SWESWESWEBeyond the BorderBeyond the Border

N JANUARY BRAZILthe eighthlargest economy in the worlddevalued its currency, initiating thefirst financial crisis of 1999. To un-derstand Brazils crisis, it is usefulto examine the economic program

that preceded it.In 1994, after years of failed price sta-

bilization plans and resulting high infla-tion, Brazil initiated a stabilization plannamed for its new currency, the real.Despite some problems, the Real Planwas cause for optimism. Brazil tooksteps to correct a large federal deficit,reducing funds transferred by the fed-eral government to the states and munici-palities and increasing federal incometaxes. Monetary policy became more re-strained. Finally, Brazil pegged its cur-rency to the dollar. Pegging involvedusing the central banks dollar reservesto buy reais or using the real to buy dol-lars, whichever was necessary, to con-trol the number of reais a dollar couldbuy.1 In other words, if the free marketwould not supply as many dollars as realholders wanted at the official exchangerate, then the government would sup-ply dollars out of its reserves.

By pegging its currency, Brazil wassending a signal not only about its cur-rency but also about its monetary policy.To effectively peg its currency to thedollar, a country must follow a mone-tary policy parallel to that of the UnitedStates. If Brazil were to peg to the dollarand run a significantly more inflationarymonetary policy than the United States,the difference between its inflation rateand U.S. inflation would ultimately causeintolerable stresses for its currency sys-tem; that is, U.S. prices expressed inreais would become cheap to Brazil-ians, but Brazilian prices expressed indollars would be expensive to U.S. con-sumers. Everyone would buy Americanand no one would buy Brazilian. Brazilsuspected it could not match U.S. mone-tary or inflation policy exactly, so itmaintained a crawling peg. This meant

the exchange rate would be allowed toslide, but within limits.

The pegged exchange rate plus theother aspects of the Real Plan did sendan important message to the world:Brazil was making a persistent effort tocontrol inflation and was achieving itsgoal. In 1994, the year the Real Planbegan, Brazils annual inflation rate ex-ceeded 900 percent. By the end of 1998,price movements were negative.

Despite the plans success, however,the controlled devaluation built intoBrazils crawling peg was not enough tooffset the cumulative differences be-tween U.S. and Brazilian inflation rates.This overvaluation of the real made itharder to sell Brazilian products abroadbecause they were so expensive in dol-lars, and also motivated more Braziliansto shop abroad.

Financial Contagion

Another event aggravated the fiscalproblems the country had hoped to address with programs linked to theReal Plan. Brazil began to suffer from financial contagion, in part because ofworries about its overvaluation. Conta-gion occurs when a financial crisis inone country motivates investors to re-move their funds from otherperhaps

similarcountries as well. When finan-cial crises swept Asia in 1997 and Russiain 1998, investors who were pulling theirinvestments out of those countries alsobegan to withdraw them from Brazil. Todiscourage the outflow of dollars,which the central bank would have tosupply to maintain the pegged exchangerate, Brazil raised interest ratesa stepintended to entice investors to hold theirmoney in Brazil to earn high interestrates. Chart 1 reveals Brazilian interestrate surges, which reflect investor nerv-ousness during the Korean and Russianfinancial crises.

The large increases in Brazilian inter-est rates, however, were not enough tokeep foreign currency in the country.To maintain its pegged exchange rate,Brazil also had to devote much of itsforeign currency reserves to defend thereal. Dollar reserves, which had peakedat more than $70 billion at the begin-ning of 1998, dropped by half thatamount by years end.

A growing fiscal deficit frightened in-vestors. Chart 2 breaks down the deficitbetween the portion attributed to interestpaymentsmarked interestand theportionlabeled primary that is thedifference between government expen-ditures on goods and services and thegovernments income from taxes andfees. The primary deficit is not large on

Brazil: The First Financial Crisis of 1999

I

Chart 1Brazilian Interest RatesPercent

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1/4/999/4/984/17/9811/28/977/11/972/21/9710/4/96

Korean crisis Russian crisis

Chart 2Fiscal Deficit WorsensPercent of GDP

Primary InterestTotal

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1998199719961995

Federal Reserve Bank of Dallas Page 13

a year-to-year basis, but the year-in/year-out accumulation of these deficitsby a country that has a history of debtmoratoriums can worry investorsespe-cially in the context of financial crises inAsia and Russia. Nevertheless, even someusual measures of overall indebtedness,such as the debtgross domestic prod-uct (GDP) ratio, did not suggest an ex-isting crisis.

While the primary deficit was notlarge, the increases in interest ratesmade the overall deficit much greater.Last year, the two parts of the deficitthe primary and interest portionssummed to about 8 percent of GDP.That, together with signs that the pri-mary deficit problems might continue,made investors nervous. Increasinglyuncomfortable with Brazilian debt inany case, debtholders became particu-larly more reluctant to hold longer-termBrazilian debt. The ratio of short-term tototal Brazilian debt increased markedly.

The Endgame to Devaluation

As problems became more acute in1998, some well-known economistsbut not all of thembegan to callopenly for a Brazilian devaluation. Afterthe re-election of President FernandoHenrique Cardoso last fall, hopes beganto rise that he could effectively addressBrazils budgetary difficulties. He an-nounced a new budget plan to saveabout $23 billion. Some analysts beganto forecast federal primary surpluses for1999. A $41.5 billion International Mone-tary Fund (IMF) pre-emptive programwas announced to assure currency specu-lators that attacks on the real would notbe warranted.

Then hopes began to fade. In Decem-ber, a deficit reduction bill was voteddown, in part by members of the presi-dents own coalition. A significant pen-sion reform effort failed. Meanwhile, stillin December, the rate of capital out-flows accelerated rapidly, to as much as$350 million per day.

If a particular event could be said tohave triggered Brazils devaluation, itwas the announcement by the new gov-ernor of the Brazilian state of MinasGerais that he would suspend his statesdebt payments to Brazils national gov-ernment for three months. Capital out-

flows accelerated even more rapidly. By mid-January, Brazil announced thatpegging was over and its exchange ratewould be allowed to float.

What Next?

What are the implications of Brazilscrisis for the United States, and for Texasin particular? Although about 20 percentof U.S. trade is with Latin America,Brazil accounts for only about 2 percentof total U.S. exports and 1 percent oftotal imports. Similarly, Texas sendsonly 2 percent of its total exports toBrazil. For Texas, direct trade effects ofthe crisis will be small. Brazils tradelinks with Texas chief trading partners,Canada and Mexico, are also extremelylimited.

Does this mean Brazil will have nointernational impact? Weakness in Brazilwill have impacts on its chief tradingpartners, of which Argentina is a pri-mary example. But a broader concern isthat while Brazil had been subject tocontagion effects, it might now triggerthem. Although such effects were evi-dent in some Latin American marketsimmediately after the onset of Brazilscrisis, they appear to have subsided. Fornow, the principal focus with respect toBrazils problems is Brazil itself, wherethe economy is already in recession. Inthe wake of the devaluation and float,Brazil began to approve fiscal reforms,including much-needed pension re-forms. Of particular interest will be thenew IMF agreement, debt negotiationsbetween state governors and the na-tional government, and further congres-sional actions to address the centralgovernments fiscal deficit. All these fac-tors will be significant as Brazil attemptsto resolve its crisis.

William C. GrubenSherry Kiser

sNote1 In Portuguese, the national language of Brazil, the plural form of

words ending in the letter l is typically is. Under this rule, becauseone unit of Brazilian currency is a real, we refer to more than one as reais.

Page 14 Southwest Economy March/April 1999

Robert D. McTeer, Jr.President and Chief Executive Officer

Helen E. HolcombFirst Vice President and Chief Operating Officer

Harvey RosenblumSenior Vice President and Director of Research

W. Michael CoxSenior Vice President and Chief Economist

Senior Economists andAssistant Vice Presidents

Stephen P. A. Brown, John V. Duca, Robert W. Gilmer, Evan F. Koenig

Director, Center for Latin AmericanEconomics, and Assistant Vice President

William C. Gruben

Senior Economist and Research OfficerMine K. Ycel

EconomistsRobert Formaini Fiona D. SigallaDavid M. Gould Lori L. Taylor

Joseph H. Haslag Lucinda VargasKeith R. Phillips Alan D. Viard

Marci Rossell Mark A. WynneJason L. Saving Carlos E. J. M. Zarazaga

Research AssociatesProfessors Nathan S. Balke,

Thomas B. Fomby, Gregory W. Huffman,

Southern Methodist University

Professor Finn E. Kydland, Carnegie Mellon University

Professor Roy J. Ruffin, University of Houston

Executive EditorHarvey Rosenblum

EditorsW. Michael Cox, Mine K. Ycel

Publications DirectorKay Champagne

Copy EditorJennifer Afflerbach

Design & ProductionLaura J. Bell

Southwest Economy is published six times annually bythe Federal Reserve Bank of Dallas. The views ex-pressed are those of the authors and should not be at-tributed to the Federal Reserve Bank of Dallas or theFederal Reserve System.

Articles may be reprinted on the condition that thesource is credited and a copy is provided to the Re-search Department of the Federal Reserve Bank ofDallas.

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