Hi Tom................
Brazil Close to Financial Meltdown
Another IMF success story
Brazil is showing the early signs of financial meltdown. What began as an attempt at a controlled devaluation is turning into a panic. Last Friday, Brazilians queued outside banks to withdraw their savings amid rumours that the government was about to freeze bank accounts. Interest rates have been raised to 39 per cent to steady the Real, which has lost almost 50 per cent of its value since the currency was allowed to float on January 13.
In the past few days, Pedro Malan, finance minister, has offered to resign, while the central bank has been given its third president in less than a month. An International Monetary Fund mission is in Brasília this week, renegotiating the terms of last year's $41.5bn emergency support package. But Stanley Fischer, the IMF's first deputy managing director, was returning to Washington last night without any sign that Brazil and the Fund were close to an agreement. There is growing scepticism that Brazil can deliver on fiscal reforms agreed with the IMF last October.
With confidence slipping fast, even George Soros, the international speculator, felt he had to lend a helping hand to Armínio Fraga, Brazil's new central bank chief and the former managing director at Soros Fund Management.
Mr Soros told the world economic summit at Davos in Switzerland that the Real was "clearly undervalued". "Brazil is in a very acute situation because on Friday you effectively had the beginning of a run on the banks and a run on the currency," Mr Soros said. He did not think the Brazilian government had much time to sort things out.
How did Brazil begin to unravel?
The government is finding it much harder to service its $94.7bn gross external debt at a time when it is all but cut off from international capital markets. Private sector companies are in much better shape, but their external debt has more than doubled in the last two years to $119bn at the end of 1998.
More worrying is the government's R$320bn domestic debt, owed mainly to Brazilian banks and other financial institutions. The recent currency depreciation has increased the stock of the debt, because about R$60bn is linked to the value of the dollar. About half of this debt falls due this year. Already there are doubts about whether investors will agree to roll it over.
The increase in interest rates - from 29 per cent to 39 per cent - will also increase the cost of debt servicing. One UK economist estimates each percentage point increase in interestrates increases debt service payments by R$2.5bn a year. When Brazil was negotiating its emergency aid package with the IMF, the government's interest bill this year was estimated at 7 per cent of gross domestic product. But following the devaluation, and with interest rates at 39 per cent, the interest bill is likely to be closer to 17 per cent of GDP.
Felipe Garcia, an analyst with Idea, a New York-based consultancy, says that some government creditors could eventually conclude that the interest rates or yield - no matter how high - would not compensate the risk of holding government paper.
"We have already reached the stage where it has become more difficult to place government debt. The fear is that at a further stage these investors will start dumping paper," he said. "Even if only 10 per cent of creditors were to sell, it could trigger a rescheduling."
So what are the government's options? Broadly, it has three: default, followed by renegotiation of debt; to slash public spending to compensate for higher interest payments; and to reduce the real value of domestic debt by inflation. All are unenviable, to put it mildly.
Duff & Phelps, an international credit rating agency, believes that the country has a one in three chance of defaulting on its domestic debt.
But default, as Russia is finding out, has consequences so devastating that the government will try hard to avoid it. For one thing, a domestic debt default would be a severe blow to Brazil's banking system. Holdings of government paper account for between 20 and 30 per cent of the banking system's assets. Even a 10 per cent fall in the value of this paper would be enough to wipe out the entire sector's profits last year.
Worse still, at time when high interest rates and economic contraction are increasing the number of bad loans, default could force some smaller banks into insolvency. "There would definitely be a banking crisis," predicts Lacey Gallagher, director of Latin America sovereign ratings at Standard & Poor's, the credit rating agency. "The only way to prevent banks becoming insolvent would be to freeze their liabilities (such as bank deposits) as well."
Default, however, is not inevitable. The government could try further budget stringency.
There is a chance that the government could stabilise its currency, halt the steady outflow of dollars and reduce interest rates. Indeed, last week's panic began to ease when Fernando Henrique Cardoso, president, made it clear he had no intention of hijacking the savings of his compatriots. The Real has appreciated by about 10 per cent against the dollar since Friday. For stability to be restored the government would need to convince investors, banks and the IMF that it is making serious progress in reducing its fiscal deficit, now equal to 9 per cent of gross domestic product.
Making cuts of this magnitude is politically controversial. Congress has already approved new taxes and bigger pension fund contributions from civil servants that are expected to produce R$28bn in savings. But with interest rates so high, the government is running to stay in the same place. The fiscal savings have already been eroded by its increased debt servicing costs.
That leaves option three: risking a bout of inflation to reduce the real value of domestic debt. In Brazil it is heretical to admit that there can be any positive impact.
Mr Fraga, the new central bank governor, says that for a country like Brazil, a little bit of inflation is like giving a drink to a recovering alcoholic.
Paulo Paiva, budget minister, adds: "We would far prefer to cut costs than rely on the help of inflation to create fiscal equilibrium."
The harsh reality, however, is that inflation could help.
Brazil's history of high inflation, and the failure of the authorities to manage inflationary expectations in the past, means that many businesses are already beginning to prepare for a new wave of price rises. Private sector forecasters are already expecting price rises of at least 10 per cent and many acknowledge that the rate could be much higher.
Inflation could ease Brazil's debt problems. Even if nominal interest rates remain at current levels, price increases of even 10 per cent a year would reduce real rates and the burden of both existing debt and interest payments.
In additional, while inflation will increase government revenues, many of its expenses are fixed in nominal terms, which should help in further reducing the fiscal deficit and reduce financing requirements.
However, a rise in inflation would hit Brazil's wage earners and make the government unpopular. But even modest levels of inflation would be hugely controversial in Brazil.
Furthermore, price increases would bring back to spectre of indexation. President Cardoso scrapped the system five years ago, but if prices were to rise again, the government would come under enormous pressure from the trades unions to reintroduce it.
"A moderate level of inflation would help them address the domestic debt problem with much less political fall-out than an outright default," says Ms Gallagher. "But a return to indexation would be extremely damaging. Given Brazil's history with inflation it is a delicate balance. They are facing some really tough choices."
The Financial Times, Feb. 5, 1999 |
