AWSJ: Brazil Government Still Faces
Struggle For Credibility
By MATT MOFFETT and PETER FRITSCH
Dow Jones Newswires
Staff Reporters
SAO PAULO, Brazil - Brazil's move on Friday to freely float its currency,
a prospect that investors had been dreading for months, was surprisingly
well accepted on markets both here and abroad.
But Brazil's government still faces a desperate struggle to win credibility for
the new currency policy from skeptics in its own political system and the
international financial community.
The decision to float the Brazilian currency, the real, came just two days
after the central bank had tried, unsuccessfully, to engineer a limited 8%
devaluation. In the wake of that first de facto devaluation on Wednesday,
markets had still considered the real to be overvalued, and the flow of
dollars leaving the country had only accelerated. So on Friday morning, the
central bank announced that it would no longer prop up the real, which
closed a hectic day of trading by falling to 1.47 reals from 1.32 reals to the
dollar.
Meanwhile, the Sao Paulo stock market surged 33% Friday, as investors
snapped up equities that had been hammered in recent days. Dollar
outflows, which had exceeded $1 billion during each of the three previous
days, dropped off to just $329 million on Friday.
The initial market reaction to the float was "extraordinarily positive," said
Francisco Gros, a former Brazilian central bank president who is now an
executive with Morgan Stanley Dean Witter.
Brazilian Central Bank President Francisco Lopes, who took office only
last Wednesday, said Brazil would announce a new exchange-rate policy
today. If the central bank elects to continue with a floating exchange rate,
as many analysts think it will, Brazil has a number of inherent economic
strengths that could make the transition less traumatic than it was for other
countries, such as Mexico, that undertook similar policy shifts. But, says
Edmar Bacha, chief executive officer of the Brazilian investment concern
BBA Securities, "There are two critical things the government must do
now: Get the support of the IMF and the G-7. And get the Brazilian
Congress to support legislation to reduce the deficit."
To attain that first goal, Finance Minister Pedro Malan and Mr. Lopes held
talks in Washington over the weekend with U.S. Treasury officials and
International Monetary Fund chief Michel Camdessus. Though the real had
lost 21% of its value in the course of last week, Mr. Malan, on arriving in
the U.S., hailed Friday's market reaction to the float of the real as a
victory. "The market set the value (of the real), and it was a stronger level
than some people had expected," he said. IMF officials, who initially were
furious about what appeared to be an improvised devaluation on
Wednesday, called the float "a wise move to stop the loss of reserves."
Infinitely more complicated for the Brazilian policy makers will be the
process of gaining political support at home for the budget-cutting
measures that are needed to make the looser currency policy viable. A key
test occurs Tuesday, when lawmakers are scheduled to vote again on a
controversial move to cut civil-service pensions and pay for both active
workers and retirees. The proposal has been rejected by the Brazilian
Congress numerous times, most recently in December. That defeat
unleashed the wave of nervousness that snowballed into the current crisis.
Meanwhile, at the same time as he tries to ride herd on an obstinate
Congress, President Fernando Henrique Cardoso must also contend with a
group of renegade state governors who are threatening to default on debts
to the federal government.
"None of these shifts in the exchange rate modify the fact that the
government's most important mission is to proceed with its fiscal
adjustment, despite political opposition," said Jose Alexandre Sheinkman,
a Brazilian who teaches economics at the University of Chicago.
Although not panicking, Brazilians have turned cautious until it becomes
clear how the fast-changing turn of events will affect them. Retailers
reported sharp declines in sales in the first days after the devaluation as
consumers closed their pocketbooks in anticipation of hard times. Brazilian
tourists, who've used the strong real to launch an international traveling
binge, returned home in recent days to the unpleasant discovery that the
credit-card purchases they had made abroad will now cost 21% more
because of the devaluation.
The devaluation opens a highly uncertain new era in the history of the real
plan, which reduced inflation to 1.5% last year from 2,700% in 1993. Up
to now, the anchor of the plan has been a rock-solid real supported by the
highest interest rates in the world. The dependence on the strong currency
had originally been planned as a transitional device until the country could
resolve its chronic budget imbalances and anchor the plan in fiscal policy.
But pressure from currency speculators and the toll the scorching interest
rates exacted on the country's businesses and consumers finally forced
Brazil to devalue with the fiscal adjustment still incomplete.
On the surface, there are several parallels between the crisis that forced
Brazil to float its currency and the 1994 Mexican peso meltdown. In both
countries, the devaluations occurred shortly after the start of new
presidential terms. And both Mexican President Ernesto Zedillo and his
Brazilian counterpart, Mr. Cardoso, had seen their inner policy-making
circles thinned by the deaths or resignations of key advisers. Finally, just as
it was unrest in the provinces - specifically, guerrilla activity in the state of
Chiapas - that sparked the final run on the Mexican peso, it was the
economic rebellion of the provincial governors that triggered Brazil's
devaluation.
But Brazil is embarking upon its new currency policy with many important
advantages that Mexico didn't have. First, unlike Mexico, which devalued
when it was broke, Brazil still has a cache of close to $40 billion in
hard-currency reserves, along with potentially another $30 billion in
undrawn loans from the IMF.
While the devaluation in the then vigorous Mexican economy helped ignite
an almost immediate surge in inflation, Brazil devalued during a recession,
which will make it harder for wage or price increases to take hold. For
instance, auto workers at Volkswagen AG's Brazilian unit recently
accepted for the first time reduced hours and wages in return for job
security - a model now being pushed by unions at other auto makers.
Moreover, Brazil has largely dismantled the complicated system of indexing
wages and prices that used to make any devaluation spread like wildfire
through the rest of its economy. "In the old days, if you had a 25%
devaluation, the price of your haircut would go up 25% the same day,"
says Mr. Gros of Morgan Stanley Dean Witter. "Today, people will simply
stop cutting their hair."
As imports make up a relatively small component of the Brazilian economy,
7.5%, the higher cost of goods bought abroad shouldn't cause tremendous
ripples. Even the seasonal timing seems to be favorable: Food prices tend
to be most stable at the beginning of the year as Brazil's harvest is just
completed.
Daniel Dantas, president of the Opportunity SA fund management firm in
Rio de Janeiro, equates Brazil's current devaluation with the relatively
painless one that the U.K. carried out in 1992. The British economy
quickly bounced back.
Victory celebrations are premature, however. Analysts are concerned that
Brazil's Congress will delay the fiscal reforms, which will provoke a new
round of speculation against the currency. And if the real falls significantly
further, that's likely to begin filtering into the Main Street economy,
reigniting inflation.
On Friday, U.S. Treasury Secretary Robert Rubin said the key to solving
the currency problem ultimately rested with the Brazilian government's
ability to balance its books. "Whatever judgment one makes on
exchange-rate regimes and the rest, it always comes back to the same thing
- having sound policies at home," he said.
The devaluation also will make it harder for Brazil to pay back the dollar
debts its government and private sector have taken on in recent years. And
Brazil will doubtless be looking at an even deeper recession than had been
projected before the devaluation. Citibank estimates that the country will
experience a 5% contraction this year.
Still, multinational corporations, which have invested about $36 bilion since
Mr. Cardoso took office, certainly don't seem to be disheartened by last
week's currency fall. Indeed, on Friday a consortium consisting of the
U.K.'s National Grid, Sprint of the U.S. and France Telecom SA agreed
to pay nearly $40 million for a concession to provide long-distance
telephone service here. The group will compete directly with former federal
long-distance carrier Embratel, bought last year by the U.S.'s MCI
International. The government also awarded a license to a consortium led
by Bell Canada and WLL International Inc. to provide wireline services to
16 Brazilian states. The new company said it plans to invest $1 billion in
developing wireline telecommunications in its service area.
Though it took Brazil only two days to go from an exchange-rate policy in
which the real was linked to the dollar to one in which it was freely floating,
a debate about the exchange rate had been roiling the Cabinet for months.
Sensing that he was losing ground to those in favor of those favoring
devaluation, the main advocate of the fixed exchange rate, former central
bank Gov. Gustavo Franco, submitted his resignation in late November.
Mr. Cardoso refused to accept the resignation, citing Mr. Franco's
importance to the administration.
An impatient Mr. Lopes, who by now was lobbying for Mr. Franco's job,
decided that his entreaties weren't being heard and considered resignation
himself in late December. Increasingly convinced that crushing interest rates
and rising unemployment called for a change in direction, Mr. Cardoso
called Mr. Lopes to his office on Jan. 7. The president asked him whether
he would be prepared to defend a more-flexible exchange-rate policy as
the central bank's president. Mr. Lopes said he would. Mr. Cardoso then
broke the news to Mr. Franco.
Mr. Franco had originally planned to stay on for another week, but rumors
of his ouster had begun to leak, accelerating the outflow of dollars. The
government was forced to switch to Mr. Lopes and his unsuccessful plan
for a controlled devaluation on Wednesday.
Central bank spokeswoman Silvia Faria said the decision not to intervene
in the foreign-exchange market was taken late Thursday and the final
go-ahead given early Friday morning. She said that Messrs. Malan and
Lopes and Amaury Bier, economic policy director at the Finance Ministry,
met Thursday night to evaluate the effects of the shift in foreign-exchange
policy announced Wednesday.
"They expressed great concern at the $1.79 billion foreign-reserve outflow
that occurred Thursday and came to the conclusion that there were only
two alternatives: a massive increase in interest rates or letting the
foreign-exchange market float," Ms. Faria told reporters at an informal
briefing.
She said Mr. Malan then phoned Mr. Cardoso. "The president decided the
best way out would be to let the exchange rate float," she said. Mr. Malan
then immediately informed IMF First Deputy Managing Director Stanley
Fischer of the decision, she added.
According to Ms. Faria, early Friday morning Messrs. Malan, Lopes and
Bier met again at the central bank head office in Brasilia to monitor the first
market movements for the day. "After quickly noticing a similar trend, they
called the president again, and he advised that the central bank should stay
out of the market for the day," she said.
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