Meltdown looks a real possibility for Brazil
None of the economy's fundamental problems has been solved by the currency devaluation
Monday 18 January 1999
This optimism is at the very least premature, and could prove decidedly misplaced. While the break-up of the ERM was indeed a boon for Europe's devaluing currencies, the ignominious collapse of Brazil's exchange-rate regime last week was not of the same ilk. This debacle has been brewing for at least two years, with the repeated failure of the Cardoso government to make the cuts in the fiscal deficit which have been so obviously necessary. The abandonment of the crawling peg for the real was not due to an irrational attack on the currency by foreign speculators, but to the steady withdrawal of funds by both domestic and foreign investors who rightly feared that the public debt position was becoming untenable.
Some, remembering the example of Russia last August, feared default on real-denominated debt, either by the government or the states of the federation. Others, remembering repeated episodes from Brazil's economic past, reckoned that the central bank would soon be forced to resort to the printing presses to redeem debt. The prospect of monetisation and hyper-inflation was in fact far more likely than outright debt default, but it was still more than sufficient to eliminate confidence in the exchange-rate regime around which the government's entire economic strategy had been constructed.
When Brazil and the IMF reached agreement on an economic reform programme last November, careful consideration was given to the option of devaluing the real in a controlled way by (say) 25 per cent. Eventually, the Brazilians persuaded Washington that their economy could not withstand this, for two reasons. First, they said, devaluation in a Latin American context would be inevitably seen as a lurch towards hyper-inflation, so interest rates would have to be lifted to stratospheric levels to prevent wholesale capital flight. This would deepen the recession.
Second, devaluation would increase the domestic currency value of the dollar-denominated debt held by both the government and the private sector. Specifically, a 25 per cent devaluation would raise the government's budget deficit by 3 per cent of GDP, and reduce the net worth of the private sector by 5 per cent of GDP. At one fell swoop, devaluation would raise the government's already- untenable funding needs and reduce the willingness of the private sector to provide that funding. In short, it was a very bad idea, likely to damage the economy in the same way that devaluations ruined Asian economies in 1997-98.
This is why devaluation was rejected as an option last November. There is no reason to change this pessimistic assessment now that the devaluation has actually taken place. This will be a malign devaluation of the 1997 Asian variety, not a liberating experience of the 1992 ERM variety. Furthermore, none of the fundamental problems of the economy have been solved by the devaluation. The budget deficit already exceeds 8 per cent of GDP and may now rise considerably further, in the absence of much tougher fiscal reforms. These reforms seem completely beyond the reach of Brazil's political system. And, in the absence of fiscal action, it is hard to see how Robert Rubin can persuade the US Congress to provide new funding for Brazil, having watched the last tranche disappear so rapidly into the ether. In fact, a complete meltdown in the currency now seems to be a perfectly likely scenario.
What would be the implications of such a meltdown? For Brazil, disaster - a drop of at least 6 per cent in GDP this year, with all the counter- inflationary effort of the last few years going up in smoke. For Latin America, severe trouble - declines of 4 to 5 per cent in GDP for both Argentina and Mexico, and a severe currency collapse for Venezuela. For the rest of the world? That is much more difficult.
To start with the least troublesome aspects, the impact on Western financial markets is not likely to be as threatening as it was last year, following the Russian crisis. Leveraged investors do not at this stage seem to be as vulnerable to Brazil as they were to Russia last autumn, so the deleveraging which hit market liquidity in 1998 should prove avoidable. This means that a repeat of the "spread" market debacle - along with a return to credit-crunch conditions in the US markets - is not the most likely event.
What about the general vulnerability of the banking sector to Latin American exposures? On the latest data, US banks have $64bn worth of exposure to Latin America, which is equivalent to 17 per cent of their capital. European banks are more exposed than US banks - they have $155bn of exposure to Latin America, which is equivalent to 23 per cent of their capital. Although some of these exposures will undoubtedly be problematic in coming months and years, the resulting loss of lending capacity should prove insufficient to lead to adverse macro-economic effects on the Western economies.
This leaves trade effects, which could prove more serious. In a meltdown scenario for Latin American currencies, the trade deficit of the region could easily improve by $60bn to $70bn in 1999. Every dollar of trade improvement for the Latin economies is, however, a dollar removed from the net exports and GDP of the rest of the world. This could prove to be the source of a significant new shock to global growth.
Because of its close trading relationships with the region, the shock would be particularly severe for the US, reducing the growth rate by 0.8 per cent this year to 1.9 per cent. Both Japan and Europe/UK would suffer much less, but nevertheless the lost trade would be worth about 0.3 per cent of GDP in both cases, taking their growth rates down to minus 0.9 per cent and 1.7 per cent respectively. Overall, the OECD area would see its likely growth rate for 1999 reduced from 1.7 per cent to 1.2 per cent, which would in turn reduce the inflation rate by some 0.2 per cent to only 0.8 per cent. This is uncomfortably close to outright deflation on a global basis.
This shock, in fact, would be similar in size for the world economy to the first Asian crisis in 1997. Fortunately, it would come at a time when the Asian crisis seems to be abating, when consumer spending in the United States is still growing at about 5 per cent per annum, and when US consumer confidence seems oblivious to all bad news, just as long as Wall Street keeps climbing. Maybe the "consumer of last resort" in America will yet again be powerful enough to keep the developed economies out of deep recession, but the world is surely now pushing this experiment right up to the limit. It is time for the European economies to do more to take up the slack.
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