|
|
|
|
Map of South America |
CIAO DATE: 2/00
Brazil Alert: Financial Turmoil
Michael A. May and Sidney Weintraub
Hemisphere Focus: 1998-2000
January 15, 1999
Overview
The financial turmoil besetting Brazil has captured the attention of the world’s financial markets and political leaders. Many observers see the crisis as being precipitated by a debt repayment issue between the federal government and a recalcitrant state. The problem, however, is more profound and revolves around the need to reform the Brazilian State.
The Brazilian electorate and world financial markets were buoyed by President Fernando Henrique Cardoso’s October 1998 huge reelection victory. His 53 percent vote tally bested his Worker’s Party (PT) opponent, Luiz Inacio “Lula” da Silva by more than 24 percentage points. This was also the first time that the country’s constitution permitted the reelection of a sitting president.
Cardoso’s reelection could not have come at a more important time for Brazil. The financial crises in Asia and Russia had reached Brazil. This contagion and the need for fundamental economic and organizational reforms in the country frightened already skittish foreign investors. Most observers saw the Cardoso election victory as a watershed in the enactment of essential reforms and as a vehicle to receive international financial assistance which would create a financial firewall that would finally end the growing crisis.
Outlook of the Package
In late October, the Cardoso government announced the long-awaited reform package. The package consisted of two basic legislative concepts: a revenue raising measure through tax increases (reforma tributária) and the reform of the social security system (reforma da prevedênça). Both have sub-components that need to be enacted into law by congressional vote or executive decree (medida provisoria). Through tax increases and spending cuts, the legislative initiatives would cut the country’s budget deficit—around 7 percent of GDP—and would create a 2-3 percent of GDP budget surplus to shore up investor confidence in the real.
Social security reform is also important. Under the current system, it is common for someone to receive several pensions and “finally” retire at a relatively young age. In addition, government retirees receive pension outlays that are comparable to their working salaries. This proposed legislation would eliminate such abuses, implement structural reforms and, more importantly, save the national treasury over $2 billion a year. Unfortunately for Cardoso, the congress—including members from all parties of his ruling coalition—overrode by one vote a key element of this plan. On December 3 congress struck down his executive order that would have taxed the pensions of retired civil servants and raise by 9 percent the contribution made by current government employees. This key reform must now be delayed until after the new congress convenes on March 1. The government, however, was more fortunate in relation to the revenue bill. As recently as January 13, the congress approved a key element of Cardoso’s tax plan.
The congressional calendar is also a problem for Cardoso. The congress is in a 30-day “extraordinary” session. Upon conclusion of the extraordinary and last session of the current congress, no legislative activity will occur until the new congress convenes in March. Thus, it is crucial that congress enact these reforms before the end of January.
Current Crisis
Cardoso came to power based on the euphoria in Brazil that the real plan, of which he was the principal author when he was minister of finance, sharply brought down the country’s long-standing inflation. It now appears that the real plan, as originally conceived, is over and done with.
The essence of the plan was to create a new currency, the real, and tie it to the dollar, but not rigidly. The value of the real was allowed to depreciate each year, but not enough to compensate for the higher inflation in Brazil than in the United States. At the same time, the real, was defended through market intervention when its fall in value threatened to breach the band. Brazil managed to accumulate more than $75 billion in foreign reserves, which was considered more than ample to permit intervention in the market to protect the floor of the band. The exchange-rate structure was reinforced by macroeconomic policy discipline.
A number of discrete but connected events worked to undermine the structure. The yearly slides in the value of the currency were not sufficient to prevent its growing overvaluation, perhaps by 20 to 25 percent before the structure collapsed. The reason for limiting the extent of devaluation was to minimize the inflationary effects of currency depreciation. However, the government was unable to maintain the fiscal discipline that underpins a structure of this type. This has long been evident to investors, both inside and outside Brazil. Then, on top of this, the financial crises in East Asia and Russia made money managers more sensitive to structural weaknesses in developing economies.
The danger that these events presented for Brazil were the basis for the IMF support package of $41.5 billion in exchange for Brazilian commitments to deal with its fiscal and other internal weaknesses. The first sign that Brazil was unable to meet its side of the bargain was the rejection by the Congress of parts of the pension reform package. The unease this created was compounded when Itamar Franco, the governor of the state of Minas Gerais, openly declared that he would not meet his state’s obligations to the central government. Itamar Franco was the president who appointed Cardoso as finance minister when the real plan was put together.
The Brazilian authorities tried to limit the devaluation on January 13 by expanding the band by about 8 percent. The central bank lost at least $2 to $3 billion dollars trying to defend the new floor. This was on top of the reserve loss of some $40 billion since the summer of 1998 used to defend the floor of the old band. The capitulation came on January 14, when the central bank said it would cease intervention and allow the real to float. We do not know the full exchange-rate package, which is scheduled to be announced on January 18.
Some old lessons were relearned by the Brazilians:
Outcome/Conclusion
Most observers hoped that Cardoso’s landslide victory would ensure the passage and implementation of the reform process. However, these same observers continually underestimate the power and independence of the Brazilian congress. Since the country’s return to democracy, the congress has played an increasingly important role in the political life of the country. Unlike Argentina, the Brazilian congress is not elected in party slates. Thus, the parties have less control over their members. The Brazilian congress is seen as a strong proponent of the status quo. Cardoso must use all of his political might and persuasion to ensure that the congress supports the needed reforms. There is not much time to do this if the financial crisis is to be contained.
Email this citation