Is Brazil’s economy coming back to life?
Sweetwood, Diane M
For the past three decades, Brazil has been pummeled with financial difficulty. Brazil’s economy experienced Incredible inflation rates up to 3000%, causing the nation to fan Into enormous foreign debt This manuscript examines the causes of the Brazilian financial crisis, including the monetization of the public sector’s fiscal deficit, and both fiscal and Balance of Payment weaknesses. The Real Plan Is illustrated as the successful stabilization program to end inflation, along with the intervention of the IMF. These attempts have enabled Brazil to set up policies to control Inflation, thus encouraging employment and economic growth. Ultimately, these policies are making Brazil’s financial future a path of recovery rather than a continued path of destruction.
Brazil, a third world country, is the world’s fifth largest nation in physical size, and has the ninth largest economy. It seems more like a continent than a country and occupies nearly half the land mass of South America. It is known for being the world’s largest tropical country, being the only Portuguese-Speaking Latin American country, one of the world’s largest exporters of agricultural products, and also for its incredibly high interest rates.
Surprisingly, Brazil has experienced one of the highest growth rates among capitalist economies in the 1900’s, particularly between the early 1950’s through the mid 1990’s, despite a crisis that lasted most of the 1980’s and early 90’s. The yearly GDP growth rates have averaged 7.15% in the fifties, 6.12% in the sixties, 8.84% in the seventies, 2.93% in the eighties, and 1.6% from 1990-1995. In comparison, the United States has averaged a 3% growth rate from 1960-1992. (Randall, 1999).
The main cause for this incredible growth was industry and prevailing technology. Most of the industrial growth occurred in the area of transport equipment, pharmaceuticals, tobacco, printing and publishing, chemicals, beverages and rubber. The yearly average growth rate for the industrial sector over the past 40 years is 8.5%. The automobile industry was also a significant contributor to the nation’s growth. This occurred primarily during the chaos of inflation and was aided by tax breaks, ending of banned imports, and the re-launching of the Volkswagen Beetle. Brazil’s automobile industry overtook Italy and Mexico in 1993 to become the tenth largest producer of cars in the world. (Library of Congress, 1997).
Brazil’s major trading partners are the United States, Germany, Switzerland, Japan, the United Kingdom, France, Argentina, Mexico, and Canada. Despite its vast resources, uncharacteristic growth and technological advancements, Brazil’s economy still struggles. It entered a recession in 1989 and experienced exponential inflation rates that grew as high as 3000%. With so many positives on its side, how did Brazil’s economy sink so low? The following sections will discuss the causes of Brazil’s incredible financial crisis, the policies that helped to stabilize the economy, the current financial situation in Brazil, and its link to the United States.
In the 1980’s, Brazilians were convinced that the enormous foreign debt was at the heart of their economic difficulties. However, ten years later other nations who were in the same debt position managed to reduce inflation to manageable levels and to grow again. Brazil did not, and thus it became obvious that some of Brazil’s economic issues were internal.
The root of Brazil’s inflation problem is the monetization of the public sector’s fiscal deficit. When debts are not financed by borrowing either from abroad or domestically, they must be covered by the creation of money. This caused a huge surge in the inflation rate between 1977-1994. It is important for non-Brazilians to grasp the significance of double-digit inflation for forty years, with triple and even quadruple inflation in the 1980s. By the late 1980s, annual rates of inflation were almost meaningless, and Brazilians characterized inflation by its monthly rate, which in the early 1990s was over 35 percent. Between the end of WW II and Brazil’s Real Plan in 1994, the price level had increased more than 100 billion times. (Library of Congress, 1997).
Adding to the inflation problem, Brazil decided to “correct” the system between 1964 and 1970 by implementing an extensive indexation system. This stabilization attempt only served to increase the problem, causing higher and continuing inflation. Although high government expenditures and the rise in energy prices contributed to early surges in inflation, the main surge occurred in the 1980’s. When Brazil lost its access to foreign capital markets, domestic borrowing to finance the growing public sector became increasingly expensive. Thus money creation became one of the primary ways to finance the deficit.
The background to Brazil’s financial crisis in early 1999 included both fiscal and Balance of Payment weaknesses. The government’s expenditures, not including interest payments, far exceeded its income. The government’s domestic debt amounted to 40% of GDP, and consisted of short-term financing. (Fraga, 2000). To make matters worse, Russia defaulted on its debt, causing capital flows to Brazil to come to a stand still. Also, in 1998, Russia’s devaluation and declaration of moratorium spread a wave of uncertainty throughout the world, especially in emerging countries. Foreign investors began to question Brazil’s ability to face the pressures from the external markets to force the country into a devaluation of the Real. Brazil’s economy slid towards recession. (IBGE, 1998).
As a result, Brazil was forced to float the Real and panic set in in January of 1999. The 1997 crisis in the Asian markets caused Brazil’s interest rate in January 1998 to start at 38%, which lead to a reduction in consumption and a decline in production. The unemployment rate increased to over 7.5%. However, President Cardosa remained committed to his anti– inflation program, even while the country’s economic growth rate experienced a short-term decline. This commitment created enough confidence among foreign investors to take advantage of the high interest rates in the Brazilian markets.
Foreign investors typically base their capital allocation decisions on four variables; interest rate, inflation rate, currency fluctuation, and the degree of certainty that the lendee will not default. This is a classic risk/reward investment scenario. Compared to the United States, Brazil is a risky investment for foreign investors. For example, Brazil has a history of defaulting on debt obligations, whereas the United States has never defaulted. The dollar has been the benchmark currency around the globe since WWII or before. Brazil’s currencies have rarely elevated to investment grade, much less being a benchmark currency. The U.S. has historically had a relatively low rate of inflation, while Brazil has had hyperinflation at times.
With these considerations, why would any foreign investor choose to place their capital in Brazil rather than in the United States? The answer is, they won’t without a “risk premium.” In the case of Brazil, the risk premium is the spread between the interest rate of a government bond for example, and the anticipated inflation rate over the life of the bond. Evidence of growing investor’s confidence is proven by the shrinking risk premium investors were willing to accept. Over a six-month period, Brazil’s interest rate declined from 38% to 20% while the inflation rate was kept to around 12%. President Cardosa’s policies were working and the economy was improving. (Fraga, 2000).
Exchange Rate and Balance of Payments
The Balance of Payments weaknesses in Brazil were also huge contributors to the poor financial state of the country. The first half of 1998 closed with a trade balance deficit of two billion (US $). This was actually an improvement over the 3.7 billion (US $) 1997 deficit. The improvement was primarily caused by a 46% increase in the exports of manufactured goods, in particular automobiles. While the reduction in the trade balance deficit acted as a stabilizing factor, Brazil faced yet another challenge. Brazil’s currency was under pressure for two reasons. First, the devaluation of currency in many Asian countries, including Russia, in 1998 caused the Real to be more expensive relative to Asian currencies.1 This in turn caused a reduction in exports to many Asian countries and increased Asian exports to the United States. Secondly, capital began to flee the country as the expectation of a devaluation rose and investor confidence evaporated. (Suk, 2000).
In October 1998, the Brazilian government began its negotiations with the International Monetary Fund in hopes of providing a financial shield to protect Brazil against an external attack on its currency, and to help accelerate the approvals of fiscal and social security reforms by Congress. With the help of the IMF, Brazil would begin addressing longstanding structural problems and budget stringency. (Dept. of commerce, 1998).
In the short term, Brazil continued to lose foreign capital at an alarming rate ($8 million in the first half of January 1999 alone). On January 3, the government announced a devaluation of the Real by 8%. Continuing reserve losses persuaded the government to allow the Real to float on January 15th. This allowed foreign investors to attack the Real, forcing a further decline that continued until mid March. Foreign investors “attack” currencies of economies that are unstable. By “attacking” they are effectively selling the Real against other currencies in hopes that the Real will continue to decline, thus creating a profit for the investor. On the open market, such attacks can cause currency volatility that applies further pressure to the troubled economy. The Real continued to decline until mid-March when it became apparent that the feared surge in inflation would not materialize. (Dept. of Commerce, 1998).
The Real Plan
In 1994, Brazil implemented the last and most successful stabilization program to end inflation. Ironically, the Real Plan, implemented to combat Brazil’s struggle against inflation, was designed by a sociologist. Fernando Henrique Cardosa, Finance Minister of Brazil, had no expertise in monetary policy when he was appointed in 1993. But as a sociologist he realized Brazilian inflation was more than an economic problem, it was deeply rooted in the national character and the nation’s social institutions. Inflation in Brazil had had a devastating effect on the population, and hopelessness had become the predominant mood in Brazil. (Goertzel, 1999).
Cardosa knew that Israel, Bolivia, and Argentina had ended severe inflation in recent years, and knew that Brazil could do the same. He gathered a team of the country’s leading economists, all with experience in the struggle against Brazilian inflation. At the first meeting of the economic advisory team, a dual currency system was proposed, in which all contracts, including salaries, would be continually readjusted to their value in US dollars. To make the readjustment, it was proposed to use the indexing system. Using a government index would preserve a degree of national authority, and thus prices would not be permanently linked to the dollar. Once everyone was used to calculating money in this new unit, a new currency could be printed which was valued in those units. (Dept. of Commerce, 1998). Thus the “Real Plan” was born.
The Real Plan was implemented in 1994, and by 1996 inflation approached an annual rate of less than 20%, an incredible achievement considering a few years earlier a monthly rate of 20% would have been considered a triumph. The Real Plan introduced the Real, a new monetary unit that actually appreciated against the dollar in the months after its creation. Unlike earlier stabilization programs, the Real Plan did not depend on a general price and wage freeze to stop inflation. At the heart of the new plan was the de-indexation of the Brazilian economy, which was done by converting salaries and a number of other prices into Real Value Units, which were linked to the US Dollar. Because of this link to a foreign currency, the Real Plan is referred to as a form of “dollarization” of the Brazilian economy. However, despite the stability of the Real against the dollar throughout the first year and a half of the Real Plan, there was a widespread expectation that the Real would eventually depreciate. (Library of Congress, 1997).
This expectation, combined with the short– term stability of the exchange rate and much greater mobility of financial capital between Brazil and other world markets led to a strong appreciation of the Real and very high domestic real interest rates. This occurred because lenders required interest rates that would protect them against a possible depreciation. With prices stable or even falling for some products, borrowers could not repay in currency that had lost its value through inflation. The first year success of the Real Plan encouraged foreign investors and Brazil resumed large scale flows of capital. These capital flows more than financed the high level of imports stimulated by the economic growth, and led to a sharp increase of Brazil’s reserves of foreign currency.
Also, the fall in inflation supported by the strong Real, led to important changes in income flows. Decades of inflation had produced a large financial sector which flourished due to the gap between borrowing and lending rated in a high-inflation environment. When this revenue fell, a substantial number of financial intermediaries came under severe pressure despite high interest rates. The Central Bank became involved, and, to prevent failures, it merged struggling banks with stronger ones.
The Real Plan significantly helped Brazil’s lower class. For the first time the less fortunate could buy home appliances and other “luxuries” on credit. The fall in inflation led to higher expenditures in consumables by lower-income groups, which led the government in 1995 to try to restrict consumption and reward savings. This rise in income produced huge support for the Real Plan, making it hard for unions and other groups opposing many of the new policies to retaliate. (Library of Congress, 1997).
By the end of 1996, the Real Plan appeared to have successfully ended decades of inflation and macroeconomic uncertainty. The biggest challenge of the Real Plan, which is to maintain strict control over inflation, was fully achieved in 1998. According to the General Price Index, Brazil’s inflation rate had an increase of only 1.78%, the lowest rate in more than four decades. The control over inflation, for four consecutive years, is the most essential factor in consolidating the economic and financial health of the country, even at the expense of short– term economic growth. (IBGE, 1998). Even though the Real Plan enabled the Brazilian economy to significantly reduce inflation rates, the finances of the nonfinancial public sector remained a source of concern. Some examples of the nonfinancial sector are media companies, electric companies, industrial exporters, and consumer goods producers. They were a concern because of their reluctance to finance business growth through borrowing. Decades of hyperinflation encouraged business owners to finance growth through retained earnings rather than through debt financing. The high real interest rates (the spread between interest rates and inflation rates) were encouraging businesses to invest in government securities (i.e. CDs) instead of investing in their own businesses. (Schwartz, 1999). Thus Brazilian officials began talks with the International Monetary Fund to fund a three year program of economic and financial reform.
International Monetary Fund
Taking advantage of its location on the American continent, its recent stellar financial performance, and its abundant natural resources, Brazil was able to secure a $42 billion line from the International Monetary Fund. After the disasters in Asia and Russia, the IMF decided that their only mistake was that they did not intervene early enough. The package, assembled by the IMF along with the World Bank and United States, was developed in hopes of preventing Brazil from falling victim to the same currency troubles that leveled Asian nations and Russia
Between the period of 1998-2001, in agreement with the IMF program, Brazil will focus on the chief source of its external vulnerability, namely its chronic public sector deficit. “The program combines a large up– front fiscal adjustment (a cut in government spending) of over 3 percent of GDP with reforms of social security, public administration, public expenditure management, tax policy and revenue sharing, that will confront head-on the structural weaknesses that lie at the root of the public sector’s financial difficulties. “The fiscal program targets primary surpluses of 2.6% of GDP in 1999, 2.8 % in 2000, and 3% in 2001,” stated Michael Camdessus, Managing Director of the International Monetary Fund. Brazilian authorities will also commit to moving to an open economy, ensuring firm monetary discipline and macroeconomic stability, and maintaining the current exchange rate regime. (IMF, 1998.)
Just after the agreement with the IMF was finalized, and not at all in the program the IMF had designed for Brazil, the Real was allowed to float in January of 1999. This caused an emergency meeting in Washington with the IMF to convince them that the Real should be allowed to float. Although inflation increased to about 7%, this was still a far cry from the 2000% inflation from just five years before. (Shelton, 1999).
Inflation remained surprisingly low for four reasons
1. Brazil does not rely on imports to the extent of other economies.
2. Relatively tight monetary and fiscal policies.
3. Slow consumption that has resulted in profit margin reduction.
4. A number of exceptional and favorable factors, like a good harvest. (IMF, 1999).
The IMF also worked with the Central Bank of Brazil to put together a formal inflation targeting framework. This resulted from the Brazilian authorities adoption of the floating exchange rate regime. The framework included outreach consultations and discussions with central banks that have experience with this kind of framework. In May 1999, a “Seminar of Inflation Targeting” was given by the Central Bank of Brazil and the IMF’s Monetary and Exchange Affairs Department in Rio de Janeiro. The seminar reviewed other countries’ experiences and provided an opportunity for Brazilian economists and policy makers to discuss plans to implement a system in Brazil. (Goertzel, 1999).
The main objective of the plan was low and stable inflation. The Research Department of the Central Bank of Brazil has developed some tools, such as short-term inflation forecasting models and surveys of market expectations of inflation and growth. The inflation targets for 1999, 2000, and 2001 were set in June 1999. The Central Bank issues a quarterly inflation report which provides information on the performance of the inflation targeting framework.
Brazil seems to finally be heading down the right path in the financial world. The Brazilian authorities have demonstrated their commitment to low inflation in the years to come. They have also decided that monetary policy should give priority to price stability. A monetary policy aimed at controlling inflation encourages employment and economic growth. For the first time since the 60s, Brazilian people went back to the practice of personal credit up to 36 months to buy consumer goods.
So why does all of this matter to you? At first glance it is difficult to see why the economic problems in Brazil are having a damaging effect on your collection of stocks. What we need to realize is that the financial distress in Latin America could create a wealth warning for the rest of the world. If Brazil falls into recession, it is likely to drag the rest of Latin America down with it and that could have serious consequences on the rest of the world economic growth, and on global stock markets. Analysts estimate that approximately one fifth of US exports are sold to Latin America. If demand ends, it could bring an end to a period of high growth in the US economy. (BBC News, 1999).
Although Brazil seems to be on the road to recovery, its government is still far from stable. In a world where international financial barriers are becoming increasingly blurred, Brazil matters. If its economy collapses, the repercussions will be felt from Sao Paolo to Tokyo.
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Diane M. Sweetwood
University of Detroit Mercy
Copyright College of Business Administration. University of Detroit Mercy Spring 2002
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