BusinessWeek Commentary: Brazil: Still on the
Edge of a Cliff
businessweek.com@@JTUqJmQAZFQOKwAA/datedtoc/1999/9905.htm
It's a Latin paradox. On Jan. 15, Brazil turned its back
on 4 1/2 years of defending an overvalued currency
pegged to the U.S. dollar. As the real floated freely on
foreign exchange markets, the Sao Paulo stock market
soared a heady 33%. It seemed as if Brazil had
escaped disaster by taking the easy way out. Next
door in Argentina, the Buenos Aires bourse also
jumped 12%, and the peso firmly held its ground. But
far from easing up, Argentine President Carlos Saul
Menem was calling for a much tougher straitjacket for
his economy: ditching the peso altogether and
embracing the dollar as its only currency.
What gives? These are wild days in Latin America's
financial markets. But in the midst of the apparent
chaos, it's possible to draw lessons. Investors seem to
be applauding both Brazil and Argentina at a time when
their exchange-rate policies are diverging. In fact, the
market will eventually hold Brazil to a tough standard.
The country is only beginning to grapple with concepts
like fiscal discipline. Argentina, by contrast, has been
squeezing budgets since 1991, when it adopted a tight
monetary regime by using a currency board to lock its
currency 1-to-1 to the dollar.
The most important lesson is that no currency policy
can work without strong economic fundamentals to
support it. Sure, Brazil had to act on its overvalued
exchange rate, but the country is still very much on
investors' watch list. Congress must carry out
long-promised spending cuts and deeper reforms of the
tax and social security systems to cut a budget deficit
running at 8% of GDP. Meanwhile, President Fernando
Henrique Cardoso has to ensure that the profligate
states make good on their $73 billion in debt to
Brasilia.
It's clear that if Brazil disappoints once again, the
economy will turn from bad to disastrous. Although
capital flight slowed from $1 billion a day to about
$350 million after the devaluation, money continued to
move out, indicating that investors think the real has
further to fall. Economists' projections that prices will
rise up to 10% this year, following deflation in 1998,
could be understated. Interest rates, already suffocating
the economy and pumping up Brazil's $200 billion in
local debt, were raised to over 40% on Jan. 18. The
economy could shrink 5% this year, the worst in three
decades.
BUILD TRUST. So why the bout of market
euphoria? First, the real didn't collapse, Asia-style.
That's partly because Brazil has taken steps in the right
direction over the last few years. Unlike much of Asia,
Brazil whipped most of its banks into shape. It has
embarked on an ambitious privatization program and
allowed relatively open capital markets. And crony
capitalism hasn't strangled Brazilian business.
Still, while Brazil and Argentina have chosen different
paths for their currencies, the Brazilians will need to
take a close look at Argentina for clues to their next
moves. That doesn't mean a currency board, or
dollarization, which Menem has been urging on his
wayward neighbors. With its political complexity and
large economy, Brazil won't seriously consider such
schemes. Besides, national pride will likely keep it from
ever ditching its own currency. To build market trust
and hold down inflation, Brazil will have to duplicate
Argentina's fiscal prudence.
Indeed, while many Argentines believe the currency
board is the primary reason their economy has been
stable since 1991, it's only part of the success story.
The Argentine plan wouldn't have worked without
austerity and a consolidation of the banking sector.
Argentina's banking business is now dominated by
foreign institutions such as Spain's Banco Santander.
Brazil could even borrow a page from the Mexicans.
Mexico has made its floating exchange-rate system
function smoothly by taking a tough fiscal line after the
disastrous 1994 peso crash. Argentina and Mexico
aren't completely cured, of course. Democratic
institutions are immature, and corruption is a problem
for both. Meanwhile, domestic savings rates are dismal
throughout Latin America, making the region dependent
on foreign money.
Brazil may get a dose of reality sooner than it thinks.
Analysts are already wondering whether the runup in
the stock market had as much to do with technical
factors as confidence. Many may have bought stocks
betting they could get good values before a new round
of inflation kicks in. And they may be right. Brazil needs
to stop watching the markets and start focusing on
basic problems. If it succeeds, it could stand out as an
example for the rest of the emerging world.
By Ian Katz
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