The Brazilian financial crisis of 1999

April 1999  Brazil devalued its currency (the real) on January 13, 1999. It now takes more reais to purchase a unit of foreign currencies. In effect, the people who have held portfolios of real assets have lost purchasing power in the global market. From April 1998 to April 1999, the real lost approximately one-third of its purchasing power. One Brazilian real will now buy about two-thirds of imported merchandise that it would have bought a year ago.

Countries are reluctant to devalue or depreciate their currencies in foreign exchange markets, because it results in a deterioration in their terms of trade. People in Brazil, for example, now have to work more hours to buy goods and services from other countries. They have to export more to buy imports. So, why do countries do this? Often, the answer is that they have no other choice. That was the case in Brazil.

In an attempt to maintain a fixed exchange rate, Brazil had been using up its foreign reserves of other currencies. The Brazilian central bank had been spending its reserves of US dollars, German marks, and British pounds to purchase excess supplies of reais. Foreign exchange speculators sensed that Brazil could not continue to do this indefinitely. They began to sell even more of their reais, draining still more of Brazil's reserves. When investors think that the assets they hold, which are denominated in a given currency, are about to go down in value, they naturally begin to exchange them for a different currency. This is called capital flight. Between April 1998 and January 1999, Brazil's reserves dwindled from $51.9 bn to $34.2 bn. That's when Brazil capitulated.

Prior to the devaluation, there had been an attempt in November 1998 to preempt the real devaluation with a $41.5 bn aid package put together by the International Monetary Fund (IMF) and the US Treasury. Besides protecting the purchasing power of Brazilians, the aid package was also motivated by the desire to protect foreign investments in Brazil. The package was contingent upon Brazil adopting an austere fiscal policy of government spending cuts and tax increases to reduce its relatively large budget deficit, which had reached 8% of the GDP in 1998.

As it turned out, the aid package didn't work. It may not have worked under the best of circumstances. Attempting to maintain an over-valued fixed exchange rate is a de-facto appreciation of a currency. This is a drag on a country's economy, because exports fall (they are too expensive) and imports rise (they are cheap). Aggregate demand decreases. The Brazilian economy was in recession by the third quarter of 1998 when the GDP declined by 0.1%. In the fourth quarter the GDP went down by another 1.9%. The unemployment rate in Brazil rose to 8% in January 1999.

The Brazilian devaluation is expected to help turn this trend around. Exports should go up (they are now cheaper) and imports should go down (they are now more expensive). Aggregate demand will increase to expand the economy and help create more jobs. However, devaluation is almost always inflationary. Recent devaluations of the Russian ruble, the Indonesian rupiah, and the Mexican peso all resulted in dramatic increases in the general price level within the first year following the devaluations.

It remains to be seen just how high inflation will get in Brazil following its devaluation. The Brazilian government had been successful at containing inflation since 1995. Prior to that, Brazil had experienced hyperinflation, with rates exceeding 1000% annually in the early 1990s! Brazil's new real policy introduced in 1995 was designed to put an end to hyperinflation in Brazil. The financial crisis that crippled Brazil in January despite a preemptive international bailout last November further discredits the lending policies of the U.S. Department of the Treasury and the International Monetary Fund (IMF)--policies supporters claimed would solve the global financial crisis. Brazil's inability to avoid devaluating its currency on January 13 confirms lessons the global community should have learned in Asia and Russia last year: The IMF's lending policies harm, rather than help, economies; keep them from instituting sound financial policies on their own; and undermine support for free trade. Instead of continuing support for IMF bailout packages, the Clinton Administration should pursue solutions that specifically address the financial problems in each country.

A Record of Failure. Following the Asian financial crisis that began in Thailand in July 1997, the IMF orchestrated a succession of bailouts--with President Bill Clinton's enthusiastic support--that totaled over $175 billion in emergency loans to Thailand, South Korea, Indonesia, Russia, and Brazil. U.S. taxpayers underwrote these loans with tens of billions of dollars. The IMF and the Clinton Administration argued that these packages would strengthen the economies of the afflicted countries, prevent their citizens from suffering undue economic hardship, and prevent the spread of the financial crisis to other countries.

The IMF and the Administration were wrong on all counts, however. The global financial crisis continued to expand following the bailouts, undermining world trade and economic growth. Every country under the IMF's financial "guidance" suffered severe economic contraction and plunged hundreds of millions of people back into poverty in a domino effect that threatens economic growth even in the United States.

The IMF's latest victim is Brazil. After the successive failures of IMF loans to arrest financial crises in Asia and Russia, President Clinton proposed in October 1998 the creation of a "new mechanism" to prevent future crises. This new IMF mechanism is to provide billions of dollars in loans to a troubled country before the onset of a crisis. This mechanism represents a significant departure from previous policy because no evidence of a crisis would need to be demonstrated in order to obtain IMF loans; merely the possibility of a crisis would be sufficient.

Brazil is Latin America's largest economy and the eighth largest in the world. It became the first beneficiary of the new mechanism in a $41.5 billion rescue package in November. According to U.S. Secretary of the Treasury Robert Rubin, the package would "guard against financial market contagion" by convincing investors Brazil had more than enough resources to defend its currency--the real--indefinitely. In return, Brazil's government, under President Fernando Henrique Cardoso, agreed to enact a three-year, $84 billion austerity program that included tax increases, government spending cuts, and a firm commitment to preserve the stability of the real.

The new preventive package for Brazil failed to "prevent" a crisis. After receiving over $9 billion of the $41.5 billion, Brazil announced on January 13, 1999, that it would allow the real to trade within a larger band (representing, effectively, a devaluation). On January 15, Brazil abandoned all pretense of supporting the real and allowed the currency to float. During January, the real lost more than 40 percent of its value against the U.S. dollar, and investors took more than $8 billion out of the country. This failure occurred for several reasons: In the wake of the real 's collapse, Brazil's government is rushing to enact the reforms President Cardoso pledged nearly three months ago. Both houses of the National Congress passed a bill to reform the social security and pension fund systems for public workers, which together account for about half of the government's $64 billion budget deficit (over 8 percent of gross domestic product). Cardoso also proffered to the state governors a plan to restructure their debts--estimated to be more than $85 billion of the $270 billion in total domestic debt--to the federal government if they agreed to downsize their bureaucracies, cut spending, and privatize water and sewage services. Most state governments are controlled by opposition political parties, however, and they do not appear disposed to accept fiscal reforms that threaten their clout.
 * The initial $9 billion IMF disbursement alleviated the urgency in Brazil to enact reforms.
 * Brazil's National Congress and state governors enjoy an extraordinary degree of autonomy in dispensing patronage and contracting debt. President Cardoso's promised reforms attacked this system of constitutionally protected political patronage and privilege.
 * Faced with strong political opposition and an IMF package that made his reforms appear less urgent, President Cardoso failed to exercise leadership and force his reforms through an unwilling legislature.
 * When Governor Itamar Franco of Minas Gerais declared a 90-day moratorium on paying his state's $15.4 billion debt in early January, investors quickly lost confidence in Brazil's ability to meet its obligations.

Implications for the Two Americas.

The crisis in Brazil will hurt the United States, too. More than 2,000 U.S. multinational corporations conduct business in Brazil, with combined direct investment totaling over $30 billion; U.S. banks have some $28 billion at risk. Although Brazil accounts for only 3 percent of total U.S. exports ($16 billion in 1998), over 200,000 jobs inside the United States are at stake. The impact on the United States will worsen if the Brazilian crisis ripples across Latin America. The region's economic growth--forecast at less than 2 percent for 1999--is likely to slow even further. Other countries may devalue their currencies to compete with exports from Brazil. Interest rates, unemployment, and poverty are likely to rise in the region this year, leading many Latin Americans to question the free-market policies that have been blamed--incorrectly--for the crisis.

Conclusion. The record shows that IMF lending practices impose undue hardships on consumers and workers in developing countries. They destroy developing economies, waste U.S. tax dollars, and hurt the economic and security interests of the United States. Instead of relying on an IMF bureaucracy that lacks transparency and accountability, the Clinton Administration should restore the primacy of free trade in U.S. foreign policy: It should reinvigorate the effort to create a Free Trade Area of the Americas in Latin America and promote currency stability through currency boards or adoption of the U.S. dollar. This would lower the risk of financial crises in the future and mitigate the severity of any such crises that may occur; it also would promote economic growth throughout the hemisphere.

Refrences
1. http://www.sonic.net/~schuelke/TheBrazilianDevalutation.htm

2. http://www.heritage.org/research/reports/1999/02/the-imf-strikes-out-on-brazil

3. http://www-personal.umich.edu/~kathrynd/Brazil.w06.pdf