Looking for Light at Tunnel’s End

The much-awaited Brazilian crisis is finally here. As many analysts predicted, Brazil’s runaway fiscal deficit--at 8% of gross domestic product--undermined the country’s rigid exchange rate policy. The hemorrhage of international reserves finally forced Brazil on Friday to float its currency, the real. Since then, the real has lost almost one-third of its value. Not even a gigantic IMF support package exceeding $41 billion could prevent the fall.

Although the Brazilian crisis has lacked the drama of the Mexican, East Asian and Russian currency collapses, it is being closely monitored by policymakers in the industrialized countries. After all, Brazil is the eighth largest economy in the world, and the largest country in Latin America. A Brazilian meltdown would be a major blow to the region’s young democracies and market-oriented economies.

Now that the uncertainty on the exchange rate is over, Brazil’s challenge is to avoid a deepening of the crisis. Although it is too early to pass firm judgment, the signals coming from Brasilia are not encouraging. The authorities don’t seem to have a consistent plan for addressing the emergency, and the mood continues to be dominated by wishful thinking and self-delusion.

Neither the political leadership nor the public appear to understand that this is a deep crisis and that as such it will be painful.

A simple analysis of Brazil’s external accounts suggests that the worst is yet to come. In fact, even under optimistic assumptions, Brazil’s financing requirements for 1999 will be of the order of $40 billion. In the next 12 months, $8 billion in government bonds and $7 billion in corporate bonds will become due. In addition, a deficit of more than $26 billion in the current account--a broad measure of external imbalance--is projected for the country during this period. But this is not all. To make things worse, about $70 billion of short-term loans by international banks will come due during the next 12 months. If some of these loans are not rolled over--as invariably will be the case--Brazil’s cash needs will increase accordingly.

In spite of the recent rally of the Sao Paulo stock market, things don’t look much better on the internal front. Almost one-third of domestic debt is linked to the dollar and has a very short maturity. Moreover, in order to persuade local investors to hold government securities, the authorities have issued increasing amounts of floating interest rate debt, the cost of which is bound to increase with inflation.

An orderly adjustment will require avoiding a spiraling devaluation process and maintaining inflation under control. To achieve these goals, decisive action will have to be taken on several fronts.

First, the fiscal imbalance has to be tackled rapidly. Now that the devaluation has increased the cost of servicing foreign-currency debt, the adjustment will have to be larger than originally foreseen. The Brazilian Senate voted Tuesday to increase the tax on financial transactions, and the National Congress voted Wednesday to limit social security benefits. But it will be almost impossible for Brazil to reduce its deficit without implementing a new round of spending cuts.

Second, interest rates will have to be raised in the short run. In that regard, the Central Bank’s decision Monday to hike the benchmark rate to 41% is a move in the right direction. The government should resist, however, the temptation to reduce interest rates prematurely. As Mexico found out in mid-1995, an early relaxation of interest rates, although politically popular, will generate a loss in confidence and send the currency tumbling.

Third, it is imperative to move forward with privatization. Putting sacred cows like Petrobas, the state oil company, and BNDS, the development bank, on the block would not only help raise urgently needed funds but would cut a bureaucracy of legendary proportions.

Securing the remaining $32 billion from the IMF package is also essential to avoid unnecessary hardship. Before disbursing new money, however, the fund should insist on a coherent plan; otherwise it risks throwing good money after bad, as it has done so often during the last few years.

The challenge that President Fernando Henrique Cardoso faces should not be underestimated. Undertaking the policies required to stabilize the economy will be difficult, even politically unpopular. But it has to be done. If, however, Cardoso succumbs to populist temptations and imposes capital controls, lowers interest rates prematurely and unilaterally restructures the debt, Brazil will experience a tremendous retrogression.

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Sebastian Edwards, a professor at UCLA’s Anderson Graduate School of Management, was the World Bank’s chief economist for Latin America from 1993 to 1996.