Brazil's Devaluation Reignites
Global Fear of Spreading Malaise
By PETER FRITSCH and MICHAEL M. PHILLIPS
Staff Reporters of THE WALL STREET JOURNAL
The 18-month-old global financial crisis, which appeared to be in remission just a few weeks ago, re-emerged Wednesday when Brazil devalued its currency.
In confusion that recalled Mexico's messy December 1994 devaluation, Brazilian central banker Gustavo Franco, a hard-line foe of devaluation, quit abruptly. His newly appointed successor, Francisco "Chico" Lopes, immediately allowed Brazil's currency, the real, to fall in value by 8.3% against the U.S. dollar.
Mr. Lopes said his step -- technically, a shift in the "band" tying the real to the dollar -- was "an improvement in policy, not a breakdown of policy." He predicted that the new exchange rate would help end a recession in the world's ninth-largest economy. But many others didn't see it that way. Throughout Latin America, stock prices slid and interest rates rose. The Sao Paulo Stock Exchange's Bovespa Index fell nearly 11% in the first 12 minutes of trading, before ending the day down 5%.
Top International Monetary Fund officials, alerted by Brazilian authorities Tuesday afternoon, were furious that Brazil had devalued without appearing to have a coherent plan for the future. And U.S. Treasury Secretary Robert Rubin issued a statement so lukewarm it seemed almost hostile.
To Guillermo Calvo, a Latin American specialist at the University of Maryland, "the whole system has all of a sudden become more fragile," with Chile, Argentina and the rest of Latin America "more vulnerable to runs" by nervous international investors. After all, when the IMF and the world's wealthy countries forged a $41.5 billion rescue package for Brazil in November, they called it a crucial firewall to keep global financial trouble from spreading.
Brazil's move comes at a moment of renewed edginess in the global economy. Europe is embarking on a historic experiment with an untested central bank and a currency that crosses national boundaries. Japan is struggling to restrain a currency that seems determined to climb and worsen the country's persistent recession. And the collapse of a major Chinese trust company is thrusting the problems of Chinese banks into the limelight.
But the U.S. economy, aside from its important export sector, so far has seemed largely immune to the global troubles. Indeed, the U.S. has enjoyed declining prices for imported goods and lower interest rates because of the turmoil that began in Asia 18 months ago. Four months ago, Chairman Alan Greenspan of the U.S. Federal Reserve warned that the U.S. couldn't forever remain "an oasis of prosperity." Yet neither the economy nor stocks in the U.S. took the hint. The economic expansion is now the longest in peacetime history, and the slowdown some expect has yet to appear.
After a sharp reaction to events in Brazil Wednesday morning, the amazingly resilient U.S. stock market made a comeback. The Dow Jones Industrial Average, off a steep 261.60 points early in the day, closed at 9349.56, down 125.12, or 1.3%. The Nasdaq Composite Index plunged even more steeply, then rallied all the way back to finish with only a tiny loss. U.S. Treasury bonds, not surprisingly, were stronger.
A further deterioration of Latin American economies would pose a threat to the U.S. Brazil is the 11th-largest market for U.S. exports, and it is the biggest economy in a region that accounts for nearly $1 in every $5 of American exports.
Still, the world economy may be better able to withstand trouble in Brazil than it was in August when Russia defaulted on some of its debt and devalued the ruble. Over the past several months, big international banks have reduced their exposure to emerging markets, so there is a limit to how much tighter those countries' credit crunch can get. New Fed data show U.S. banks cut their loans to Brazil by 25% between the end of June and the end of September.
In the past four months, the Fed itself has helped shore up the U.S. economy -- and global financial markets -- with three quarter-point cuts in short-term interest rates, which were followed by rate cuts in Europe and elsewhere. The continued strength of the U.S. economy is a big help to vulnerable economies in Asia and Latin America, which count on American buyers for their products. The rate cuts also have reassured global investors that the world's central bankers recognize that the big risk facing the global economy isn't inflation but a global recession -- and are responding accordingly.
In addition, many developing-country governments and companies have had time to adjust to the idea that they can't borrow abroad nearly as easily as before the July 1997 Thai devaluation, which marked the beginning of the turmoil. South Korea and Thailand, which finally seem to be turning around, "are in better shape to withstand this than they were four months ago or five months ago," said Robert Hormats, vice chairman of Goldman Sachs International. "They won't be immune, but they'll be less adversely affected than they would have been had this occurred last summer."
Even Rudi Dornbusch of the Massachusetts Institute of Technology, who long has warned that Brazil is pursuing an unsustainable economic policy, said Wednesday that a Brazilian collapse wouldn't have nearly the world-wide ripple effects it would have had a few months back. Latin nations would suffer from severe Brazilian troubles, he said, especially if Brazil imposed capital controls that prompted further flight by foreign investors all over the continent. But the IMF-led rescue for Brazil has already worked in one way: It gave the rest of the world time to prepare for Brazil's devaluation.
The U.S. stock market apparently concluded the same thing, rebounding after it digested the initial reports from Brasilia. "I talked to a couple of economists this morning who said the devaluation in Brazil might work," said Michael Murphy, a trader with Kern Capital Management in New York. After the initial plunge, other traders said, bargain hunters moved in to buy stocks. "When it became clear that the market wouldn't be down 500 points, the pool of uninvested money just started to kick in," said Jon Olesky, head of block trading at Morgan Stanley Dean Witter.
Although the timing of Brazil's devaluation was unexpected, that it happened wasn't a surprise to many observers, despite vows by President Fernando Henrique Cardoso to avoid such a step. Private and government analysts have long felt the currency was overvalued. And foreign and domestic investors have been deserting Brazil as it became clear there wasn't a political consensus for fiscal reforms Mr. Cardoso was pressing to cut the budget deficit and lessen pressure on the real. Foreign-exchange reserves fell by $3 billion in December. On Tuesday, Brazil lost $1.2 billion, a pace of outflows not seen since last summer. Traders said yesterday's outflows were even greater.
The two immediate questions raised by Wednesday's developments were whether the devaluation would suffice and to what extent the turmoil would jolt Brazilian politicians into falling in line behind President Cardoso. "It is important," Mr. Rubin warned in his terse statement, "that Brazil carry forward the implementation of a strong, credible economic program."
The Brazilian Congress last month rejected measures to tax retirees and force bureaucrats to contribute more to a bankrupt pension system, and it delayed voting on a 90% increase in Brazil's financial-transaction tax. In addition, the new governor of the province of Minas Gerais, former Brazilian President Itamar Franco, stopped payments on $15 billion in debt owed to the central government.
"A lot will depend on whether the Brazilian Congress passes the measures that it has in front of it," said William Cline, chief economist for the Institute of International Finance, an organization of financial institutions. "If they do, then I would not be terribly surprised to see a considerable easing of pressures on Brazil in the next few days."
President Cardoso argued that the adjustment of the real's trading band against the dollar -- a band that shifts by 7% a year anyway -- was merely "a technical adjustment." Rushing back to the capital from a beach vacation, he told a news conference, "We will continue in our efforts to re-establish conditions for sustainable growth in Brazil." And he reassured investors that Brazil would honor its debt. He also estimated that Congress had approved 70% of his austerity plan. Later Wednesday, a special session of Brazil's Congress approved additional measures that are projected to save the government nearly $1.5 billion a year, a victory for Mr. Cardoso.
When to Devalue?
The central bank's move renews an international debate over the appropriate exchange-rate strategy for a country in Brazil's position. The former central banker, Mr. Franco, a 42-year-old technocrat trained at Harvard (and no relation to the governor who has stopped debt payments), had warned that devaluation would be a mistake, even though supporting the real required economically punishing interest rates. "The prescription of devaluation always comes with a dose of inflation that isn't supposed to hurt," Mr. Franco said in an interview in December. "But here, that's like telling an alcoholic that a couple of drinks are OK." Earlier in this decade, inflation in Brazil was above 2,000% a year; now it's near zero.
The central banker had become a favorite target of Brazil's business establishment, which has been chafing under high interest rates in a deflationary environment. They are particularly painful for Brazilians because interest rates fluctuate on two-thirds of the country's $225 billion in domestic, local-currency debt. People familiar with Mr. Franco's thinking say he had grown tired of defending an unpopular exchange-rate system while others in the government dithered in delivering the belt-tightening policies needed to make that system work.
The new central banker, Mr. Lopes, 53, also a Harvard-educated economist, has been a quiet advocate of allowing the real to trade more freely. For nearly a year, the central bank has tried to keep the real trading at between 1.12 and 1.22 to the dollar, and it was due for its annual adjustment. Mr. Lopes did more than tinker with the band Wednesday, setting a new range at between 1.20 and 1.32. The currency quickly moved to the outer edge of the band: 1.32 to the dollar, compared with Tuesday's close of 1.21.
Mr. Lopes said he plans to allow only about 3% further devaluation this year, and insisted he wasn't moving toward a floating exchange rate. Unlike some other governments that have devalued, Brazil still has, according to Mr. Lopes, about $45 billion in reserves to back its currency. In addition, if the IMF goes along, it has $30 billion or so in undrawn loans from the November rescue package.
IMF Stance
IMF Managing Director Michel Camdessus issued a statement welcoming Brazil's assurances that it would "put in place ... in the shortest possible time, the full fiscal-adjustment program" announced in November. He said the IMF "will be analyzing and discussing" the latest developments with Brazilian officials in coming days.
Both inside and outside Brazil, there was substantial skepticism Wednesday that Mr. Lopes could hold the exchange rate where it is now. "If they think that throwing the dogs a bone of a 9% devaluation will make them go home, it won't," said another former Brazilian central bank president, Francisco Gros, now an executive with Morgan Stanley Dean Witter & Co.
Another investment executive, David Wheeler of Bear, Stearns & Co. in Sao Paulo, said, "If the international markets say, 'This is not credible. We don't believe it,' and if the billion-dollar outflows continue, it's a very negative situation."
MIT's Mr. Dornbusch predicted that the devaluation was just a taste of what's to come. "This is just the opening shot, and the currency will go a lot further," he said. "At a minimum, they'll have to restructure their debts."
The decline in the value of the real should tend to make Brazilian exports more attractive in the U.S. and elsewhere, helping to reduce Brazil's trade deficit and the amount of foreign money it needs to attract. At least, that's what economic textbooks suggest. But if investor anxiety and the central bank's determination to stop the currency from falling further means that high interest rates persist, Brazilian businesses and consumers will suffer.
When the government boosted overnight interest rates to 35% last year to attract buyers for government debt, interest rates throughout the economy rose. Consumers had to buy 6% a month on bank loans and 10% on credit cards. Auto sales sank 27% last year, forcing Ford Motor Co. to lay off nearly half its 6,000 Brazilian workers before Christmas.
The Debt Situation
Already, there are signs of resistance to the new austerity. Workers at the Rio de Janeiro telephone company, Telerj, plan to stage a 24-hour strike Thursday to protest the company's plan to freeze wages and reduce benefits, a union official said. Brazil's Treasury is extremely vulnerable if a loss of investor confidence keeps interest rates high or scares away investors altogether. It needs to roll over about $9 billion of domestic debt this month, $12 billion next month and $15.4 billion in March. Of course, the decline in the value of the real makes Brazil's external debt burden still heavier.
The country currently has about $230.5 billion in external obligations, of which $145 billion is owed by the private sector. Of the total, only about $30 billion matures in the next few months, suggesting that Brazil doesn't face the same sort of crisis Mexico encountered in late 1994 when it couldn't roll over short-term debt and ran out of reserves.
If the devaluation ends up sparking a revival of inflation in Brazil, newly re-elected President Cardoso, who is closely identified with the successful campaign against inflation, could lose popular support. Stable prices have helped improve the situation of the working poor, even though the country is now in a painful recession. Ivanilda Santos, a 27-year-old housekeeper in Sao Paulo, shook her head when confronted with the prospect that prices could begin to rise faster than wages -- again. "I knew it couldn't last," she said.
Outside of Latin America, the concern Wednesday was that the turmoil in Brasilia would provoke another round of anxiety about investments in all emerging markets and in highflying investments of all sorts. George Magnus, who monitors Asia from London for Warburg Dillon Read, suggested recently that Brazil could damp the rally in Asian stocks. "What worries me is that the bullish euphoria we've seen recently will eventually give way, and it doesn't take much for that to happen... . It could be a weak dollar, it could be Brazil, it could be anything," he said.
--Jonathan Friedland and Laurie Lande contributed to this article
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