Success for Cardoso and Brazil
is Critical for the Region

Domingo Cavallo

The following text is an edited transcript of remarks made by Domingo Cavallo to the 1999 annual meeting of the Trilateral Commission in Washington, D.C. Domingo Cavallo is former Economy Minister of Argentina.

I want to tell you what we have learned in Latin America, not about economic reform because I think we have not learned much more than we already knew in the 1980’s, but about the politics of economic reform. There we have learned a lot; in particular, Fernando Henrique Cardoso has learned a lot. I think that the big teacher was Carlos Menem, the President of Argentina, because he discovered that you can build very strong political support if you are able to stabilize the currency and eliminate inflation in a country with a long history of high inflation. If you find a way to suddenly deliver price stability and currency stability, then you receive much popular support, you win elections, and you are able to assemble a coalition in congress that will approve the necessary measures to open up the economy, to deregulate, to privatize, and to undertake economic reform programs. The key to fundamental success over the middle or long term is to use this opportunity to find a way to stabilize the currency and eliminate inflation and implement reforms in a sustainable way.

Fernando Henrique Cardoso learned this lesson very well. He built up his popular support and his political support by implementing the Real Plan and then he won the election. He became president and was able to get enough support in congress. Political support for Fernando Henrique Cardoso is completely tied to the real, so if the real devalues, then political support for him and his government will devalue also, and may even collapse. That is why I think the situation right now in Brazil is critically important not only for Brazil, but for all of Latin America.

There is another political circumstance that makes the situation in Brazil critically important—the end of Menem’s leadership in Argentina and Latin America. Unfortunately, he is not helping generate a new leadership in Argentina, so it is very uncertain what kind of leadership we will have in Argentina in the next four years. With no clear prospects of efficient leadership in Argentina, it is critically important to have a leader like Fernando Henrique Cardoso in Brazil to provide leadership for Brazil and the region.

Brazil needs to prevent reintroduction of inflation and indexation into the Brazilian economy. It is critical that Brazil in the next few months stabilize the real at a price lower than 1.7 reals per dollar. If Brazil stabilizes the real at a higher price, inflation will build within the Brazilian economy. Once inflation is introduced into the Brazilian economy, the popularity of President Fernando Henrique Cardoso will disappear, and he still has four years ahead as leader of Brazil. He needs support in congress to approve many more laws than those that have been approved so far. The last package just increased taxes, some of them very distorted taxes. The kind of laws that Fernando Henrique Cardoso needs to have approved in congress are, for example, the deregulation and the privatization of the energy sector and, of course, social security reform.

How Brazil stabilizes the real again, to keep political power and the economy functioning and expanding, is critically important now. I prefer the Argentina way. To prevent the reintroduction of inflation into the Argentinean and Brazilian economies depends on a monetary rule that has to be strictly enforced by the central bank of Brazil. Industrialists, bankers, and ordinary Brazilians will put pressure on the central bank to relax its monetary policy because the interest rates are very high and the recession is very deep. But if monetary policy is relaxed, inflation will be reintroduced into the Brazilian economy.

Brazil needs all Brazilians working for the stability of the real, and the way to have the Brazilians working for the stability of the real is to have the system that we have in Argentina. You give them, like we gave the Argentineans, freedom to choose between two currencies—the real and the dollar. Backing the reals in dollars like we did in Argentina is not dollarizing the economy. Brazil will have a period during which it can rebuild confidence in the real using the dollar as a supporting currency. If Brazil in four, five, or even ten years, together with Argentina, has increasing productivity and an expansion that allows us to have good currencies not backed by dollars, then we could let those currencies float, individually or jointly, vis--vis the dollar. But that will be in the future. Meanwhile we have to rebuild the credibility of the Brazilian and Argentinean currencies. Bimonetarism is crucial. If this reform were implemented in Brazil, but the Brazilians did not have the right to deposit their money in the Brazilian banking system in dollars, then nobody will believe in the commitment of the government to maintain the price of the real vis--vis the dollar.

Let me give you just one figure. Right now, Brazil has a public sector debt of 50 percent of GDP. It was just 40 percent a few months ago, but now with the compound effect of extremely high interest rates plus devaluation, the public debt in relation to GDP is 50 percent. If Brazil paid the Brazilians that are the main creditors of the government (fortunately for Brazil it is domestic debt, not foreign debt) 10 percent interest, like it would be paying if it had borrowed in dollars, not in reals, the cost of servicing the public debt would be 5 percent of GDP. With the primary surplus that Brazil can generate of 3 percent of GDP, the fiscal deficit would be 2 percent of GDP. But if instead, Brazil tries to finance its deficit and its public debt using a currency that, because of the inflationary expectations and what it embodies, generates interest rates above 20 percent in real terms, the cost of servicing the 50 percent debt is 10 percent of GDP. And, of course, with 10 percent of GDP servicing the debt, even if Brazil generates a 3 percent of GDP primary surplus, you still get an unsustainable deficit.

So for the benefit of the Brazilians and Latin America, Brazil should work hard to prevent additional devaluation of the real and the reintroduction of inflation. That will preserve the leadership of Fernando Henrique Cardoso in the region. I say in the region because I think that his leadership in the next four years will be relevant not only for Brazil, but for the region.