Fraga's Market Savvy Converts Brazil's Skeptics to Trust Logic
By PETER FRITSCH
Staff Reporter of THE WALL STREET JOURNAL
** Howdy everyone. Hope all is going ok! (david)**
RIO DE JANEIRO -- Brazilian currencies have lasted an average of 30 months since the military fell from power in 1985. So it was with great satisfaction that central bank President Arminio Fraga recently began printing 10 real bills on long-lasting plastic -- much to the chagrin of the treasury's local paper supplier.
The switch, Mr. Fraga says, "is symbolic of the stability we've been able to achieve after some had written us off."
Scarcely more than a year after a clumsy currency devaluation appeared to rob the world's ninth-largest economy of its rudder and sails, Brazil does appear to be back on course.
Interest rates, though still stiff, are the lowest they have been in decades. Trade accounts are improving, and direct foreign investment may break last year's record $30 billion. Inflation is dormant and growth accelerating.
So just what did President Fernando Henrique Cardoso do right? By all accounts, one answer is that he hired Mr. Fraga, a 42-year-old, Princeton-trained economist who can do what most in the administration can't: speak Wall Street's language.
Tapping a George Soros fund manager was a gamble. Even the region's early free-market champions such as Chile and Mexico have stuck by the tradition of putting central-bank policy in the hands of career technocrats -- only to see decision making ossify in times of turmoil. The same had been true for Brazil -- until Mr. Fraga put together a team of precocious market operators drawn mainly from the private sector.
"Arminio has played a key role" in this recovery, says U.S. Treasury Secretary Lawrence Summers. He says Mr. Fraga's "recognition that market logic supersedes political convenience ... has been hugely refreshing to us and to markets."
There were other forces helping, too. Finance Minister Pedro Malan's persistence brought Mr. Fraga to the central bank in the first place. Congress knotted the national purse strings, keeping the swollen budget deficit from ballooning further. Ideal rainfall brought a record harvest last year and kept food prices from causing a dangerous spike in inflation.
Problems Remain
Brazil still has a lot of work to do. A bankrupt pension system and bloated bureaucracy remain a drain on government coffers. An archaic tax code stifles competitiveness. The huge national debt -- equivalent to about half of annual economic output -- leaves the country vulnerable to external shocks. The divide between rich and poor remains one of the world's worst.
But the lesson of Brazil's lightning trip to the financial doghouse and back is that the decisive actions of a few individuals well-versed in market psychology can go a long way toward gaining quick control of an explosive situation. "It used to be that you would meet with the central bank and get nothing back, not a smile or a frown -- as if they were afraid of being cheated," says Francisco Gros, a former central-bank president and Morgan Stanley Dean Witter executive now in charge of Brazil's National Development Bank. "Happily, that attitude is gone."
Mr. Fraga, who grew up in Rio de Janeiro, comes from a long line of physicians on his father's side. His mother is American and the reason he speaks English fluently. When time allows, he devotes himself almost fanatically to golf.
The groundwork for his role in Brazil's recovery was laid in a windowless room at the U.S. Federal Reserve Bank in 1984. Mr. Fraga, then a doctoral candidate at Princeton, held one of three prestigious internships at the Fed's international-finance division. Just two years after the Latin American debt crisis, the division was a nerve center of crisis management.
There, he saw the influence solid market research can have on policy. He observed as Brazilian Finance Minister Delfim Neto swooped into Washington to haggle with the IMF. And he made important contacts, such as Ted Truman, then head of the international-finance division and today a senior Treasury official.
After Princeton, Mr. Fraga headed for the private sector. At leading Brazilian investment bank Garantia SA, where he became chief economist, and at Salomon Brothers Inc., he used his keen mathematical skills to trade in sovereign and corporate debt and money markets. He quickly became known as one of Brazil's most astute operators. That reputation brought him to the central bank in 1991 as head of international affairs. There he made important changes to capital markets as Brazil began to open its economy to the outside world.
Before long, Mr. Fraga was in the middle of Brazil's long-delayed debt negotiations with foreign creditors. That was an extremely sensitive task: Unlike Mexico or Argentina, which had declared a moratorium on debt payments, Brazil had defaulted. Mr. Fraga departed from the well-established tradition of benign neglect with which the debts had been treated for years and actively pursued creditors to work something out. The experience won him the respect and an continuing relationship with Mr. Cardoso, then a powerful senator. He built other important bridges.
"I learned that Arminio was smart as hell, deeply pragmatic and not at all arrogant -- crucial qualities," recalls Citigroup Inc. Vice Chairman William Rhodes, who was involved in the debt talks and would later answer Mr. Fraga's call to help line up private lender support after the 1999 devaluation.
When it became clear that corruption allegations would bring down President Fernando Collor in 1992, Mr. Fraga returned to the private sector, joining George Soros in New York, where he managed emerging-market investments. Before long, he was intimately involved in yet another crisis, Mexico's late-1994 peso devaluation. As a money manager, he made frequent trips to Mexico and studied the steps and missteps of officials. It was a dress rehearsal for events in Brazil more than four years later.
In January 1999, heeding a cadre of politically ambitious friends calling for an export-led growth boom, and ignoring Mr. Malan and then-central bank President Gustavo Franco, President Cardoso ordered the devaluation. It began with the central bank weakening the currency by moving the preset limits within which the real can trade against the dollar. Days later, it was forced to eliminate that trading band altogether and let the currency float freely to find its own level against the dollar.
Rewards and Risk
By devaluing, Brazil hoped to make its goods cheaper on world markets while discouraging imports, which become more expensive in local-currency terms. But devaluation is risky. Because the cost of raw materials can rise, so can prices throughout the economy. Devaluation also makes it more costly to repay debt denominated in other currencies.
The move came only weeks after Brazil got its first installment of a $41 billion international rescue package -- money extended with the understanding that Brazil's macroeconomic policies wouldn't change. Mr. Franco quit, giving way to Francisco Lopes, a respected economist but a critic of the IMF with little market experience or poise.
Mr. Cardoso quickly realized he had made a major mistake, especially when Mr. Malan also offered his resignation (which wasn't accepted). He called Mr. Fraga at Soros and got a frank assessment of how badly Brazil's credibility had been hit on Wall Street. It was hit hard, mainly because the country's leaders had no solid plan to manage such a change.
Mr. Malan, a former teacher of Mr. Fraga's at Rio de Janeiro's Pontificia Universidade Catolica, had always respected his star pupil's opinion "and always joked about me joining the government," Mr. Fraga says. Days later, Mr. Fraga was dining with the president and Mr. Malan in Brasilia. Mr. Malan pressured the president into replacing Mr. Lopes with Mr. Fraga by threatening to quit -- a move that would have been disastrous for Brazil's shaky relationship with the IMF and the U.S. Treasury.
Before Mr. Fraga even got the nod, he did some lobbying with powerful Senate president Antonio Carlos Magalhaes, whose godfather was Mr. Fraga's great uncle and whose support would prove critical. When he did take charge of the central bank in March, Mr. Fraga moved quickly.
Rapid Moves
He made the politically perilous decision to raise interest rates to a vertiginous 45%, putting markets on notice that a return to inflation wouldn't be tolerated. But he also introduced the concept of a "downward bias" for rates -- scaring off speculators by suggesting the increase would be short-lived. He began disclosing hard-currency reserves on a daily basis, as Mexico had done, as a gesture to show creditors he was hiding nothing relevant to Brazil's obligations. He also put together a system under which future cuts in interest rates would be linked to price stability.
When Mr. Fraga saw the central bank had no in-house research department to track prices, he had colleague Sergio Werlang address the problem. Mr. Werlang found 25 economists with advanced degrees and created one.
Still, Mr. Fraga needed the patience and backing of foreign bankers, investors and aid groups around the world. Job No. 1 was a revision of Brazil's bailout package with the IMF, since the devaluation had pretty much tossed the agreed-upon macroeconomic targets and principles out the window. Support was weak among the Group of Seven's European members -- who had signed off via the IMF on the former aid package and so felt betrayed by a devaluation that Brazil had sworn it would never pursue -- and among private bankers holding credit lines to Brazil.
On the positive side, Brazil's budget austerity -- the fruit of Draconian measures taken in 1997 and 1998 -- was beginning to pay off on the national balance sheet. And because many in the Brazilian private sector had long feared a devaluation, the country's banking system was in relatively healthy shape. In addition, Brazil had dismantled the system of daily price-indexing that had characterized its years of hyperinflation. Finally, a bumper crop was keeping a lid on food prices.
A Winning Attitude
Reviewing the economic outlook with Mr. Fraga and others over dinner one winter evening, Mr. Summers concluded that things weren't as bad as some thought. Mr. Fraga, however, "basically undersold the positives and, if anything, exaggerated the worries," says Mr. Summers -- a conservative stance he and other officials found particularly winning.
But for Mr. Fraga to persuade the IMF's board to renew its support for Brazil, he would have to get private banks to step up, too. With the help of Citigroup's Mr. Rhodes and others, Mr. Fraga and Brazil's economic team hit New York, London, Frankfurt and Tokyo to plead their case. Thanks to their convincing performances, major banks agreed to hold their credit lines. "This was put together in record time without anything in writing," Mr. Rhodes recalls.
Well, not exactly. Precisely because there was nothing on paper, some banks feared competitors would secretly pull their credit lines, leaving them holding the bag. So Mr. Fraga in April created detailed weekly reports on each part of the world's credit exposure to Brazil and distributed then freely. "This was important to put everyone at ease, to make sure no one was cheating" Mr. Fraga says.
With foreign investors suddenly chasing cheap assets and the IMF back on board, markets began to recover rapidly. Prices found no room to rise in a recessionary environment and interest rates began to fall. Eager to capitalize on the turn in psychology, Mr. Fraga decided to bring Brazil back to the global bond market just three months after the devaluation.
Instead of dickering for the best deal, Mr. Fraga offered a generous premium to investors -- ensuring that the $2 billion in government bonds sparked hot demand. As the bonds hit the market, he was able to help manage their sale with old friends on the trading desk of Morgan Stanley. "This was a key psychological move, and Arminio was right at home," Mr. Gros notes.
Last month, the crisis appeared to come full circle when the central bank paid back $10.3 billion in emergency funds it had borrowed from the IMF and others. Mr. Fraga then swapped pricey Brady bonds for cheaper, longer-term debt. He is now ending nearly 40-year-old foreign-exchange controls, rewriting bankruptcy laws and creating more liquidity for capital markets. "They are undoing years of ossification extremely quickly," says Ian Dubugras, co-head of J.P. Morgan's Brazil office. "And they're doing it with the active participation of the markets."
From his office overlooking Rio de Janeiro's famed beaches, Mr. Fraga took a call one recent afternoon from his personal banker in New York. Extremely cautious with his own money, he feels confident enough these days that he's building a house in nearby Petropolis -- the former mountain retreat of the Portuguese court. After requesting a hefty wire transfer, he mused over Brazil's newfound footing: "The important thing is that there is nothing we really need on the macroeconomic level at this point -- it's all in our own hands now." |
