Brazil: Analyzing the Crisis
And Prospects for Recovery

André Lara Resende

The following text is an edited transcript of remarks made by André Lara Resende to the 1999 annual meeting of the Trilateral Commission in Washington, D.C. André Lara Resende was Special Advisor to the President of Brazil from August 1997 to April 1998, and then President of the National Bank of Development (May-November 1998).

I will talk briefly on two schematic interpretations of what went wrong in Brazil. Of course, you could simply say nothing was wrong domestically and that we were simply the victims of the contagion from the crisis of emerging markets. I don’t think this view should be taken seriously. The important question anyway is why Brazil was vulnerable to such a crisis.

Why Was Brazil Vulnerable? Exchange Rate Policy, Inadequate Fiscal Adjustment
The first view is that the root of the problem in Brazil was the exchange rate policy. When the real was introduced in July 1994, it managed very successfully to stabilize prices after three decades of chronic inflation. The real was left free to float from July 1994 until approximately April l995 and became overvalued in relation to the dollar. The starting parity was one real per dollar, but the parity went up to 83 cents of the real per dollar, and then came back slightly. The reason that the real revalued was the fact that extremely high domestic interest rates had to be maintained to consolidate the stabilization of prices. The resulting differential between domestic and external interest rates attracted a lot of short-term capital.

For many analysts, this was a huge mistake and there was no reason whatsoever to allow the real to revalue immediately after the stabilization program began. The revaluation of the real was, however, very important to reverse some of the currency substitution—the dollarization—in the Brazilian economy; and the importance of this revaluation in bringing inflation down quickly cannot be underestimated. However, in April 1995, the exchange rate policy was changed, and though it was presented as an exchange rate band, it was, in fact, a crawling peg. The only difference between this crawling peg and the crawling peg of the inflationary period was that now it had no fixed relation with domestic inflation; Brazil simply devalued by approximately a rate of six or seven percent per year (on a monthly basis, 0.5 or 0.6 percent) with respect to the U.S. dollar.

According to this view, these actions were not enough to reverse the original revaluation of the real; inflation was under control, but the exchange rate was dangerously overvalued. This put domestic industry in a difficult situation, squeezed between an extremely high cost of capital due to high interest rates, on the one side, and foreign competition due to an overvalued exchange rate, on the other. As a result, the large trade surplus that Brazil had maintained for many years was reversed. The current account deficit started to increase rapidly. The government insisted on playing the card of high interest rates to finance the increasing current account deficit. Therefore, when we were hit by the crisis in Asia, and then in Russia, confidence went down and to float the real was imperative to stop losing reserves. According to this view, the use of an overvalued exchange rate for so long, combined with high interest rates to attract short-term speculative capital, now risked threatening domestic inflation stabilization.

According to a second view, the problem in Brazil was not really related to the exchange rate; it was simply a question of not being able to promote the necessary fiscal adjustment. When the Real Plan was introduced, it included a very specific constitutional amendment to guarantee some kind of fiscal relief. This was, however, only a transitory measure that would maintain fiscal balance for a few years. Everybody knew that fiscal equilibrium in the long run would depend on institutional reforms. Resistance from pressure groups with interests in maintaining a heavy state sector delayed these reforms. The government had to go on financing a rapidly increasing public debt with higher and higher interest rates. The fiscal deterioration caused a loss of confidence. Low confidence ended up provoking the crisis when other emerging markets collapsed. According to this view, the exchange rate was not in question, and if the real had been devalued, the only winners would have been those forces against the structural reform and the quest for fiscal equilibrium It would have been the victory of those accustomed to living under an apparatus of protection from outside competition and dependent on public subsidies.

Of course, it is possible to recognize in these two views the two classical cases of wrong relative prices and the necessity of expenditure-switching policies, on the one hand, and, on the other, of too much expenditure, low public saving, and the necessity of expenditure-reducing policies. I think that to accept one of these extreme views and to reject the other is incorrect; virtue most of the time is in the middle, and both have some merit. There is no doubt that if we had managed to make more progress on the fiscal side we would have been less vulnerable to the external crisis. At the same time, it is clear that a more devalued domestic currency would have helped significantly, since the current account deficit to be financed would have been smaller. Interest rates could, therefore, have been lower. As a result, there would have been more growth, less unemployment and a better fiscal situation. These two questions—exchange rate policy and fiscal equilibrium—should be handled together.

Recent Events
After the Asian crisis in 1997, Brazil started to lose reserves. Interest rates, down from levels in excess of 50 percent at the beginning of the real stabilization program to levels around 20 percent, had to be sharply increased again to face the external shock. Higher interest rates led to a further deterioration of the fiscal situation and to a rapid increase of domestic public debt. A large and increasing current account deficit associated with successive failures to reduce the public sector deficit eroded confidence, and Brazil started to lose reserves. Late last year, it became clear that the country should try to have a preventive arrangement with the IMF. An agreement was reached, with the understanding that Brazil would not devalue. In fact, this was a point that Brazilian negotiators stressed as a condition for the accord. In January, with foreign reserves continuing to fall, in spite of the agreement with the Fund, Brazil tried to change the exchange rate policy. The crawling peg was abandoned and an exchange rate band, with explicit rules of intervention, was announced. After two days it had failed miserably. Faced with massive capital outflow, Brazil had to stop defending the band and to adopt the float.

In my view, the attempt to change the crawling peg rate to a band was technically correct, but the timing was wrong. It was too late. Immediately after the agreement with the IMF, the government suffered two important political defeats. First, it failed to approve a piece of legislation on the Social Security reform which was vital for meeting the fiscal targets agreed with the Fund. Second, in early January, the new governor of the state of Minas Gerais, ex-President Itamar Franco, declared a moratorium on that state’s domestic and external debt. These two factors, associated with the substitution of the Central Bank Governor, who had defended the previous exchange policy, led to a complete loss of confidence in Brazil’s ability to defend the newly announced band. The fact that the IMF was surprised by the change of policy—and did not hide the fact that it was not very happy—was also very important in aggravating the confidence crisis. In these circumstances, I think it was the right decision not to try to defend something that had become clearly indefensible.

What happened next? The real fell from 1.21 per dollar to 1.45. It held there for a few days. There was some initial optimism that this rate could be sustained. Well, not so. When the excess reserves of the banks dried up, there was complete illiquidity in the exchange market, and the real started to devalue more and more, ending up below 2.2 per U.S. dollar, far beyond any reasonable point of long-term equilibrium. All credit lines to the country were significantly reduced; even trade lines were called back. Since external payments still had to be paid, any additional demand on the exchange market only added to the pressure on the price of foreign reserves.

The Central Bank of Brazil had its hands completely tied by the IMF. The first “tranche” of nine billion dollars had already been drawn. Before using the money to try to stabilize the exchange market, Brazil had to renegotiate with the Fund. So for all practical purposes, the Central Bank—with about 39 billion dollars of reserves, counting the IMF money—had to act as if it had zero reserves, and could not intervene in the market for two weeks. After a new agreement was negotiated and the IMF agreed that the Central Bank of Brazil could intervene in the market, the real recovered to levels around 1.80 per U.S. dollar.

Prospects for Recovery
Where are we now and what are the perspectives? Well, I think that after a few extremely rough weeks, things are much better. Those who subscribe to the view that the roots of the Brazilian problems were the overvalued exchange rate would certainly say that we have a high probability of a fast recovery. The current exchange rate seems to be, by all means, undervalued. Brazil’s exports will recover, even if the world situation does not improve significantly, and imports have collapsed. The trade surplus will, therefore, reappear soon. The current account deficit will be reduced; confidence should then come back and credit lines return. Finance Minister Malan is now with the new governor of the Central Bank, Arminio Fraga, in Paris to discuss with banks the possibility of reestablishing the credit lines so that the market can stabilize. A short recession seems unavoidable but the economy should probably start to recover before the end of the year.

If, however, you take the view that Brazil’s difficulties are due to the lack of long-term fiscal adjustment, you would still have to ask if the agreement with the IMF will finally lead to serious fiscal homework before taking a positive stance on the economy. Is it sufficient to guarantee that inflation will not come back after the large nominal devaluation of the currency?

There is one additional restriction that tends to be overlooked in most analyses, which is the socio-political restriction.

The crucial question is why are interest rates in Brazil still so high? The lack of confidence is certainly an important part of the answer. High interest rates are due to the lack of confidence, but high interest rates aggravate the fiscal situation that is the main cause of the lack of confidence...

A Mercosur Currency Union?
Is there an alternative to this difficult situation? The alternative of adopting a “currency board,” of using a fixed exchange rate with a currency fully backed by foreign reserves, has many supporters. This is, of course, what Domingo Cavallo has adopted in Argentina and what he defends as the best alternative for countries that come from a recent experience of hyperinflation, like Argentina and Brazil.

The consensus today on exchange rates seems to be that there is a superiority of the extremes—either you float or you go to a fixed exchange rate. The float is believed to be more adequate for large closed countries and fixed exchange rates for small open economies; so Brazil would clearly qualify as a candidate for the float. This would be certainly true if Brazil were not coming from a long period of chronic inflation and a serious crisis of confidence in its currency.

There is strong political resistance to the Currency Board. This resistance seems to be, at first, of a psychological nature, probably due to the association of currency boards to the colonial regimes of the past. There are, however, two recent misconceptions associated with the adoption of the currency board. The first is that the adoption of a currency board has to be preceded by a forced restructuring of public debt. The second is the idea that it is not the stock of M0, the monetary base, which has to be fully backed by external reserves, but indeed M4, the broadest definition of a monetary aggregate. The reasoning is the following: Since domestic public debt is mostly short-term debt, it could, in principle, be totally transformed into money; in order to avoid a run it would, therefore, have to be fully backed by foreign reserves. This is, however, a case of the classical confusion between stocks and flows. All you need is a guarantee that no additional currency will be issued without an equivalent increase in the stock of the reserve currency. The current stock of domestic currency is being held under very adverse circumstances. Introducing the restriction on the issuance of additional currency will only increase the quality of the stock of financial assets denominated in the domestic currency and, therefore, lead to an increase in the demand for money and debt.

There is one additional risk with respect to the idea of a currency board. There is always the temptation to look at it as a short-term panacea to which you can turn in a desperate situation. Most of the benefits of the currency board come in the short run: a higher degree of confidence and lower interest rates. The fiscal constraints and the restrictions on the ability to react to adverse external shocks, however, are longer-term consequences.

I believe that to consider the possibility of adopting a fixed exchange rate in the near future, fully backed by foreign reserves, only makes sense as part of a long-term program towards a currency union for the Mercosur region. This is not incompatible at all with a successful way out of the current crisis with a floating exchange rate. On the contrary, I believe that the monetary union should not be viewed as an easy alternative to short-term difficulties, but as part of the process of going toward a new world. Everything seems to indicate that, in the future, there will be fewer currencies. There seems to be too many currencies and too much instability for an increasingly integrated world economy.