Briefing on Brazil's Economic Crisis

by Satya Gabriel

January 14, 1999, 4 p.m. (e.s.t.)

The world's attention has now turned to the eighth largest economy in the world. Brazil's economy generates twice the value of products and services as Russia, accounts for over half of Latin American output (whose consumers and firms buy 20% of U.S. exports, totally about 115 billion dollars), and has the potential to do significant damage to the earnings of many American firms, if the current crisis results in a collapse in corporate and household spending in Brazil. This latter scenario seems, at the moment, a distinct possibility.

The widespread devaluations of currencies against the U.S. dollar has acted as a virus in the global economy since the Mexican peso devaluation at the end of 1994 (and, perhaps, since the Chinese devaluation earlier in that same year). Particularly in many less industrialized nations, wealth has vanished overnight. Holders of U.S. dollars have found themselves in increasingly privileged positions, able to gobble up cheap assets from Mexico to Thailand. The virus has now clearly taken hold of Brazil.

It wasn't supposed to happen. It was widely believed that Fernando Henrique Cardoso's victory in the Brazilian presidential election would serve to inoculate Brazil from the devaluation virus. Cardoso, architect of Brazil's "Plan Real," was to implement structural adjustments and economic reforms designed to satisfy the conditions set by the International Monetary Fund (IMF) for a $41.5 billion loan. This $41.5 billion was deemed more than adequate to bolster Brazil's dollar reserves and protect the real from speculative attack or capital flight, despite a rising current account deficit, budgetary problems, and rising levels of dollar denominated debt in the Brazilian corporate sector. Structural reforms were to put a break on rising dollar equivalent wages in Brazilian manufacturing, buoy profit rates, and create more attractive conditions for foreign direct investment and exporters. To the extent the fiscal and structural reforms would enhance profitability in Brazil, particularly in the export sector, the price of capital assets, and related equity shares, could be protected from the sort of financial sector collapse that has recently come to epitomize Asian financial markets. Brazilians would not, if all went according to plan, suffer the neocolonizing impact of collapsing capital asset prices, institutional desperation for dollars (particularly by those firms holding dollar denominated debt), and the humiliation of watching foreigners, particularly Americans, cherry picking the best assets the country has to offer at fire sale prices.

But at the end of the day, Cardoso could not deliver. He was unable to get the IMF supported budget (with tax increases and spending cuts) or the economic reforms (particularly liberalization of the pension system) through the Brazilian legislature. The possibility of default on Brazilian sovereign debt became a topic of some debate. The well heeled in Rio and Sao Paolo became convinced that devaluation of the real was inevitable and began shifting their wealth out of Brazil and into bank and brokerage accounts in the U.S., Europe, and off-shore havens. The more dollars fled Brazil, the more negative expectations about Brazil's future, particularly the future value of the real. The more negative the expectations, the more the capital flight.

In an effort to defend the real, the Brazilian Central Bank pushed up interest rates to nearly 50%. The higher the interest rates domestically, the more lucrative it is, all other things being equal, to keep savings in Brazil. However, this is only true if those who buy the depressed Brazilian bonds or put their money in Brazilian savings accounts can feel reasonably certain that the dollar value of their savings will not be eroded by a devaluation and the financial solvency of institutions invested in will not become questionable. In fact, the high interest rates raised the cost of servicing debt, both public and private debt, to levels that were so high that investors became even more certain that a major default would occur, followed by a subsequent collapse in the dollar value of the real. Thus, the high interest rates did not stem the tide of dollars flowing out of Brazil. Indeed, the high interest rates only speeded up the fall in asset prices in the Brazilian economy, reducing the collateral backing existing loans, increasing the rate and risk of bankruptcies, and placing extraordinary burdens on the entire financial system.

The final blow to any expectation that the crisis might be resolved "efficiently" came with the announcement by Itamar Franco, a former president and current governor of Minas Gerais, that his state government was calling a debt moratorium and would cease servicing the state's $15 billion debt to the federal government for ninety days. This announcement has further threatened the fiscal integrity of the federal government. Governors in the populous states of Rio de Janeiro and Rio Grande do Sul have expressed support for the idea of a debt moratorium. If the states refuse to service their federal debt, the federal government's fiscal crisis could spin out of control. The potential of default rose into the economic red zone. Capital flight increased. The Brazilian Central Bank began waving warning flags as the dollar reserves were rapidly draining --- at a rate of over $2 billion a day.

For whatever reason, President Cardoso and his advisers decided that the solution was a devaluation. He had earlier pledged not to devalue. Thus, the devaluation not only reinforced the negative expectations in the financial markets and community of the Brazilian well-to-do, but destroyed one of the most precious non-physical assets that any government can have, credibility. Recognizing this, the head of the Central Bank, Gustavo Franco (who decided that he would not be the one to implement such a devaluation), and the director of banking supervision, Claudio Mauch, both resigned. The 9% devaluation in the real/dollar exchange rate not only did not stop the bleeding of dollars out of Brazil but speeded it up. The Sao Paolo Stock Exchange plunged 10% on the day of the devaluation (January 13th) triggering a limit down halt to trading. The next day (January 14th), the Exchange went limit down again, closing down 9.97%. As happened in Mexico in December of 1994, the domestic rich preceded the foreigners in heading for the exits.

The devaluation threatens the financial health of many Brazilian firms, particularly but not only those exposed to foreign exchange risk. Afterall, if firm A has a high degree of foreign exchange risk and is a major customer of firm B that has little or no foreign exchange risk, then anything that impacts firm A is likely to indirectly impact firm B. Thus, firm B could find its top and bottom line impacted by the devaluation via the impacts on firm A. This type of relationship is replicated thousands of times within the Brazilian economy and includes the relationships between firms and financial institutions.

To make matters worse, credit agencies, who were criticized for being too slow to reassess the Asian economies, are now downgrading Brazil's sovereign debt. This will further raise borrowing costs and create even tighter credit conditions for the entire Brazilian economy. The devaluation will raise the costs of imported inputs to industry, as well as imported consumer goods. Cardoso's much praised "Plan Real," which is credited with bringing inflation down from hyperinflationary levels (as high as 8,000% annualized during part of 1994) to around 5%, may soon be seen as nothing more than an accident of good circumstances because many of the ad hoc measures of Plan Real remain in effect but inflation will surely return with a vengeance.

What is the short-term solution to the Brazilian crisis? There are two distinct and opposed possibilities and a wide range of possibilities in between. The Brazilian government could either abandon any attempt to control the exchange rate and, therefore, stop frittering away the Central Bank's dollar reserves trying to keep the real within its targeted trading band or the government could simply fix the exchange rate in a manner that does not require managing the real. This latter approach could be achieved by copying the Argentinean currency board (or even joining that currency board). The currency board solves the most difficult problem in a fixed exchange rate regime --- controlling domestic monetary growth. There is always, however, concern that a currency board would take away the flexibility of the Central Bank to respond to economic crises and could lead to even worse economic downturns than might occur under a freely floating currency. Whatever the Brazilian government does, it must find a way to regain credibility and restore confidence. Whether this is by a free float or a currency board, the clock is ticking and something must be done soon or the virus will certainly become even more virulent and Brazil's neighbors may be next in line to be infected.

Addendum (Jan. 18, 1999):

The Brazilian government has decided to float the real against the dollar. This will help to solve one of the structural problems that was deemed a negative factor in Brazil's economy. Dollar equivalent wages in Brazil will fall precipitously. For exporters, this will mean, potentially, a big boost in profit rates. The decision to float the currency also eliminates one element of uncertainty --- what the Brazilian government will do next, at least with regards to the exchange rate.

The decision to float the real was somewhat drastic, but not surprising. Cardoso still needs to prod the Brazilian legislature and the governors of the states to cooperate in structural reforms, both in terms of getting them legislated and in terms of implementing them. By floating the real, the Brazilian economy is more exposed to foreign influences. Negative sentiments in global financial markets can more efficiently and quickly be transmitted into the Brazilian economy via a falling value of the real vis-a-vis dollars. This means that any drastic actions by Brazilian governors, such as debt moratoria, or continued intransigence by the Brazilian legislature would have rather immediate negative consequences for Brazilian workers and consumers. Cardoso is betting that his fellow politicians will be more cooperative in such an environment. We'll see.


Copyright © 1999, Satya Gabriel, Economics Department, Mount Holyoke College.