News Analysis: Brazil bows to IMF pressure

Brazil has unveiled details of its $24bn austerity plan. Will it prevent a Latin American crisis?

IT'S make-or-break time. Yesterday, Brazil - seen by almost all experts as the next potential flashpoint in the global financial crisis - yesterday unveiled details of a $24bn austerity plan.

The plan, which will almost halve the country's budget deficit at a stroke, is widely expected to pave the way for a $30bn bail-out package from the International Monetary Fund.

The next few weeks are critical. If the new Brazilian government has failed to convince the markets its economy is back on track, or if the IMF money is not forthcoming, then the consequences will be disastrous.

As Pedro Malan, the Brazilian finance minister, put it at the launch of the austerity plan: "The challenge is set. [Without these steps] we're on the road to fiscal insolvency."

Why is Brazil vulnerable? It operates a fixed exchange rate regime - its currency, the real, is set at about 1.1 to the US dollar. It has substantial amounts, some $35bn, of short-term debt. And its fiscal position is dire - its budget deficit is running at a heady 8 per cent of Gross Domestic Product (GDP).

As a result, like Russia before it, the currency in Brazil has come under immense pressure, prompting the government to spend valuable foreign exchange reserves in its defence, and worries have mounted about a default on debt payments. So far, unlike Russia, Brazil has managed to fend off the currency speculators and pay its creditors. This is partly because of its decision to hike interest rates to close on 50 per cent, partly because of the belief that the government will sort out its finances and partly because of hopes of IMF help. The current level of interest rates in Brazil is unsustainable. This means that if either the Brazilian austerity plan or the IMF package disappoints, there is a real possibility that Brazil will succumb to a Russian-style collapse in its currency and possibly a Russian-style debt default.

As John Llewellyn, global chief economist at Lehman Brothers, said last month: "The immediate threat to the global economic and financial system comes not from the inaction of central bankers, but from inappropriate policies in a number of emerging market economies, with Brazil the focus of attention."

Why is Brazil so important? First, its significant trade volume with the rest of Latin America, particularly Argentina. Second, the damage a Brazilian devaluation or default would do to confidence in other Latin American markets. Third, the country's strong trade links with the US, and fourth, its financial links to the developed world.

As Doug McWilliams, chief executive of the Centre for Economics and Business Research, said: "Failure to agree a package would likely lead to a sharp devaluation and recession in Brazil, a moratorium on debt servicing that would leave developed economy banks with billions of dollars worth of losses, and an acceleration in outflows from Argentina and Mexico. US exports would also be badly hit. The knock-on effect on Western stock markets could be savage."

So has Brazil done enough? It is too soon to tell. The preliminary signs are hopeful. The scale of the fiscal tightening, which is predicted to turn in a primary budget surplus of some $21 billion next year, before interest payments, is in line with market expectations. The constituents of the austerity package, including tax increases of 15.9 billion reals, government spending cuts of 8.7 billion reals and cuts in social security spending of 3.5 billion reals, have also met with investor approval. After a nervy start to the day, the FTSE 100 ended well off its intra-day lows, closing down 37.3 points at 5293.9 as UK traders took their lead from a stronger-than-expected opening in New York.

Market circumstances are also on the side of the Brazilians. Hedge funds, whose activities helped drive down exchange rates in much of the emerging world, were badly wounded by the last bout of financial market turmoil, and the IMF seemed last night to give a thumbs-up to the package, boosting hopes that a bail-out would be forthcoming. An IMF spokesman said: "They [the plans] represent important progress in the implementation of Brazil's stabilisation and reform programme, which will be supported by the IMF and other members of the international community."

Jeremy Batstone, head of research at NatWest Stockbrokers, said: "There is hope now that a crisis can be averted."

However, Brazil is not out of the woods just yet. The austerity plans need to be approved by the Brazilian politicians, a tough proposition given the public clamour for fiscal and monetary loosening.

As Carl Ross, head of Latin American sovereign research at Bear Stearns, said: "Now all eyes are off Malan and his economic team and on the Congress".

Investors will be praying that the Brazilian Congress does not lose its nerve.