The change could have momentous effects for Brazil's capital markets, internationalising the real and helping Brazil build a full scale fixed rate government bond market.
The government may also abolish a transactions tax on fund transfers between debt and equity holdings.
Lula summoned a meeting this week to discuss the tax cuts with finance minister Antônio Palocci, treasury secretary Joaquim Levy and the presidents of the Bolsa de Mercadorias & Futuros and Bovespa, the stock exchange.
Brazil has also begun to turbo-charge its debt management efforts by buying back up to $20bn of short term foreign currency debt and Brady bonds.
The aim of both moves is to draw foreign money into Brazil's government bonds, reducing the government's dependence on the international markets and its exposure to currency shocks.
The Brazilian government has R$810bn ($370bn) of domestic debt and $45bn of foreign bonds, but 56% of the domestic debt is floating rate as of last September and there is no liquid fixed rate yield curve in reais.
Bond market specialists in the US have argued for some time that Brazil should follow Mexico by liberalising its domestic debt market, mainly by dropping prohibitive taxes.
Foreign funds are more likely to buy long dated fixed rate bonds than domestic investors, so they can lead the development of a fully functioning fixed rate government bond market. That also reduces the government's exposure to interest rate volatility.
"This is huge news," said one managing director of Latin American debt capital markets in New York. "This has been a big topic of discussion for some time and the fact they are now officially discussing it is a phenomenal step in the right direction."
Giving foreign investors tax cuts and inviting in foreign cash that could push up the real is politically risky, which may explain why the Brazilian government did not bring forward these measures last year, although treasurer Levy is thought to have been in favour.
Lula faces a battle for re-election in October, but is now willing to entertain these ideas. The tax changes are expected to be announced sooner rather than later. Both Palocci and Levy have stated that the debate on abolishing the taxes is well advanced.
However, the initiative might take several months to pass through congress.
Buybacks get going
News of the bond buybacks came yesterday (Thursday) when Joaquim Levy said Bacen, the central bank, had bought back about $2.3bn of bonds with maturities up to 2010 since January.
The programme is a joint effort between the Brazilian Treasury and Bacen. The latter buys the external debt and sells it to the Treasury, which retires it. So far it has retired about $774m of bonds.
"The programme started last month and has been going extremely well," said Levy. "The buyback is part of a larger government effort to improve the profile of Brazil's foreign debt."
The buybacks will go through to the end of the year and will target all external bonds with maturities before 2010, as well as Brady bonds. In all, the programme could amount to $16bn-$20bn in 2006, which is the amount of outstanding bonds eligible for buyback.
The objective is to reduce total debt and extend the average life of Brazil's foreign debt.
Taken together, the buybacks and tax cuts should help improve Brazil's credit rating.
Brazil's benchmark 2040 dollar bonds leapt 1.75 percentage points on the news to a record 131.3125 on Thursday.
The move is in line with the government's long term aim of retiring all its dollar debt. In the last few years it has retired domestic dollarised debt, prepaid IMF and Paris Club debt and retired a large chunk of its Brady bonds.
However, the proposed tax changes mark a break with recent government policy, which has been to offer foreign investors bonds denominated in reais in global format, rather than in the domestic market.
The two initiatives — retiring dollar debt and opening up Brazil's markets to foreigners — might well be combined, argues Paulo Leme, senior Brazilian economist and debt strategist with Goldman Sachs.
"If the government approves the reform aimed at eliminating the tax burden on foreign investments in the local market, then the real show will start," he said yesterday. "The Treasury would be able to conduct an exchange to retire the global bonds, paying with a menu of local fixed interest rate debt."
Brazil can well afford to buy back its short dated dollar debt. Its balance of payments surplus is expected to reach $17bn by 2006.
By using this surplus to retire debt, the Treasury would take out hard currency from the system that would have put pressure on the real to appreciate further.
Following Mexico's success
Brazil appears to be following in Mexico's footsteps. Several years ago Mexico abolished all withholding taxes on foreign bond buyers. As a direct result, it has been able to extend its fixed rate yield curve in pesos out to 20 years.
Mexico found that foreign investors were a vital ingredient in extending its fixed rate domestic peso yield curve, because local investors did not want to take on illiquid long dated paper.
As recently as January last year foreign investors held up to 80% of all Mexico's long dated peso bonds. Local buyers have since become more comfortable going out along the curve.
If Brazil abolishes the taxes on foreign bond investors, it should be able to drop its present strategy of building a yield curve in reais in the global bond market.
Brazil's first and only global in reais, the $1.5bn equivalent 2016 bond issued last year, widened about 30bp this week as investors started adjusting to the fact that the transaction might soon lose its cachet as the only liquid deal foreigners can buy in reais without being taxed.
If the taxes are abolished, foreign investors are likely to stampede into the Brazilian local market.
With the country's overnight Selic rate at 17.25% and expected inflation of 4.2%, real yields are close to 13%. That makes Brazil's government bonds one of the best opportunities in the fixed income market to get an attractive return, both for carry and total return investors.
"Brazil is basically where Mexico was 15 months ago," said one banker. "The Mexico carry trade has been played out and now everyone is focusing on Brazil."
In the last few months international banks have collectively sold billions of dollars of passthrough structured notes that give foreign investors exposure to inflation-linked Brazilian domestic bonds, without having to incur the taxes.
The inflation-linked bonds are attractive because they offer a play on the expected plunge in real interest rates in Brazil in the next 12 months.
Real rates of 13% are far too high for a country whose GDP growth needs a jumpstart. Inflation and real rates are expected to fall, so inflation-linked bonds offer carry as well as the prospect of high total rates of return.
"Since early January Brazil has really stepped up issuance of IPCA [the local inflation index] bonds and international investors have just been buying gobs of passthrough structures that give them exposure to these inflation-linked real securities," said one syndicate manager at a leading emerging market bond house in New York. "We have sold $500m or more of these structures in the last few weeks."
Analysts in New York are already recommending that investors position themselves in long dated Brazilian inflation-linked bonds.
"If Mexico is a good reference for Brazil, which we think it is, then increasing participation of international investors in the local market is likely to push yields lower and extend the local curve," said JP Morgan in a research report this week. "In the period from July 2001 to date, the yield curve in Mexico has tightened by around 500bp to 300bp between two year and 10 year and the longest maturity has extended from 10 years to 20 years."
Colombia plans to prepay $580m of 'costly' external debt in the first half of this year, according to comments by the government this week.
The announcement follows the central bank's sale of $800m of foreign exchange reserves to the government in January, bringing total government purchases of foreign reserves to $2.8bn since last year.
The government has allocated $2bn of the total toward external financing needs in 2006.
Venezuela's external debt was lifted this week by news that Standard & Poor's had upgraded the country from B+ to BB-.
"Continuing sharp improvements in Venezuela's external and debt indicators motivated the upgrade," said Richard Francis, a sovereign analyst at S&P. "High oil prices have generated large current account surpluses for the country, which in turn has boosted the external assets of the public sector. S&P expects the government to use some of these assets to retire debt and, in the process, reduce the government debt burden and lengthen the debt's average maturity."