Meltdown looks a real possibility for Brazil

None of the economy's fundamental problems has been solved by the currency devaluation

LAST NOVEMBER, world share prices surged because Brazil had avoided devaluation. On Friday they surged again - this time because Brazil had devalued. Far from being the source of a global economic disaster, optimists were depicting Brazil as a faraway country of only moderate size, and with few trading links with the rest of the world. Others were arguing that devaluation would be a liberating force for Brazil itself, helping the country to recover from the onset of a deep recession. Comparisons with the beneficial devaluations which occurred in Europe in 1992-93, when the ERM was smashed by market pressures, were rife. Even Brazil's most important economic neighbours, Argentina and Mexico, were being deemed safe from "contagion".

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.

Start your day with The Independent, sign up for daily news emails
Arts and Entertainment
The Doctor and Clara have their first real heart to heart since he regenerated in 'Deep Breath'
Arts and Entertainment
James Hewitt has firmly denied being Harry’s father
arts + ents
Arts and Entertainment
Jamie Oliver
filmTV chef Jamie Oliver turned down role in The Hobbit
The official police photograph of Dustin Diamond taken after he was arrested in Wisconsin
peopleDownfall of the TV star charged with bar stabbing
Life and Style
Arts and Entertainment
Jeremy Clarkson, left, and Richard Hammond upset the locals in South America
tvReview: Top Gear team flee Patagonia as Christmas special reaches its climax in the style of Butch and Sundance
Ashley Barnes of Burnley scores their second goal
footballMan City vs Burnley match report
Arts and Entertainment
Peter Mayhew as Chewbacca alongside Harrison Ford's Han Solo in 'Star Wars'
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Arts and Entertainment
Man of action: Christian Bale stars in Exodus: Gods and Kings
Life and Style
Apple showed no sign of losing its talent for product launches with the new, slightly larger iPhone 6 making headlines
techSecurity breaches and overhyped start-ups dominated a year in which very little changed (save the size of your phone)
Arts and Entertainment
Catherine (Sarah Lancashire) in Happy Valley ((C) Red Productions/Ben Blackall)
Arts and Entertainment
Clueless? Locked-door mysteries are the ultimate manifestation of the cerebral detective story
booksAs a new collection of the genre’s best is published, its editor explains the rules of engagement
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Selby Jennings: VP/SVP Credit Quant- NY- Investment Bank

Not specified: Selby Jennings: VP/SVP Credit Quant Top tier investment bank i...

Selby Jennings: Quantitative Research | Equity | New York

Not specified: Selby Jennings: Quantitative Research | Global Equity | New Yor...

Selby Jennings: SVP Model Validation

Not specified: Selby Jennings: SVP Model Validation This top tiered investment...

Selby Jennings: Oil Operations

Highly Competitive: Selby Jennings: Our client, a leading European Oil trading...

Day In a Page

A timely reminder of the bloody anniversary we all forgot

A timely reminder of the bloody anniversary we all forgot

Who remembers that this week we enter the 150th anniversary year of the end of the American Civil War, asks Robert Fisk
Homeless Veterans appeal: Former soldiers pay their respects to a friend who also served

Homeless Veterans appeal

Former soldiers pay their respects to a friend who also served
Downfall of Dustin 'Screech' Diamond, the 'Saved By The Bell' star charged with bar stabbing

Scarred by the bell

The downfall of the TV star charged with bar stabbing
Why 2014 was a year of technological let-downs

Why 2014 was a year of technological let-downs

Security breaches and overhyped start-ups dominated a year in which very little changed (save the size of your phone)
Cuba's golf revolution: But will the revolutionary nation take 'bourgeois' game to its heart?

Will revolutionary Cuba take 'bourgeois' golf to its heart?

Fidel Castro ridiculed the game – but now investment in leisure resort projects is welcome
The Locked Room Mysteries: As a new collection of the genre’s best is published, its editor Otto Penzler explains the rules of engagement

The Locked Room Mysteries

As a new collection of the genre’s best is published, its editor explains the rules of engagement
Amy Adams on playing painter Margaret Keane in Tim Burton's Big Eyes

How I made myself Keane

Amy Adams hadn’t wanted to take the role of artist Margaret Keane, because she’d had enough of playing victims. But then she had a daughter, and saw the painter in a new light
Ed Richards: Parting view of Ofcom chief. . . we hate jokes on the disabled

Parting view of Ofcom chief... we hate jokes on the disabled

Bad language once got TV viewers irate, inciting calls to broadcasting switchboards. But now there is a worse offender, says retiring head of the media watchdog, Ed Richards
A look back at fashion in 2014: Wear in review

Wear in review

A look back at fashion in 2014
Ian Herbert: My 10 hopes for sport in 2015. Might just one of them happen?

Ian Herbert: My 10 hopes for sport in 2015

Might just one of them happen?
War with Isis: The West needs more than a White Knight

The West needs more than a White Knight

Despite billions spent on weapons, the US has not been able to counter Isis's gruesome tactics, says Patrick Cockburn
Return to Helmand: Private Davey Graham recalls the day he was shot by the Taliban

'The day I was shot by the Taliban'

Private Davey Graham was shot five times during an ambush in 2007 - it was the first, controversial photograph to show the dangers our soldiers faced in Helmand province
Revealed: the best and worst airlines for delays

Revealed: the best and worst airlines for delays

Many flyers are failing to claim compensation to which they are entitled, a new survey has found
The stories that defined 2014: From the Scottish independence referendum to the Ice Bucket Challenge, our writers voice their opinions

The stories that defined 2014

From the Scottish independence referendum to the Ice Bucket Challenge, our writers voice their opinions
Stoke-on-Trent becomes first British city to be classified as 'disaster resilient' by the United Nations

Disaster looming? Now you know where to head...

Which British city has become the first to be awarded special 'resilience' status by the UN?