This Brazilian situation could spin out of control and nail us. Remember what happened when Tiny Thailand went bad.
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Can Brazil Be Saved?
By Robert J. Samuelson
Wednesday, August 14, 2002; Page A29
With more than 170 million people and an expanding middle class, Brazil now ranks as the world's ninth-largest economy, just behind China (seventh) and Canada (eighth). For Brazil to default on its government debt would be a national tragedy and a big problem for the rest of the world. The $30 billion loan to Brazil announced last week by the International Monetary Fund and supported by the Bush administration aims to avoid that. Though the odds of success aren't good -- no better than 50-50 -- the loan is a justifiable gamble precisely because Brazil is so important.
It has come a long way in 20 years. In the mid-1980s, the country was still under military rule. In the early 1990s, it still endured hyperinflation averaging around 1,400 percent a year. Now inflation is about 6 percent to 8 percent. Since 1994 annual economic growth has averaged almost 3 percent -- respectable, though not spectacular. And the country is conducting its fourth free presidential election since 1989.
A default would jeopardize all these gains. It would also hurt the rest of Latin America -- already reeling from Argentina's default and turmoil in Colombia and Venezuela -- and damage the fragile global economic recovery. Because Brazil is the region's largest economy, regional trade would suffer. In 2001 Brazil imported about $13 billion from other Latin countries, including almost $7.5 billion from Argentina and about $1 billion each from Venezuela, Chile and Mexico. Global investors would incur losses not only from depreciated government debt but also, quite probably, from a wave of private bankruptcies. At the end of 2001, all foreign banks had $142 billion in cross-border loans to Brazil, says the Bank for International Settlements.
To imagine the worst, look at Argentina. Since its default, the banking system has collapsed. Deposits have been largely frozen. Poverty has spread. Something similar could happen in Brazil, because government debt represents banks' largest investments, equal to two to three times the banks' stockholder capital, according to Standard & Poor's. A debt write-down could destroy much of banks' capital and trigger a panic by depositors. The political and social side effects could be (to put it gently) unpleasant.
But whether the IMF can prevent a default is unclear. Morris Goldstein of the Institute for International Economics (IIE), a Washington think tank, doubts it. Within the next 18 months, Brazil will have to write down its debt by 30 percent to 40 percent, he predicts. John Williamson, another IIE economist, disagrees. Under favorable -- but plausible -- conditions, Brazil can handle its debt and resume faster economic growth, he says.
The problem is less the debt's size than its continual growth. According to Williamson, Brazil's net government debt is now about $290 billion. About 80 percent of that is domestic debt, mainly in Brazil's own currency, the real. (This debt was converted to dollars at an exchange rate of $1 equals 2.92 reals.) The rest of the debt is foreign, mostly in dollars. The total debt equals about two-thirds of Brazil's gross domestic product. Although this isn't low, many other countries have higher debt ratios.
The trouble is that Brazil's debt has expanded rapidly. In 1994 it was 30 percent of GDP. Runaway spending is no longer the main culprit. In 2000, Brazil's Congress passed a law effectively limiting spending by the national, state and local governments. Taxes have also increased. As a result, Brazil now has what economists call a primary budget surplus. This includes all spending except payments on the debt. The primary surplus is now 3.75 percent of GDP. Unfortunately, interest payments on the debt have exploded to more than 9 percent of GDP, says the Institute of International Finance. The result is an overall budget deficit exceeding 5 percent of GDP.
Why? The answer is that to attract investors -- to get banks and others to buy debt -- the government has to offer exceptionally attractive terms. Interest rates are high, now about 18 percent. As important, about a third of the domestic debt is indexed to changes in the exchange rate. This protects investors against currency loss. If Brazil's real depreciates against the dollar, the government's debt payments automatically rise. Since early 2000, the real has lost about 40 percent of its value. More than half of that has occurred since February. This has been devastating.
The latest cause is nervousness about the October election. The government's candidate, Jose Serra, has lagged badly in polls. Two leftist presidential candidates -- Luiz Inacio "Lula" da Silva and Ciro Gomes -- have raised fears among investors that either's election would mean a debt default. The result: currency flight. Local and foreign investors are cashing out, selling their Brazilian currency and buying dollars.
Williamson is probably right: If Brazil's exchange rate and interest rates improved, the debt would be bearable. The danger is a self-fulfilling prophecy. As investors abandon Brazil's real, the debt burden grows -- prompting more investors to flee the currency. The $30 billion IMF loan tries to break this cycle by providing Brazil with dollars to halt the drop of its currency and to prod the leftist presidential candidates into supporting a large primary budget surplus. This ought to cheer market psychology.
But it hasn't yet. Despite endorsing a primary budget surplus, the leftist candidates criticize the policies that have produced it. Investors remain wary. The exchange rate and the stock market have weakened. One reason is that foreign commercial banks are reportedly reducing dollar loans to Brazilian companies, neutralizing the IMF loan.
Critics argue that the IMF is rescuing private investors more than Brazil. Perhaps. But if Brazil defaults, the shock waves will spread far and wide. Then the IMF and the U.S. Treasury will wonder whether they could have done more or were simply swept along by forces that no one could control
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