BRAZIL
PRESIDENTIAL OPTIONS: Reality bites
Geoff Dyer and Stephen Fidler explain what went wrong in Brazil and outline the president's options now
The whole economic strategy of the world's ninth-largest economy collapsed this week under the weight of its internal contradictions.
President Fernando Henrique Cardoso of Brazil allowed his country's currency to float yesterday after giving up on a controlled devaluation. The Real has lost almost 20 per cent of its value in a week, and Brazil no longer has the anchor that delivered growth with low inflation for the past 4½ years.
It is hard to exaggerate the political and economic risks it now faces. Only draconian budget cuts and perhaps high interest rates are likely to stabilise the currency. A recession is inevitable, deepening grotesque social inequalities. Worse still, inflation could return to destroy Mr Cardoso's credibility at the start of his second term as president.
Latin America's growth this year is also jeopardised. Contagion effects in Asia cannot be ruled out.
Brazilian investors, however, have responded to the flotation in a surprisingly upbeat fashion. Stock and bond prices soared on the news that the currency had been allowed to float and the Real stabilised at $1.43 to the dollar.
This was partly the result of relief that the government had not spent any more of its reserves, now below $40bn, in defending the indefensible - that is, the wider currency band set on Wednesday.
But some analysts argued the weaker Real was good news for exporters. And now that the government is no longer committed to fighting off speculators, many were hoping Brazil's punitive interest rates would be allowed to fall. "If they can get the currency to stick at around R$1.50, the effect could even be positive for the economy," said one economist in Rio de Janeiro.
Only 18 months ago, Brazil was celebrating unprecedented economic success. Inflation, which reached an annual 2,000 per cent earlier in the decade, had been brought under control. A massive privatisation programme was attracting swathes of foreign investment and productivity was rising sharply. Brazil, once a laughing stock in financial markets, was standing tall.
The policy, called the Real plan, used a strong currency, which depreciated gradually against the dollar, to stifle inflation.
But public spending cuts, which the government knew were central to the plan's sustainability, did not happen. On the contrary, the fiscal deficit grew to 8 per cent of gross domestic product. So did Brazil's public sector debt.
The situation was sustainable only as long as international financial markets were awash with liquidity which they were happy to channel to Brazil.
At every new wave of the crisis in emerging markets - with the October 1997 attack on the Hong Kong peg and the Russian default last August - Mr Cardoso's options narrowed. Interest rates were ratcheted up to stem capital flight, worsening the budget deficit. Investors grew more nervous.
The government hoped that fiscal cuts announced after October's elections, together with a $41.5bn bail-out led by the International Monetary Fund in November, would take pressure off the currency.
But reserves continue to fall as the approval of the budget cuts in Congress slipped. Then, on January 6, Itamar Franco, a former president and newly appointed governor of Minas Gerais, announced the state would not repay its debts to Brasilia. It was the final straw.
The decision to try a modest devaluation and then be forced into a float has uncomfortable parallels with the Mexican financial crisis in 1994.
Concern about how far the Mexican peso would fall was intensified by worries about the government's ability to repay its short-term dollar-linked debts. The crisis gathered momentum as the extent to which the banking system had been shattered became clear.
In Brazil, one important difference is that the government has not allowed foreign exchange reserves to fall to zero. It has some $40bn at its disposal and has, unlike Mexico, an active programme with the IMF.
On the face of it, too, Brazil's short-term government debt linked to the dollar is modest and the banking system appears in better shape - though there is always room for surprises, which in a financial crisis tend to be nasty ones.
This should give the Brazilian government more flexibility in choosing its policy options now. They are:
Float the currency - the Mexican option. This was taken by Mexico because it had no choice: without reserves it could not defend any level of the exchange rate. But flexible exchange rates entail higher currency risks and this is reflected in the higher interest rates that increase the costs to the economy.
Re-peg the currency. The main problem here is that the credibility of a new pegged rate would suffer from the same problems of the old, namely a large fiscal deficit. A temptation may be to stem capital outflows through capital controls, an option the IMF and US Treasury are likely to be eager to avoid.
Lock the currency to the dollar using a currency board. This option would encounter significant political opposition on nationalist grounds. It would also restrain the ability of the government to offer support to problem banks or to create money to repay government debt. This could generate internal debt problems in Brazil. A restructuring of the government's short-term debt to stretch out its maturity would also be necessary, and indeed may be desirable even if the government chooses another currency option.
All the alternatives sound painful but at least there are reasons for not expecting a total meltdown in Brazil. The corporate sector, which has lived through a number of crises in recent decades, has much lower debt levels than was the case in Asia, either in dollars or in domestic currency.
The public sector's debt is another matter. No one is suggesting Brazil is running into trouble on its foreign obligations, as only about 20 per cent of the R$300bn total is linked to the dollar. But the burden of servicing the domestic portion of the debt rose dramatically when the government raised interest rates to defend the Real last year. If interest rates must be kept high to prop up the Real, the government may not be able to continue servicing its debt oblig-ations.
The resurgence of inflation is another important risk. The further the currency falls, the bigger the increase in import prices. Moreover, although the inflationary surge from a 20 per cent devaluation in an already shrinking economy should not be huge, the government has always been afraid that the indexation mechanisms that made inflation bearable in the past, but made it harder to eradicate, would quickly return at the first sign of rising prices.
Fortunately, the government has got rid of some of the other institutional mechanisms that perpetuated inflation, such as the public sector state banks, which acted as an unofficial money supply for profligate governors. "Inflation will come back, but it will be not nearly as bad as it was in the past," says John Welch, economist at Paribas in New York.
Perhaps the biggest risk is on the political front. In the short term, the devaluation might scare members of Congress into supporting budget cuts. However, Mr Cardoso, who was elected twice because of his success in taming inflation, will find his popularity plummeting if prices rise. "If there is no impact on inflation, the devaluation will be just a bit of bad economic news," said Murillo de Aragão, a political analyst in Brasilia. "However if prices jump, Cardoso will be severely damaged."
The devaluation could unwind the political consensus Mr Cardoso had built up behind his anti-inflation strategy, further undermining support for the budgetary reforms.
Rather than dividing into left and right, Brazilian politics has historically been split between those in favour of "stability" (low inflation), and those who pushed for "development" (big spending, short-term growth). The great political success of the Real plan was its ability to knit together these two factions in the belief that sustainable growth could come only from stability.
The recession revived this old debate and now, with the devaluation, the gloves are off. "It will be war now between the two camps," said Riordan Roett, professor of Latin American Studies at the Johns Hopkins School of Advanced International Studies in Washington. "It could undermine the whole generation of reformers behind Cardoso."
With these risks preying on investors' minds, Brazil has no choice but to plough ahead with its fiscal reforms. Only progress on cutting the budget deficit will alleviate concerns about a domestic debt explosion, inflationary pressures resulting from further currency weakness, and political fragility.
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