The Asian crisis spread to Brazil at the end of 1997. Foreign investors began to flee, putting pressure on the real. The real was temporarily stabilized by President Fernando Henrique Cardoso’s administration, which raised the lending rate and reduced government outlays (Desai 2003).

Trouble resurfaced in August 1998 when the Russian crisis peaked, and at the same time a large Brazilian state, Minas Gerais, declared a debt moratorium. Brazil had been spending excessively and owed a large amount of debt to foreign creditors. Persistent accumulation of debts worried foreign investors. When the Asian crisis and the Russian crisis struck, Brazil raised interest rates. At the same time, it put forth a fiscal reform package. These policies reduced Brazil’s credibility as a debtor nation. The increased interest rates had the effect of forcing up nominal deficits. Speculative attacks on the currency ensued as investors predicted currency devaluation (Gruben and Welch 2001). Foreign exchange reserves fell as the government tried to support the real, but by December 1998, the government was forced to turn to the IMF. The real was floated on January 18, 1999.

Although growth was present, the budget and current account deficits were considered unsustainable. IMF requirements brought budget deficits under control, but slow exports and increasing current account deficits put the currency under pressure again in 2001. The IMF again injected funds to prevent a debt default and promote investor confidence (Desai 2003).

Causes of the Crisis

Brazil’s currency, the real, was initially introduced in 1994 as part of a plan to combat inflation and was successful. The Real Plan used indexation tied, through the exchange rate, to the number of dollars used to purchase goods, and the real was allowed to fluctuate within a band (Gruben and Welch 2001). Brazil also liberalized trade and foreign investment restrictions in order to increase competitive forces, decreased funds distributed to its states, and increased federal income tax rates. Indeed, capital flows into the country through 1997 increased greatly, particularly in the form of foreign direct investment, allowing expenditure to be increased (Palma 2000). Although foreign debt increased, Brazil’s transition from state-led to private sector-led growth appeared to be taking off.

Unemployment and current account deficits rose in 1997. Fiscal spending at the state and central levels over this period was out of control, and translated into the current account deficits that depended on net foreign inflows for balance. Fiscal revenues were increasing, but fiscal government expenditures grew significantly. Government payroll expenses, social secu-

Brazil’s real interest rate

Figure 7.2 Brazil’s real interest rate

rity expenditures, and transfers to states continued to rise over the period (Giambiagi and Ronci 2004).

Brazil encountered several external shocks - the Mexican, Asian, and Russian crises - after each of which the Brazilian government raised interest rates (Figure 7.2), in order to prevent capital flight (Palma 2000). Once capital outflows began as a result of the Asian crisis, trouble began. Interest rates were doubled on October 31, 1997 to combat the crisis, but higher interest payments on government debt and a widening fiscal deficit perpetuated the crisis (Bulmer-Thomas 1999). As a result of interest rate increases, industrial production declined.

In addition, despite increases in interest rates, it became clear that the real was increasingly overvalued and foreign investors expected devaluation. To make matters worse, foreign investors were aware that the Brazilian government lacked consensus on deficit reduction policies. The Parliament was notoriously slow in approving the budget, which did not improve confidence in Brazil’s mounting external and internal public debts. President Cardoso, attempting to push through Congress an amendment to the constitution which would allow him to run for a second term, made many concessions to Congress on fiscal reform (Amann and Baer 2000).

Events of the Crisis

When Minas Gerais Governor Itamar Franco declared a debt moratorium in August 1998, and was supported by six other Governors who wished to renegotiate their debt as well, serious speculative attacks began to take place (Gruben and Welch 2001). Brazil’s commitment to fiscal adjustment was called into question. Shortly after, at the very beginning of 1999, the head of the central bank, Gustavo Franco, resigned, and capital flight increased.

The currency was attacked again in October 1998, and the $41.5 billion IMF rescue package issued in December 1998 failed to provide sufficient reserves to restore investor confidence. Brazil’s currency was floated in January 1999 and swiftly devalued to 45 percent of its value. The devaluation created inflation, and in response authorities raised interest rates and implemented a new policy of inflation targeting (Bulmer-Thomas 1999). With the flotation of the currency, an inflation targeting framework as a nominal anchor was chosen to create a more transparent monetary commitment, in the hopes that market uncertainty would decline (Fraga 2000). Exports became more competitive with the devaluation. The exchange rate continued to float with little central bank intervention.

Brazil’s IMF package totaled $41.5 billion, and included more than $18 billion in loans from the IMF, $4.5 each billion from the World Bank and Inter-American Development Bank, and $14.5 in bilateral credits from 20 governments (Flynn 1999). The size of the package was intended to assure markets, but because there were no policy requirements to engage with the private sector or to change the exchange rate regime, the package did not produce the confidence that was expected. According to the IMF requirements, Brazil was to achieve a primary budget surplus of 3.1 percent of GDP (Amann and Baer 2000). This was obtained by collecting more taxes from wealthier individuals. Attempts to increase taxes on public workers to add to the fiscal surplus were declared unconstitutional by the Supreme Court. IMF requirements also required reforms of social security, public administration, public expenditures, and revenue sharing (IMF 1998).

In February 1999, the central bank President, Francisco Lopes, was sacked after only three weeks in office, due to his failure to prop up the real on January 29 (Flynn 1999). Reserves declined rapidly, from US$75 billion in August 1998 to less than US$35 billion in January 1999 (Amann and Baer 2000).

Export and gross domestic product (GDP) growth picked up in the aftermath of the crisis, with exports increasing steadily as a percentage of GDP for several years thereafter (see Figure 7.3). Foreign direct investment

Export and GDP ratios, Brazil, 1996-2001

Figure 7.3 Export and GDP ratios, Brazil, 1996-2001

continued to flow into the country (Palma 2000). Recovery after the crisis was quite fast, due to Brazil’s low dependence on imports, its political stability at the time, its largess of reserves after the crisis, and the promise of an IMF package before the crisis took place.

Outcomes of the Crisis

The banking sector suffered due to events of the crisis. As a result of increasing interest rates, many individuals and firms were unable to repay their loans, which resulted in a large increase in non-performing loans (Amann and Baer 2000). Maturity mismatches between liabilities and assets created additional problems for banks. State banks in particular faced difficulties, since they had little experience managing risk and insufficient autonomy, with non-performing loans. For private banks, the government set up a Credit Guarantee Fund, to which all financial institutions were required to contribute 0.024 percent of all balances in accounts covered. Forty-three financial institutions were put under a Temporary Special Administrative Regime to shore up resources. Banking mergers and acquisitions were also made easier through the Program of Incentives for the Restructuring and Strengthening of the National Financial System, while privatization was made easier through the Program of Incentives for the Restructuring of the State Public Financial System.

Political Economy of the Brazilian Crisis

Brazil was governed, over the crisis period, by President Fernando Henrique Cardoso. Cardoso was a scholar who believed that Brazil followed the dependency theory, which meant it had been caught in a low state of development due to vested interests on the part of the bourgeoisie and foreign powers. Cardoso believed development was possible where domestic ownership of industry was significant. He later became an advocate, in his role of President, for business interests. Cardoso was one of the main architects of the “Real Plan” which was formulated to stabilize the economy.

Brazil was entering a pre-crisis phase in 1998, and Cardoso made a speech underscoring the fact that major fiscal adjustment was to take place. Government scandal involving wiretapping of privatization deals further weakened political capital. A bailout package, centered around a crawling rate exchange rate regime, was approved by the IMF in December.

Cardoso had just been re-elected when Brazilian state Minas Gerais declared a debt moratorium. Cardoso was accused of postponing new economic policies in the run-up to his re-election, and his government was later blamed by the Group of Seven (G-7) and IMF for failing to preserve the crawling peg, which had been a requirement of the December bailout package (de Paiva Abreu and Werneck 2005). A new central bank board was appointed to uphold the conditions of the IMF package. The government proved successful in carrying out fiscal adjustment, reducing the inflationary shock from devaluation, and improving exchange rate conditions.

Brazil recovered rapidly from its crisis, as Argentina’s economy became increasingly vulnerable. Mounting external debt, coupled with a number of external shocks, from the Asian, Russian, and Brazilian crises, weakened the Argentine economy. We next turn to the crisis in Argentina that began in 2000, and examine the causes, events, and outcomes of the crisis.

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