CONNECTING THE DOTS
The Latest Victim of Global Financial Crisis
The ripple effect of the global financial crisis that started with the devaluation of baht in Thailand in July 1997 can still be felt around the world. The latest victim of this financial contagion is Brazil.
Brazil is now in deep crisis. Its currency, the real, has plunged more than 30 per cent against the dollar, since last week when the currency was first devalued and then allowed to float in the market.
The economic turmoil in Brazil started late last week with the resignation of the central bank president, Gustavo Franco, a hardline foe of devaluation. His replacement, Francisco Lopes, didn't waste any time in announcing that the trading band for the real set under the Real Plan, would be widened.
The Real Plan was initiated in 1994 by pegging the Brazilian currency to the US dollar. The real traded within a narrow band with a slow depreciation for more than four years, ending a hyperinflation that had reached an annual rate exceeding 2000 per cent in 1994.
In abandoning the narrow band of the currency peg, Lopes triggered a massive devaluation. The Brazilian currency slumped in value by about 9 per cent within a span of 48 hours. The devaluation was exacerbated by the steady decline in the central bank's international reserves. Lack of confidence among investors, both foreign and domestic, due to the absence of commitment on the part of the Brazilian political leadership about economic reform, cost the country about $6 billion in December. In the wake of the devaluation earlier this week, more than 2 billion dollars of international reserves left the country.
Once the government realised that it was spending its international reserves in a futile defence of the currency, it decided last week to float its currency in the market.
Although the timing of Brazil's devaluation and the subsequent floating was unexpected, that it happened wasn't a surprise to many people. Despite vows by Fernando Cardoso, who began his second term as Brazil's president on the New Year's Day, to carry out economic reform, both foreign and domestic investors have been leaving Brazil as it became clear that there wasn't a political consensus for fiscal reforms. The Brazilian Congress last month rejected measures aimed at reducing federal budget deficits.
Initial signs of the trouble started when Itamar Franco, the former president of Brazil and the current governor of Minas Gerais, one of Brazil's 27 states, declared a moratorium on the state's $15 billion debt with the federal government. This was a major challenge to Cardoso's austerity programme which was introduced last summer, when Brazil came close to having to devalue its currency.
Towards the end of 1998, Brazil narrowly averted a currency crisis by taking some immediate steps, including an increase in the interest rate to prevent capital flight, drastic cuts in the federal budget, long-term fiscal reform, and a $42 billion package of IMF aid package.
However, the measures have so far not restored the government's credibility. The high interest rates designed to attract foreign portfolio investment, combined with the IMF aid package, proved to be no substitute to fundamental structural changes in the economy. In Brazil's case, this includes a major reduction in the size of the public sector.
The situation in Brazil would definitely result in scarcer capital, higher interest rates and lower economic growth in the rest of Latin America. That's certainly the case if the initial response of regional markets is any indication. Throughout Latin America, jitters in currencies and equity and debt markets became evident as already nervous investors further cut their exposure to regional assets.
The crisis would postpone the recovery stage in many countries. Interest rates will increase as investors will demand a higher return on both dollar-denominated international bonds and local-currency assets. However, market conditions immediately after the initial devaluation show that the widening of the spreads aren't as pronounced as they were last August when Russia defaulted on some of its debt and devalued its currency. One reason for this may be that the investors are less leveraged than they were even a few months ago and that those who are likely to sell in a steep downturn had already bailed out of Latin America.
The ripple effect of the Brazilian crisis on the economic fundamentals in other Latin American countries could be felt in the foreseeable future. Argentina, Brazil's main trading partner in Latin America, would be beset with higher unemployment and falling wages, just as it was after Mexico's sudden devaluation in 1994. It will also be forced to maintain high interest rates in the coming months in order to attract scarce capital.
Mexico's economy is also expected to slow as a result of Brazil's problems, though it benefits from its close commercial and investment ties with the resilient US economy. However, the Mexican authorities will have to find out ways to prevent downward pressure on their currency, peso, from exacerbating an increase in inflation that already threatens to wipe out real gains in buying power. They need to tighten monetary policy in order to keep price increase under control. Monetary authorities in Chile and Ecuador responded by either selling dollar and buying domestic currency or raising the interbank target lending rate.
Several other countries in the region, such as, Columbia and Venezuela, would also be affected. In these countries, high interest rates and skidding property prices have already sparked a financial crisis that is putting a strain on their budget deficit situation. The situation in Brazil will only raise the prospect that more problems will emerge in these countries.
The possibility that emerging market economies, especially in Asia, would face a fresh wave of financial crises also cannot be ruled out. The crisis has already sent shock waves across global financial markets, weakening the dollar and pushing stock markets lower.
The short-term global effect of the Brazilian crisis would be mainly through financial contagion which may work in several ways. First, international investors and speculators may readjust their portfolios. Second, countries may be affected through trade or banking operations. Third, economic agents in other countries may react because the situation in a crisis-hit economy resembles the situation in another.
The long-term effect of the crisis would be much broader. The move towards globalisation during the last decade has encouraged the free flow of goods, services, and capital across countries. Recent financial crises in East and Southeast Asia and Russia have challenged this world view. Some critics of globalisation have already started to argue that the risks of interacting with the global economy is greater than the risks of partially withdrawing. Events in Brazil would only strengthen their view.
As I have written repeatedly in this column on previous occasions, the international community needs to impose some type of control in speculative capital movement across countries. A regime of capital account convertibility that includes free flow of capital is pushing the developing countries towards more uncertainty as their economy is not robust enough to be exposed to the shocks that unhindered capital flows can bring.
There should be no doubt in anyone's mind that the developing countries need productive and long-term capital inflows. However, flow of capital based solely on speculation and short-term profit motive would only help to destabilise a developing economy. By imposing restrictions on speculative capital movement, the domestic economy can be protected from the pressures of the global financial markets. It would also help to introduce economic reform in a prudent and sequential manner. The latest episode of economic and currency turmoil in Brazil can only help to emphasise this point.
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