very pessimistic thestreet.com article. Brazil's Road to Ruin
Excerpt: "Molano expects the real to sink to 3.0 to the dollar and then recover to around 2.5 in the coming weeks."
thestreet.com
By Peter Eavis
Senior Writer
1/21/99 2:02 PM ET
Can Brazil's president hold off a debt default and
rampant inflation?
With hundreds of millions of dollars still leaving the
country each day, President Fernando Henrique
Cardoso is doing his utmost to calm nerves: "The
population can remain calm," he said Monday.
"There's no reason to get ahead of ourselves."
But it's hard to have faith in the much-weakened
leader. The crisis is progressing too fast on too
many fronts. He's fast losing control of events.
Yes, the government had something of a victory last
night when the lower house of Congress approved
measures designed to reduce social security
spending. But these are but a small part of the
program that aims to slash the country's huge
budget deficit.
What's more, another $400 million left the country
Wednesday, taking the total for the week to a scary
$1.1 billion. And both the stock market and the real
weakened sharply this morning.
Brazilians are still running for the exits. This is the
chain of events they rightly fear.
First, the government's attempts to reduce the fiscal
deficit will most likely fail. In that event, the market
will penalize the now free-floating real. For a while,
Cardoso's lieutenants, including the new central
bank governor, Francisco Lopes, will keep interest
rates punitively high to shore up the currency. This
will prove politically and economically
unsustainable, as interest costs add to the fiscal
deficit and deepen the recession.
In the end, Cardoso will have to call an end to the
sweat-it-out strategy. With the inevitable easing of
monetary policy, the real will most likely plunge. If
that happens, inflation will flare up and the
government will forcibly restructure (i.e., "default
on") its 310 billion reals ($188 billion) of domestic
debt.
"Right now, it seems the government is acting
timidly, and the return of inflation is a distinct
possibility," says Sebastian Edwards, professor of
international business economics at UCLA.
"Interest rates have not been increased sufficiently,
and, on the fiscal side, we haven't seen enough
action."
Walter Molano, economist at BCP Securities,
goes further. "I think 40% inflation for 1999 is an
optimistic number," he says. "I'm 95% positive that
a domestic debt restructuring will happen."
All Change at the Top
Despite the semblance of calm that has come over
the Brazilian markets, this has all the elements of
crisis.
First, the exchange-rate regime change was clearly
unplanned -- just like Mexico's in 1994. The IMF
apparently didn't have a hand in it, and the
government did not accompany the abrupt change
with a range of supportive economic policies. This
implies that it probably arose from a sudden spat
between Gustavo Franco, the former central bank
governor who resigned last week, and Cardoso.
If this was the case, then it reflects that Cardoso
may have been forced (or has even chosen) to now
recognize the complaints of the renegade forces in
Brazilian politics, like the state governors currently
threatening to default on their debts to the federal
government. "President Cardoso seemed to make
the initial decision [to enact the de facto devaluation
on Jan. 13] after meeting with governors who
demanded a cut in rates," says Jose Gonzales,
Latin America equity strategist at Credit Lyonnais
Securities.
Lopes' does not have much of a chance of
maintaining a tight monetary policy to see off
inflation. Yes, he has quickly hiked rates to an
annualized 41% from 29%. But if Gonzales'
analysis is right, then it can only be a matter of
time before the governors -- not to mention other
anti-reform groupings -- turn the screw on Cardoso.
UCLA's Edwards believes that Cardoso is in deep
trouble if he does not see off the debt moratorium
threat by Itamar Franco, the governor of the state of
Minas Gerais. "Cardoso is not broken, but he's in a
serious stalemate with Itamar Franco," he says.
"Whoever blinks first will see their political career
finished."
The Numbers Don't Add Up
In the unlikely event that Cardoso firmly backs the
reformers and slays the dinosaurs, there's still the
question of whether it's possible for even the most
committed president and economic team to tackle
the budget deficit. The fiscal savings package
forged with the IMF last year called for an overall
budget deficit equivalent to 4.7% of GDP this year.
That target will be missed by miles. Here's why.
If Brazil keeps interest rates high, then the deficit
gets worse, as some 70% of the domestic debt is
floating-rate. If it lets rates come down and the
currency slips, then the cost of servicing the
dollar-indexed debt, which accounts for 20% of the
total, soars.
Adding pressure on Cardoso is the unavoidable
squeeze on tax revenues that will occur under a
sharp recession. The IMF package assumes a
recession of minus 1% of GDP this year. But Latin
America economists are predicting the Brazilian
economy will slump by between 5% and 8% this
year.
And the financial-transactions tax hike will almost
certainly not be implemented until July at the
earliest. As a result, it will raise only a fraction of
the hoped-for 7.3 billion reals, an amount which
represents a sizable 25% of the fiscal savings the
government aims to close this year.
Some pundits are saying that because the forces of
deflation are so strong in Brazil, there's little chance
that inflation can surge.
But some Brazilian firms are already upping prices.
Molano estimates that for every 10% decline in the
currency, the Brazilian inflation rate accelerates by
an extra 5%. The real has already slipped over 30%
since Jan. 12. Molano expects the real to sink to
3.0 to the dollar and then recover to around 2.5 in
the coming weeks.
Any Way Out
So what could save Brazil from meltdown?
Some might argue that more aid from the IMF will
buy time. Brazil has only drawn down around $9
billion from the $41 billion IMF credit line. But
relations have cooled markedly with the Fund,
which is thought to be more intent on protecting
other Latin American countries than salvaging Brazil
at this point. Even publicly they're playing it tough.
An IMF spokesman says: "The likelihood of [IMF]
board approval of a further disbursement is not too
great if key fiscal measures are not approved." He
declined to say which measures are deemed "key."
Maybe, Cardoso's team, Congress and the
rebellious governors will all realize just how nasty
the consequences of high inflation and a debt
default could be. If prices rise more than 50% this
year, the Brazilians could return to the practice of
indexing prices and wages, a fatal move that
essentially institutionalizes inflation.
Cardoso must know that if inflation returns, he's a
dead duck. His two election victories have been
based on his record of instituting price stability.
"The government can't let inflation take off with this
backdrop of unemployment and recession," argues
Walter Stoeppelwerth, an analyst with Flemings in
Sao Paulo.
Plus, if Cardoso's team decides to restructure its
domestic government debt, the banks are in trouble,
since they hold huge amounts of government paper.
Any restructuring would mean the banks earning a
lot less interest on those positions, which would
impair their income statements and reduce their
lending capacity.
And weaker banks would add another nasty twist to
the imbroglio. "One reason the Brazilian market
isn't already down 50% is that the financial system
is relatively solid," says Lisa Riley, a Latin banks
analyst at Lehman Brothers.
As the debt problem illustrates, Cardoso has run
out of easy options. He can't default, but in many
ways he has to. He can't lower rates, but he can't
keep them this high. Something has to give.
The only hope may be that, as the crisis reaches
its peak, Cardoso, Congress and the people work
as one on a far-reaching reform effort. This is, after
all, what happened in Argentina in 1990 and 1991,
and that country has weathered many storms
since. That, regrettably, is the only ray of hope. |
