How the future looked 6 years ago. Now time is passing faster than before.
Why fear of Lula grips Brazil
K. Subramanian
A FEAR grips the financial markets in Brazil: The "fear of Lula." Lula is Luis Inacio Lula da Silva, the candidate of the Leftist Workers Party for the presidential election tomorrow. From early June, pollsters began to predict a favourable lead for him against Mr Jose Serra, the government-sponsored candidate. Fear seized the market. The Brazilian real began to depreciate. The price of Brady bonds declined. "Brazil risk" exploded and rating agencies were quick to downgrade its debt and signal rising risk of default. All because Mr Lula said, in his election speeches, that his party would renegotiate Brazil's debt if voted to power.
Renegotiations, or restructuring, Brazil's debt is a legitimate goal for its survival. Brazil has been through a succession of crises in recent years. There is a widening cycle; each crisis appears to get resolved for a while, but leads the country deeper into another. In all the years, Brazil had the helping hand of the IMF and the US. How `helpful' and whose interests it served are debatable, though.
An IMF working paper "External Debt and Growth" notes that while a reasonable level of external debt that promotes productive investment may enhance growth, beyond a threshold it reduces growth. Also, additional debt distorts allocation by driving capital into less efficient projects with short-term horizons. The "overall contribution of debt to growth appears to become negative at 160-170 per cent of exports and 35-40 per cent of GDP." Another significant finding is that with higher debt burdens, there might be less willingness to incur the "costs of reforms" if there is a perception that foreign lenders appropriate the fruits of the `reforms' more than domestic constituents.
By these criteria, Brazil crossed the debt threshold two decades earlier. On the political side, it is a deeply divided society with excessive income inequalities and regional disparities which render it difficult to arrive at consensus on `reforms'. It is this soil which nourishes leaders like Mr Lula. The US Treasury Secretary, Mr Paul O'Neill, blamed it on Brazil's politics and would not see its links to economics.
Studies have showed that Brazil's current account deficit did not meet the requirements of a long-term sustainable path. A study on fiscal policy in 2000 found that while the policy was sustainable before 1980, it was not after that period. This divide in the policy regime was more marked post-1994, that is, after the Real Plan.
The new government that took office in 1990 decreed the blocking of 80 per cent of all government bonds. These were unblocked 17 months later. Capital inflows in 1993-94 sustained public debt by swapping domestic debt against foreign debt leading to dollar denomination of domestic debt. There was a semblance of stability, which created the backdrop for the introduction of the Real Plan. What was the Plan?
Mr Fernando Henrique Cardoso was the Minister of Finance who drafted and implemented the Real Plan in 1994. A new currency called real was created. Along side, there was a Brady Plan to restructure and roll over Brazil's external debt. Together, the two Plans guaranteed pegged exchange rate and high domestic interest rates. The aim was to attract foreign investment and capital flows by removing currency and capital controls. Short-term flows flooded the banking system. Further, the government opened up state-owned enterprises like communications, gas, transportation, petroleum and mining to foreign capital.
Neighbour Argentina was already admired as a poster child and Brazil became a model pupil. Inflation was brought under control and capital flows began to surge and internal debt rose from $60 billion in 1994 to $350 billion in 1998. The advice was that if Brazil could contain prudently its fiscal limits and maintain stable exchange rates in line with global developments, it would continue to have a high rate of growth.
The honeymoon was too short.
The Real Plan was successful in the short-run due to the accumulation of foreign currency that allowed stabilisation of the local currency. However, as one economist put it, "it seems much more plausible that capital inflows to Brazil and other Latin American countries were a result of external environment and not because of economic reforms." Most crucial `external' elements were the US interest rate and the tightening of fiscal policy by the Fed from 1998. Argentina collapsed under the stress and Brazil was not far behind.
A statutory currency board and high dollarisation fettered Argentina. It could not free itself from dollar parity without disastrous balance sheet effects and excessive social costs. Brazil, unlike Argentina, had the option to devalue; but the decision was delayed for months. The delay was linked to the presidential election of October 1998. It was rumoured that Mr Cordoso preferred to have an over-valued real to bolster his chances in the election. Anticipating devaluation after the election, speculators drove real down and the capital flight was estimated at $ 4-5 billion per week. The Central Bank sold dollars in defence and the reserves fell from $70 billion in July 1998 to $26 billion in January 1999. Devaluation of real was delayed until January 1999. The agreement with the IMF was signed in November 1998 and stipulated inter alia that Brasilia should maintain exchange rate stability and avoid imposition of exchange controls.The IMF package was said to be `precautionary' and to differ from the bailouts offered in East Asia. The idea was "to help economically healthy nations" to stave off speculation and prevent contagion spreading to other countries. In Brazil, it triggered speculation rather than containing it. It was estimated that from July 1998 to January 1999, when real was devalued, Brazil witnessed capital flight of US$50 billion. Without the IMF credit, Brazil would have defaulted on its debt.
The compression of domestic demand resulting from reduction in social spending, increased unemployment and declining wages led to economic stagnation. Even those on the right, like Prof Rudi Dornbusch of MIT, doubted the wisdom of the bailout. As he explained, "The maturity of domestic debt is very short and external debt is even shorter — everything is a rollover situation and therefore confidence is totally essential; without confidence Brazil will go the cliff even faster than..." He felt that the maturity of debts must be lengthened and interest burden reduced. Strangely, the IMF arrangement did not address these issues. Even in a meeting of creditors organised by the Fed on January 20, 1999, the view taken was that Brazil's debt levels — both domestic and external — were manageable and there was no need to renegotiate or forgive any part of its debt!
Even in later months, the IMF was not seized of the weaknesses and infirmities. Brazil continued to draw from the Supplemental Reserve Facility (SRF). The third review was undertaken in June 2002. Full certificates were given to Brazil and it was noted that "its performance remained strong and had met all the performance criteria, indicative targets and structural benchmarks". The advice was that the authorities should continue to work to reduce Brazil's external borrowing requirements, especially the public sectors, and reduce the share of public debt contracted at floating rate or was exchange rate related. There was no reference to the adverse conditions created in the region by the crisis in Argentina or to the extreme fragility, which had enveloped the financial markets.
By June 2002, a chorus of economists and journalists began to express concern over the serious crisis developing in Brazil and in the region. The Economist called it `dominoes'. Data supplied by a Brookings Institution document suggested that as on June 2002 the total foreign debt was $176 billion of which $56 billion was public sector and $120 billion held by private sector. The official ratio of external debt to GDP is 41 per cent while the document estimates it at 66 per cent. With the presidential election due in October, it is unavoidable that the debt problem becomes a major issue.
The polity is now more fractured than during the presidential election in October 1998. Opposition parties have gained strength in the intervening years. The pollsters began to give a higher lead to Mr Lula and `fear of Lula' grips the market. The message from Washington is that "Unless Jose Serra is elected, there would be no IMF loan." What happens if the people of Brazil decide otherwise?
The US Congress and administration have been schizophrenic in dealing with the IMF. In 1998 some Congressmen demanded abolition of the Fund and were reluctant to provide funds to deal with the Asian crisis. In the end, though they passed the Omnibus Bill, they also created the Meltzer Commission. The Commission was very critical and took the view that the IMF should not engage in bailouts, but serve as a `quasi-lender of last resort' to emerging countries. It advocated greater involvement of the private sector in bailouts and raised arguments about `moral hazards.' The US Treasury Secretary could say that "wasting American taxpayer money on Latin America was not a brilliant idea".
When Mr Paul O'Neill embarked on his Latin American tour on August 2, there was no expectation that he would offer assistance to any country he was visiting. Between August 2 and 7, which was the last day of his tour, announcements came from the White House and the IMF offering assistance to Uruguay and Brazil. Assistance to Uruguay ($1.5 billion) is initially from the US Exchange Stabilisation Fund to be recouped when the IMF loan is agreed. More than the offer, the size (US$30 billion) surprised many. Financial papers commented upon it as a major reversal of US policy. It may seem so in form; in reality it is not so. It is so crafted that the Brazilian voters become hostages to the IMF. It may turn out to be a gamble in Brazilian politics.
The euphoria, which marked the announcement of the loan on August 7, did not last long. Soon the bond interest rates settled at levels incompatible with long-term solvency. Many analysts feel that the loan arrangement does not address the underlying problems creating financial turmoil.
Prof. Joesph Stiglitz, writing in The New York Times, felt that instead of insisting on the continuance of existing policies, "if they had set a cyclically adjusted target, which would be more flexible" it would have enhanced stability and confidence. The arrangement fails to not create stability and confidence even in the short run.
There is a short-term buffer of $16 billion to take care of the foreign exchange requirements assessed at $14 billion till October 2002. This is skating on thin ice. In the current, regional context, the reserve requirements cannot be precisely estimated.
When uncertainty grips the market, there is no reserve that is sufficient. When the loan was negotiated, there were reports that the IMF insisted that all parties should agree to the loan conditions. Mr Cordoso could not ensure this. Perhaps, it is for this reason that the loan has been divided into two parts. The first part ($6 billion) is to be given immediately and second part ($24 billion) is due for release after the presidential election and subject to the new government agreeing to the conditions.
The agreement is being thrust on a future government without giving it a chance to negotiate the terms. If the assumption is that the new government has no choice, as the other option is to lead Brazil to economic ruin, it amounts to a new form of economic terrorism. Instead of strengthening the hands of Mr Serra, as it seeks to do, it could well drive the people more towards Mr Lula. There are already riots on the streets of Peru, Uruguay, Paraguay, Ecuador, and Bolivia in opposition to globalisation and free-market reforms.
There is anger over the US neglect of Argentina. Unlike in Argentina, the US banks and companies have greater stakes in Brazil. American banks hold about $26 billion outstanding as loans to Brazilian borrowers. Of this, Citicorp is said to have around $10 billion. Investments by American companies are estimated around $30 billion.
The loan arrangement would no doubt ensure repayment of loans and profit remittance for banks and companies. GM and Citicorp are said to have lobbied with the Bush administration.
The Fed bailed out LTCM mainly to safeguard the value of derivatives and thereby the US banking system. The Brazilian and Uruguayan bailouts appear to have similar aims. (It is not surprising that Argentina has also been allowed to draw on the earlier credit lines!) They safeguard broadly the interests of the US banks in Latin America, their holding of Brady bonds, EMBIs, and so on. The relief would be purely temporary. Much depends on the fate of elections in Brazil. Till then, the fear of Lula will loom.
(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.) |
