the exchange rate. In our view the Ministry of Finance should draft a 2007 budget law that implies no more than an 8% real expansion of the government’s expenditures.

Pablo Correa (56-2) 336-3361

15

Chile – Economic Projections, 2002-2007F Structure % GDP 2002 2003 2004 2005E 2006F 2007F National Accounts Real GDP (∆% YoY) 2.2 3.9 6.2 6.3 5.6 5.2 Total Demand (∆% YoY) 105.8 2.4 4.9 8.1 11.4 8.1 6.8 Consumption (∆% YoY) 64.6 2.4 4.2 6.1 8.2 7.3 5.5 Investment (∆% YoY) 30.5 2.2 7.8 14.3 22.2 10.7 10.0 Gross fixed capital formation (∆% YoY) 29.2 1.5 5.7 11.7 24.7 10.5 10.5 Government Spending (∆% YoY) 10.7 3.1 2.4 6.1 4.5 5.3 6.1 Exports (∆% YoY Local Currency) 35.0 8.0 19.6 31.1 15.7 28.8 5.2 Imports (∆% YoY Local Currency) 40.9 5.1 10.0 14.7 21.8 14.0 19.7 GDP (US$bn) 67.3 73.7 95.0 115.3 130.0 135.1 GDP Per Capita (US$) 4,257 4,635 5,901 7,088 7,911 8,138 Population (Mn) 15.8 15.9 16.1 16.3 16.4 16.6 Monetary and Exchange Rate Indicators CPI Inflation (Dec Cumulative %) 2.8 1.1 2.4 3.7 3.5 3.0 WPI Inflation (Dec Cumulative %) 10.4 -1.0 7.8 3.2 12.9 3.7 US$ Exchange Rate (Year-End) 719 594 557 514 559 570 US$ Exchange Rate (Avg) 689 691 610 560 540 562 Central Bank rate (interbank 24h target) (Year-End) 3.0 2.3 2.3 4.5 5.5 6.0 Central Bank rate (interbank 24h target) (Avg) 3.9 2.7 1.9 3.5 5.0 5.8 Money Base (US$bn) 2.8 3.0 3.9 4.6 5.1 4.9 M1A (∆% YoY) 11.4 16.2 19.9 14.0 13.7 14.9 Fiscal Policy Indicators Fiscal Balance (% of GDP) -1.2 -0.4 2.2 5.4 6.7 4.2 Primary Balance (% of GDP) -0.1 0.7 3.3 6.3 7.8 5.3 Government Financing Needs a (Local Currency Billions) 0.5 0.0 0.0 0.0 0.0 0.0 Gross Total Government Debt (US$bn) 9.6 10.1 9.3 6.7 6.4 5.9 Local Currency (US$bn) 0.7 0.9 1.6 2.4 2.3 2.1 Foreign Currency (US$bn) 8.9 9.2 7.7 4.3 4.2 3.8 Balance of Payments Trade Balance (US$bn) 2.4 3.7 9.2 10.2 18.5 14.0 Merchandise Exports (US$bn) 18.2 21.7 32.2 40.6 54.1 54.8 Merchandise Imports (US$bn) 15.8 18.0 23.0 30.4 35.6 40.8 Services and Income Receipts (US$bn) 5.2 6.1 7.4 8.8 9.1 9.1 Services and Income Payments (US$bn) 8.8 11.3 16.1 20.0 26.2 23.7 Transfers (US$bn) 0.6 0.6 1.1 1.7 1.7 1.8 Current Account (US$bn) -0.6 -1.0 1.6 0.7 3.2 1.2 Current Account (% of GDP) -0.9 -1.3 1.7 0.6 2.4 0.9 Foreign Direct Investment (US$bn) 2.2 2.7 5.6 4.5 4.6 4.5 Debt Profile International Reserves (US$bn) 15.4 15.9 16.0 15.7 16.5 16.7 Total Internal Govt. and Central Bank Debt (US$bn) 20.7 20.0 22.5 24.7 24.1 23.4 Short Term (less than 12 months) (US$bn) NA NA NA NA NA NA Long Term (over 12 months) (US$bn) NA NA NA NA NA NA Total Internal Govt. and Central Bank Debt (% of GDP) 30.8 27.1 23.7 21.4 18.5 17.3 Total External Debt (US$bn) 40.5 43.1 43.3 44.8 45.7 46.9 Short Term (less than 12 months) (US$bn) 11.4 12.6 14.1 14.4 15.7 14.1 Long Term (over 12 months) (US$bn) 29.1 30.4 29.2 30.5 30.0 32.8 Total External Debt (% of GDP) 60.2 58.4 45.6 38.9 35.1 34.7 Total External Debt (% of Exports of goods & services) 173.0 155.2 109.1 90.8 72.2 73.4 Debt Service Ratio a 58.9 57.8 47.0 37.7 30.7 27.2 Labor Markets Unit Wages (real ∆% YoY) 2.0 0.9 1.8 1.9 1.9 2.3 Unemployment Avg. (% of EAP) 8.9 8.5 8.8 8.0 8.3 7.6 Total Payroll (real ∆% YoY) 3.1 4.0 3.7 5.0 5.6 4.4

(a) (Amort + Fiscal Deficit). (b) (Amort+Interest Ext Debt)/Exports Goods & Services. Sources: Central Bank and Santander Investment.

Strictly Macro – September 15, 2006

16

MEXICO

STRONG EXTERNAL ACCOUNTS CONFIRM ECONOMIC STABILITY

• Recovering manufacturing exports and high oil prices have improved the trade balance. The trade balance surplus and remittances resulted in a current account surplus in the first half of 2006.

• Better-than-expected foreign investment and favorable external debt management support the good performance of the capital account.

• Political noise has had a minimal impact on the FX market. Instead, the currency has responded to external financial volatility.

One of the good results for the Mexican economy in 2006 is related to the external accounts improvement that has resulted from high oil revenues. At the same time, we have seen a recovery in manufacturing exports, significant flows from remittances and foreign direct investment, and good external debt management.

In the first half of the year there was a surplus in the trade balance figures as well as in the current account, and this shows a favorable path since 2000 – and particularly in 2004 and 2005. Note that in this period GDP registered a recovery along with higher levels of consumption and investment spending. The Mexican economy grew 4.2% in 2004, 3.0% in 2005, and 5.1% in 1H06, but this did not result in a worsening of the external accounts.

Improvement in trade balance and current account figures

-9.0

-7.0

-5.0

-3.0

-1.0

1.0

3.0

2000 2001 2002 2003 2004 2005 2006

Trade Balance Current Account

External accounts in the first half of each year, in billions of U.S. dollars. Sources: Banxico and Santander Investment.

Manufacturing exports have recovered since 2004, and in 1H06 they grew 18% YoY. This includes automobile exports, which have registered a better performance in the last year. However, manufacturing excluding cars also saw good figures in the same period. In the January-June period manufacturing exports excluding autos grew 14.9% YoY, and this represented 90% of total manufacturing exports.

Oil exports rose 44.1% YoY in 1H06 owing to high oil prices. In this period the Mexican oil mix was US$53.1 per barrel on average, US$15.4 per barrel higher than in the same period of 2005 – an increase of 40.8% in the international oil price.

17

Manufacturing exports have registered a good performance

68.170.6 68.9 67.3

76.3

82.7

97.4

60.8 62.3 61.9 60.6

70.6

77.0

88.5

40

50

60

70

80

90

100

110

2000 2001 2002 2003 2004 2005 2006

Total Excluding autos

Manufacturing exports in the first half of each year, in billions of U.S. dollars. Sources: Banxico and Santander Investment.

Consumption and investment spending resulted in significant imports growth. In 1H06 consumption imports rose 23% YoY and capital goods imports grew 18.7% YoY. However, total exports performance was higher than expected, and this has explained the trade balance surplus in the January-June period.

High remittances growth and stability in foreign direct investment

3.0

4.34.8

6.3

7.9

9.3

11.4

9.08.4

9.9

8.9

12.6

9.7

8.7

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005 2006

Remittances FDI

Figures in the first half of each year, in billions of U.S. dollars. Sources: Banxico and Santander Investment.

Better figures in the trade balance and high revenues from remittances resulted in a current account surplus in the January-June period of US$1.8 billion. In 2004 and 2005 the current account deficit represented 1.0% and 0.6% of GDP, respectively, and we estimate that it could be close to 0.3% of GDP in 2006.

Remittances amounted to US$16.6 billion in 2004 and US$20 billion in 2005, and we estimate that they could exceed US$24 billion in 2006. Note that in 2005 remittances represented 63% of total oil exports, and in 1H06 they represented about 60% of oil revenues.

The good growth of total exports together with extraordinary growth of remittances resulted in low external current account imbalances and a lower risk in the structure of the balance of payments.

In the case of the capital account, since 2001 foreign direct investment has been higher than the current account deficit, which represents long-term revenues and stability. In 2004 FDI amounted to US$18.9 billion

Strictly Macro – September 15, 2006

18

and in 2005 it reached US$18.8 billion, compared with US$6.7 billion and US$4.6 billion for the current account deficit. In 2006 FDI could exceed US$17 billion, despite political noise.

Good management of the external public debt

12.311.7

12.111.5

8.8

6.0

13.2

4

5

6

7

8

9

10

11

12

13

14

2000 2001 2002 2003 2004 2005 2006E

Figures as a percentage of GDP. Source: Santander Investment.

The improvement of external accounts is also related to the management of external public debt. The budget discipline and the higher-than-expected public revenues resulted in good figures for external public debt in the Fox administration. At the end of 2000 the net external public debt amounted to US$76.6 billion, which represented 13.2% of GDP, while at the end of 2006 the external debt could reach US$50 billion, only 6.0% of GDP.

Recently, the Ministry of Finance announced that it issued US$12.4 billion in local bonds (Bondes D) and used the proceeds to prepay public external debt. The government said it prepaid US$9.0 billion to the Inter-American Development Bank and the World Bank. The remaining US$3.4 billion was used to cancel sovereign bonds (UMS) maturing between 2007 and 2033.

To July the external public debt amounted to US$64.9 billion, so considering the prepayment of US$12.4 billion it was probably US$52.5 billion at the end of August. We believe that there will be additional prepayments from debt exchange warrants in coming weeks, around US$2.5 billion, so for the end of the year the external public debt could amount to US$50 billion. This represents a reduction of US$26.6 billion under the Fox government.

We believe that the drivers of the external accounts improvement are due not only to oil resources but also to the good performance in manufacturing exports, high remittances, good figures for foreign direct investment, and excellent external public debt management. The strengthening of external accounts confirms the current economic stability.

On the political front, the Tribunal Electoral del Poder Judicial de la Federacion (TEPJF) finally confirmed Felipe Calderon as president-elect for the 2006-2012 period. The seven judges of the court unanimously rejected fraud claims and said that Mr. Calderon (PAN) won the election by 233,831 votes over Mr. Lopez Obrador (a difference of 0.56%). The decision of the Electoral Court cannot be appealed, and the judges also rejected claims of improper influence by President Vicente Fox and business groups working in favor of Mr. Calderon.

Felipe Calderon will take office on December 1, and now he will work with his transition team to review the main issues in all public sector areas. Mr. Calderon has been open to working in alliance with other political parties, particularly the PRI and Nueva Alianza, so it is possible that we could see personalities from outside the PAN in the new administration.

19

Meanwhile, according to a Reforma poll, most Mexicans agree with the Electoral Court ruling. This poll indicated that 74% of respondents support the decision by the court, and the survey also said 85% believe the PRD party must accept the final decision of the TEPJF.

MAIN CONCLUSIONS

The external accounts of the Mexican economy registered a significant improvement owing to a good performance in manufacturing exports, high oil revenues, significant remittances, good figures for foreign direct investment, and favorable external debt management. Finally, the electoral process has finished and Mr. Felipe Calderon is set to take office on December 1.

Héctor Chávez, Delia Paredes & Rafael Camarena (5255) 5269-1925

Strictly Macro – September 15, 2006

20

Mexico – Economic Projections, 2002-2007F Structure % GDP 2002 2003 2004 2005E 2006F 2007F

National Accounts Real GDP (∆% YoY) 0.8 1.4 4.2 3.0 4.5 4.0 Consumption (∆% YoY) 70.2 1.6 2.3 4.1 5.4 6.1 4.9 Investment (∆% YoY) 23.9 (0.6) 0.4 7.5 7.6 11.4 9.8 Private (∆% YoY) 21.4 (4.1) (1.5) 8.8 9.6 9.9 9.1 Public (∆% YoY) 2.5 17.0 8.5 2.5 (0.5) 18.5 12.7 Government Spending (∆% YoY) 7.0 (0.3) 0.8 (0.4) 0.5 2.9 0.9 Exports (∆% YoY) 30.6 1.6 2.7 11.6 6.9 10.2 8.1 Imports (∆% YoY) (31.7) 1.5 0.7 11.6 8.7 13.1 9.1 GDP (US$bn) 648.6 639.0 683.5 769.4 839.6 872.9 GDP Per Capita (US$) 6,495.3 6,320.0 6,704.8 7,463.1 8,067.4 8,308.8 Population (Mn) 99.9 101.1 101.9 103.1 104.1 105.1 Monetary and Exchange Rate Indicators CPI Inflation (Dec Cumulative) (%) 5.7 4.0 5.2 3.3 3.5 3.7 PPI Inflation (Dec Cumulative) (%) 9.2 6.8 8.0 3.4 4.7 3.3 US$ Exchange Rate (Year-End) 10.4 11.2 11.1 10.6 11.0 11.5 US$ Exchange Rate (Avg) 9.7 10.8 11.3 10.9 10.9 11.3 28-day Cetes Interest Rate (Year-End) 7.0 6.0 8.5 8.2 7.0 6.6 28-day Cetes Interest Rate (Avg) 7.1 6.2 6.8 9.2 7.2 6.7 Monetary Base (US$bn) 24.5 25.9 29.6 33.7 36.0 37.8 Monetary Base (∆% YoY) 2.9 5.9 14.2 13.8 6.7 5.2 Fiscal Policy Indicators Fiscal Balance, % of GDP (1.2) (0.6) (0.3) (0.2) 0.0 0.0 Primary Balance, % of GDP 2.7 2.3 2.6 2.6 2.9 3.0 Government Financing Needs a (US$bn) 53.7 70.9 83.9 96.8 105.4 97.3 Gross Total Government Debt (Includes Central Bank) 232.7 234.0 244.9 258.0 248.1 240.6 Local Currency (US$bn) c 153.9 153.1 165.7 186.3 194.4 186.9 Foreign Currency (US$bn) (Includes Tesobonos) 78.8 80.9 79.2 71.7 53.8 53.7 Balance of Payments Trade Balance (US$bn) (7.6) (5.8) (8.8) (7.6) (6.1) (11.8) Merchandise Exports (US$bn) 161.0 164.8 188.0 214.2 254.7 269.2 Merchandise Imports (US$bn) 168.7 170.5 196.8 221.8 260.8 281.0 Services and Income Receipts (US$bn) 16.8 16.5 19.6 21.4 22.7 23.7 Services and Income Payments (US$bn) 32.9 33.2 34.5 39.1 43.3 47.1 Transfers (US$bn) 10.3 13.9 17.0 20.5 24.5 28.2 Current Account (US$bn) (13.5) (8.6) (6.6) (4.8) (2.2) (7.0) Current Account (% of GDP) (2.1) (1.3) (1.0) (0.6) (0.3) (0.8) Foreign Direct Investment (US$bn) 15.5 12.3 18.7 18.1 17.3 16.1 Debt Profile International Reserves (US$bn) 48.0 56.1 61.5 68.7 71.7 74.6 Total Internal Govt. and Central Bank Debt (US$bn) 153.9 153.1 165.7 186.3 194.4 186.9 Short Term (less than 12 months) (US$bn) 30.8 30.6 21.7 27.1 38.9 37.4 Long Term (over 12 months) (US$bn) 123.1 122.5 144.0 159.2 155.5 149.5 Total Internal Govt. and Central Bank Debt (% of GDP) 23.7 24.0 24.2 24.2 23.2 21.4 Total External Debt (US$bn) 140.8 141.0 139.2 129.4 111.7 111.8 Short Term (less than 12 months) (US$bn) 20.0 20.2 18.7 15.9 15.7 15.7 Long Term (over 12 months) (US$bn) 120.8 120.8 120.5 113.4 95.9 96.1 Total External Debt (% of GDP) 21.7 22.1 20.4 16.8 13.3 12.8 Total External Debt (% of Exports of Goods & Services) 87.4 85.6 74.0 60.4 43.8 41.5 Debt Service Ratio b 22.7 24.5 18.7 19.8 13.9 12.3 Labor Markets Unit Wages (real ∆% YoY) d 4.1 1.4 0.2 0.4 1.0 0.6 Unemployment Avg. (% of EAP) 2.7 3.2 3.7 3.9 3.8 3.8 Total Payroll (real ∆% YoY) 1.9 1.0 3.2 2.6 6.6 4.7

(a) (Amort + Fiscal Deficit). (b) (Amort + Interest Ext Debt)/(Exports Goods & Services). (c) Includes Fobaproa as of 99. (d) Manufacturing Industry. E Santander Investment estimate. F Santander Investment forecast. Sources: Ministry of Finance, Banco de México, and Santander Investment.

21

VENEZUELA

REVISING OUR 2006-2007 FORECAST

• As has happened in the past, higher-than-expected oil prices are helping to improve our macro numbers for 2006-2007.

• In general terms, we expect high GDP growth, but with a lowering trend next year.

• 2006 will record a new maximum for public spending growth, but we are still far from a fiscal stress scenario; we expect a similar picture in 2007.

• However, higher excess liquidity due to high public spending is likely to keep inflationary pressures high in the remainder of the year, with a lower impact in 2007.

• We continue to see a maximum 6.0% exchange rate adjustment in early 2007.

• The strength of the current account is not in doubt, but the deficit in the capital account is set to persist in 2007.

Why change our forecast for the macro numbers?

External markets have been facing higher-than-expected oil prices over the past few years, which has led us to improve our forecast for the most important economic variables. The year-to-date Venezuelan oil basket has averaged close to US$58.00 per barrel, and this price level is significantly above the US$26.00 per barrel projected in the 2006 fiscal budget, whereas the use of the implied extra resources in the domestic market is having a positive impact in terms of the fiscal balance, private consumption, and GDP growth. However, a higher public spending level is also responsible for both the excess liquidity of around US$18 billion and a resurgence of inflation since May of this year.

Higher oil prices for Venezuela in 2006 should continue in 2007.

In light of this scenario, we decided to change our oil price assumption for 2006 to US$58.50 per barrel, from US$55.00 estimated in July. For 2007, the Venezuelan oil mix is likely to record a value no lower than US$56.00 per barrel, up from the previous projection around the US$48.00 mark.

Lower GDP growth rate next year; GDP growth is strongly consumption-driven.

In spite of the high oil price scenario next year, the country will probably record a lower GDP growth rate. Economic activity should be reporting a 9.6% growth in 2006, up from the previous projection at 7.5%. However, we see the Venezuelan economy growing at 7.2% next year, compared with the 5.0% GDP growth we projected in July. Note that the main difference in the current scenario with respect to the older forecast is that now we have very similar numbers for the Venezuelan oil basket in both years. We believe that political factors and lower fiscal spending growth will be responsible for this lower GDP growth next year. The bad news about high GDP growth is that it is strongly consumption-driven, and consumption makes up around 63% of total aggregate demand, whereas investment represents no more than 24%.

The oil windfall sustains high public spending with no worrisome fiscal imbalances.

The improvement in the oil price assumptions provides relief for the fiscal accounts given the higher public spending level reported in the first three quarters of the year. In addition, healthy non-oil tax collection helps widen the gap between fiscal revenues and total expenditures. We now see the central government fiscal accounts closing with a small surplus at 0.7% in terms of GDP, compared with the 0.6 deficit previously projected. This result does not include extra expenditures by the National Development Fund (FONDEN), which is fed by both BCV’s international reserves transfers and PDVSA’s direct disbursements. For 2007, we see a higher surplus, 1.5%, compared with the 0.8% surplus projected in April. However, next year the fiscal accounts are likely to see a higher surplus, with an oil price approximately US$8.00 per barrel higher.

Strictly Macro – September 15, 2006

22

The expansive fiscal policy operates as a driver of inflation.

The Consumer Price Index (CPI) recorded a 14.9% increase in August on a YoY basis. In our view, there has been an inflationary process developing in the economy over the past four and a half months amid a higher excess liquidity in the economy. Around 76% of total state funds are local-currency denominated, and a significant portion of these funds have remained idle in the local market. This (among other factors) has been putting pressure on prices, whereas the government sees its 10% inflation goal as having a low chance of being achieved.

Given that the local market expects to see higher public spending in the remainder of the year, combined with a high private consumption level, we believe that inflation is going to pick up in 4Q06. We expect to see CPI changing 15.9% in 2006, up from the previous projection at 12.3%. For 2007, given a lower GDP growth and a lower increase in public spending, inflation could be 11.5%, which would be below the 2006 number but higher than the previous projection at 10.1%. In any event, we do not assign a high probability to seeing a one-digit inflation figure until 2008.

We continue to expect no more than a 6.0% devaluation in early 2007.

According to our calculations, the public sector holds around US$47 billion in various funds. Given the prospect of high oil prices in 2007, we see no reason for a steep official exchange rate adjustment next year. Recent steps taken by the Executive and the Central Bank to deal with the excess liquidity make us believe that there will be no significant move in the FX rate.

The external accounts remain strong, but we will see high values for the deficit in the capital account.

The new current account forecast for 2006 is US$28.6 billion, down from the US$33.0 billion surplus projected in April of this year. For 2007, it could record a higher surplus of around US$32.6 billion compared with both the 2006 number and the previous projection. The reason for this better outcome in terms of the current account next year has to do with a reduction in imports, given a lower GDP growth rate and a lower liquidity growth, which could imply a diminished effort by the FX administration board (CADIVI) to disburse hard currency to private companies.

The capital account is on track toward a higher deficit in 2007. It could reach US$23.2 billion in 2006, down from the US$29.4 billion deficit forecasted by our research team. For 2007, the capital account will probably show a US$27.1 billion deficit. These results in 2006-2007 are related to transfers of international reserves from BCV to FONDEN, external debt buybacks, and possible dollar-against-bolívar debt issues in the local market.

MAIN CONCLUSION

In general terms, we have improved all the macro forecast for 2006-2007, with the exception of inflation and the 2006 current account. However, with higher oil prices, Venezuela still faces internal distortions regarding excess liquidity, the growth of prices, and increased oil dependency. In the meantime, we expect that nothing will change.

Milton Guzmán, Homero Gutiérrez, and Laura De Freitas (58-212) 401-4234

23

Venezuela – Economic Projections, 2002-2007F Structure % GDP 2002 2003 2004 2005E 2006F 2007F

National Accounts Real GDP (∆% YoY) (8.9) (7.7) 17.9 9.3 9.6 7.2 Consumption (∆% YoY) 67.0 (6.6) (4.6) 16.6 16.3 17.3 14.5 Investment (∆% YoY) 15.7 (22.0) (36.7) 43.0 33.2 26.2 17.4 Private (∆% YoY) 7.1 (26.0) (40.2) 41.9 28.1 22.0 13.6 Public (∆% YoY) 8.6 (22.7) (35.2) 44.6 36.9 29.7 17.2 Government Spending (∆% YoY) 7.2 (2.5) 5.7 13.9 7.3 67.9 3.5 Exports (∆% YoY) 27.1 (7.8) (9.9) 11.8 3.9 18.3 0.5 Imports (∆% YoY) -18.6 (26.7) (19.6) 60.0 36.0 20.9 (11.1) GDP (US$bn) 85.7 84.0 109.2 127.0 176.3 198.7 GDP Per Capita (US$) 3,401 3,263 4,184 4,774 6,529 7,147 Population (Mn) 25.2 25.7 26.1 26.6 27.0 27.8 Monetary and Exchange Rate Indicators CPI Inflation (Dec Cumulative) (%) 31.2 27.1 19.2 14.4 15.9 11.5 WPI Inflation (Dec Cumulative) (%) 51.4 48.8 22.4 15.0 16.1 11.4 US$ Exchange Rate (Year-End) 1,403 1,600 1,920 2,150 2,150 2,280 US$ Exchange Rate (Avg) 1,164 1,610 1,895 2,112 2,150 2,248 TAN Interest Rate (Year-End) 32.3 19.3 16.0 14.0 15.1 14.0 TAN Interest Rate (Avg) 38.4 25.3 17.9 15.6 15.4 14.6 M2 (US$bn) 13.8 19.3 24.2 32.6 52.8 76.5 M2 ∆% YoY) 14.8 57.5 50.5 50.8 60.2 53.7 Fiscal Policy Indicators Fiscal Balance ( % of GDP) (6.3) (7.6) (3.5) (0.8) 0.7 1.5 Primary Balance (% of GDP) (2.0) (2.6) 0.1 2.3 2.5 3.3 Government Financing Needs a (Local Currency bn) 9.3 14.4 10.4 6.3 7.0 5.7 Gross Total Government Debt (US$bn) 34.3 38.6 42.2 44.5 41.2 51.6 Local Currency (US$bn) 10.3 14.3 15.0 13.6 15.9 16.5 Foreign Currency (US$bn) 24.0 24.3 27.2 30.9 24.5 23.1 Balance of Payments Trade Balance (US$bn) 13.4 16.4 21.4 30.4 36.7 40.2 Merchandise Exports (US$bn) 26.8 27.2 38.7 55.6 65.6 65.9 Merchandise Imports (US$bn) 13.4 10.7 17.3 25.2 28.9 25.7 Services and Income Balance (US$bn) (5.7) (5.1) (7.5) (6.1) (8.1) (7.6) Transfers (US$bn) (0.2) 0.0 0.0 (0.1) (0.2) (0.2) Current Account (US$bn) 7.6 11.4 13.8 24.4 28.6 32.6 Current Account (% of GDP) 8.9 12.9 12.5 20.0 16.2 16.4 Foreign Direct Investment (US$bn) 0.8 2.7 1.5 3.0 0.5 0.4 Debt Profile International Reserves including MSF (US$bn) 14.8 21.3 24.2 30.0 35.8 41.2 Total Internal Govt. and Central Bank Debt (US$bn) 10.3 17.9 18.9 25.2 14.5 24.1 Short Term (less than 12 months) (US$bn) 3.0 8.2 6.2 11.0 8.1 11.1 Long Term (over 12 months) (US$bn) 7.3 9.7 12.7 14.2 11.0 13.0 Total Internal Govt. and Central Bank Debt (% of GDP) 12.0 20.3 17.3 19.8 8.2 12.1 Total External Debt (US$bn) 32.6 33.4 36.1 38.9 26.7 27.5 Short Term (less than 12 months) (US$bn) 3.7 3.5 3.1 3.8 2.4 2.9 Long Term (over 12 months) (US$bn) 28.9 29.9 33.0 35.1 24.3 24.6 Total External Debt (% of GDP) 38.0 37.8 33.1 30.6 15.1 13.8 Total External Debt (% of Exports) 121.6 124.2 93.3 70.0 40.7 41.7 Debt Service Ratio b 12.2 19.0 10.2 7.1 5.5 5.6 Labor Markets Unit Wages (real ∆% YoY) (11.4) (17.2) 0.2 4.2 9.1 3.1 Unemployment Avg. (% of EAP) 15.7 18.0 15.1 12.3 9.9 10.2 Total Payroll (real ∆% YoY) na na na na na na

(a) (Amort + Fiscal Deficit). (b) (Amort+Interest Ext Debt)/Export Good & Services. E Santander Investment estimate. F Santander Investment forecast. Sources: Finance Ministry, Budget Office, Central Bank, and Santander Investment.

Contacts

2006-0136

Economics Research Ernest (Chip) Brown Head of Economics Research ebrown@schny.com 212-583-4663 Juan Arranz Economist – Argentina jarranz@bancorio.com.ar 5411-4341-1065 Andre Loes Economist – Brazil aloes@santander.com.br 5511-3012-5726 Pablo Correa Economist – Chile pcorrea@santanderinvestment.cl 562-336-3361 Héctor Chávez Economist – Mexico hchavez@santander.com.mx 5255-5269-1925 Milton Guzman Economist – Venezuela milton_guzman@banvenez.com 58212-401-4235

Fixed Income Research Jorge de Gortari Head of Fixed Income Research jdegortari@schny.com 212-350-3917 Juan Pablo Cabrera Senior Economist – Local Markets jupcabrera@gruposantander.com 3491-257-2172 Matthew Claeson, CFA Fixed Income Strategy mclaeson@schny.com 212-350-0733 Naveen Kunam Quantitative Analysis nkunam@schny.com 212-350-3435

Equity Research Dario Lizzano Managing Director, Head of Equity dlizzano@schny.com 212-350-3979 Cristián Moreno Head, Equity Research cmoreno@schny.com 212-350-3996 Fernando Peres Head, Argentina fperes.buenos-aires@sinvest.es 5411-4341-1213 Andre Loes Head, Brazil aloes@santander.com.br 5511-3012-5726 Raimundo Valdés Head, Chile rvaldes@santanderinvestment.cl 562-336-3387 Francisco Rivero Head, Mexico frivero@santander.com.mx 5255-5269-1923

Electronic Media Bloomberg STDR <GO> Reuters Pages SISEMA through SISEMZ Santander Investment Securities Inc. http://www.schinvestment.com This report has been prepared by Santander Investment Securities Inc. (“SIS”) (a subsidiary of Santander Investment S.A., which is wholly owned by Banco Santander Central Hispano, S.A. ("Santander"), on behalf of itself and its affiliates (collectively, Grupo Santander) and is provided for information purposes only. This document must not be considered as an offer to sell or a solicitation of an offer to buy any relevant securities (i.e., securities mentioned herein or of the same issuer and/or options, warrants, or rights with respect to or interests in any such securities). Any decision by the recipient to buy or to sell should be based on publicly available information on the related security and, where appropriate, should take into account the content of the related prospectus filed with and available from the entity governing the related market and the company issuing the security. This report is issued in Spain by Santander Central Hispano Bolsa, Sociedad de Valores, S.A. (SCH Bolsa), and in the United Kingdom by Santander Central Hispano S.A., London Branch (Santander London), which is regulated by the Financial Services Authority in the conduct of investment business in the UK. This report is not being issued to private customers. SCHI, Santander London, and SCH Bolsa are members of Grupo Santander.

ANALYST CERTIFICATION: The following analysts hereby certify that their views about the entities and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Ernest W. (Chip) Brown, Martín Mansur, Rodrigo Sebastián Park, André Loes, Constantin Jancsó, Mauricio Molan, Pablo Correa, Héctor Chávez, Delia Paredes, Rafael Camarena, Milton Guzmán, Homero Gutiérrez, and Laura De Freitas.

The information contained herein has been compiled from sources believed to be reliable, but, although all reasonable care has been taken to ensure that the information contained herein is not untrue or misleading, we make no representation that it is accurate or complete and it should not be relied upon as such. All opinions and estimates included herein constitute our judgment as at the date of this report and are subject to change without notice.

Any U.S. recipient of this report (other than a registered broker-dealer or a bank acting in a broker-dealer capacity) that would like to effect any transaction in any security discussed herein should contact and place orders in the United States with SIS, which, without in any way limiting the foregoing, accepts responsibility (solely for purposes of and within the meaning of Rule 15a-6 under the U.S. Securities Exchange Act of 1934) for this report and its dissemination in the United States.

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