The day of reckoning comes despite bailout

News Analysis: The $41bn IMF rescue package for Brazil was only putting off the inevitable
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THERE IS no more certain sign of an impending crisis than capital flight. Ever since it reached agreement two months ago on a $41bn rescue package led by the International Monetary Fund, Brazil has been kissing goodbye to billions of dollars fleeing to safer havens elsewhere.

In December, it was more than $5bn. Up to Tuesday about $1bn had left in January, with another $1.2bn on Tuesday itself. Altogether, the total capital flight in recent months has passed the $50bn mark.

No wonder Professor Rudiger Dornbusch at the Massachusetts Institute of Technology has joked that the IMF's new phone number is 1-800-BAILOUT. Yesterday's devaluation, resignation of the central bank governor and market implosion in Brazil confirmed the worst fears of the Fund's critics. Its rescue package, pumping in taxpayers' funds, had given investors enough time to get their money out of Brazil before what many saw as an inevitable speculative attack on the currency.

The emergency loan, of which the UK's share amounts to $1bn, was due to be doled out to the Brazilian government in tranches, subject to it satisfying the terms of an IMF adjustment programme. The second instalment is due to be handed over next month.

The loans were meant to tide the country over on its repayments on international loans, mostly short-term, of which $60bn will fall due during 1999. In effect, the IMF would ensure that commercial banks and other investors in Brazil got paid on old loans so that they would continue to make new loans.

The plan was controversial, with little support among the governments of the G7 leading economies. Some, including France and Germany, were bitterly opposed. They argued that it created more "moral hazard", whereby banks would continue to make too many risky loans on the assumption that the authorities would always bail them out.

The decision to fix the Brazilian currency, allowing it to depreciate only in tiny steps, was also unwelcome. Brazil has a huge balance of payments deficit amounting to 4 per cent of its gross domestic product, and without a devaluation it would stay bigger for longer, increasing the country's need for foreign capital.

But strong US support, given the exposure of the US banking system to Latin America, swung the day. The alternative to the IMF rescue, it was argued, was a new panic in the international financial markets, hard on the heels of Russia's default and the collapse of the Long-Term Capital Management hedge fund.

Also, Brazil's legacy of hyperinflation - peaking at more than 2,700 per cent a year in the early 1990s - until the introduction of a new currency, the real, in 1994, made President Cardoso reluctant to contemplate a big devaluation.

Yet only days after the formal agreement with the IMF had been signed last month, the rescue plan ran into trouble. Brazil's congress voted against the first measures Fernando Henrique Cardoso, the President, had proposed to cut government spending and raise taxes. The plan to cut the deficit from 8 per cent to 5.5 per cent of GDP - equivalent to a reduction of more than $20bn - fell at the first hurdle.

Combined with interest rates of around 30 per cent, the plan certainly set Brazil on course for a recession this year.

The IMF downgraded its forecast from 2 per cent growth in GDP to a 1 per cent fall in 1999. Other forecasters are more pessimistic: for example, HSBC was predicting a 2.1 per cent drop before yesterday's crisis.

David Lubin, HSBC's Latin American economist, feels that as the IMF loan and fiscal adjustment have failed, the only option is a devaluation and renegotiation of Brazil's foreign debts. "There is no alternative now to making private lenders share some of the pain," he said.

Others reckon that the government and international authorities will be reluctant to take this route, and will instead try to shore up the credibility of the existing package.

Anna Gaworsewska of Lloyds Bank said: "I think everything possible would be done to avoid a renegotiation of external debt."

To clear the way for an overhaul of the foreign exchange regime, Brazil's central bank president, Gustavo Franco, quit yesterday and was replaced by one of his deputies.

Although Brazil might be tempted to introduce tough capital controls to prevent further flight, it is too late for the country to avoid a severe shortage of funds.

Service on debts this year will amount to nearly three-quarters of its export earnings, themselves under threat from low commodity prices. Interest rates will have to stay high, plunging the economy into a deeper recession.

Professor Dornbusch, who predicted back in November that the IMF agreement would merely postpone the crisis, recommends a currency board for Brazil. Guaranteeing a fixed exchange rate against the dollar through this mechanism - which would tie every real in circulation to reserves of the US currency - is the only credible exchange rate policy left, in his view. The government must also balance its budget and begin root-and-branch reform of the economy, he says.

If things look bleak for Brazil after yesterday's events, the broader outlook is little brighter. International efforts to prevent financial crises failed in Asia and failed in Russia, and have now failed in Latin America too. The IMF is sure to come under renewed criticism over its crisis management.

And even if leading stock markets bounce back once again in weeks to come, the already-disrupted flow of capital to emerging economies could dry up entirely.

The flow of investment fell to a meagre $67bn in 1998, compared with a peak of $250bn. For Brazil, the danger that its creditors will refuse new loans could force it to default - an event that would ratchet up the two-year global financial crisis another notch.