EconSouth (First Quarter 1999)
Brazil's Policy Changes Dampen
It's too early to gauge the full impact of the central bank's decision to change its foreign exchange policy. One can, however, begin to map out some of the implications that the real devaluation will have for Brazil as well as the rest of Latin America and the United States.
ecent changes in Brazilian monetary policy have received significant attention in both financial markets and economic policy circles. Indeed, Brazil's importance should not be minimized — it is the world's eighth-largest economy and represents more than 40 percent of Latin America's gross domestic product (GDP). Almost certainly, the recent developments in Brazil will have implications beyond its borders. The key to sorting through these developments is to examine the policy measures Brazil's government has recently taken and then determine how they might affect the remainder of Latin America as well as the United States.
Floating the real
On Jan. 13, Brazilian authorities modified the Real Plan (see sidebar) by eliminating the inner trading band that it used to micromanage the currency's value. This modification effectively devalued the currency by 9 percent, to 1.32 reais per dollar.
On Jan. 15, the Brazilian central bank announced that it would no longer intervene in the foreign exchange market, effectively ending the Real Plan. The real quickly fell as low as 1.61 per dollar and closed the day at 1.45 reais to the dollar — a decline of over 20 percent from the predevaluation level. As of the end of February, the real had declined to approximately 2 reais per dollar, a 69 percent devaluation. Prior to Brazil's policy changes its currency had been trading at 1.21 per dollar.
Although some observers had long predicted or recommended a devaluation, and many had noted the increasing likelihood of such a move in 1999, the timing of the devaluation was a surprise. The $41.5 billion financial assistance package sponsored by the International Monetary Fund (IMF) in November 1998 and the progress being made in the government's reform agenda seemed to indicate that Brazil was working through its problems.
But several negative developments occurred in the days preceding the decision to float the currency, developments that made it more difficult for Brazil to finance its budget deficit. Approximately $5.5 billion left Brazil in the first two weeks of 1999. By the end of January, Brazil had about $36 billion in reserves compared to just over $70 billion in August 1998. The Standard and Poor's ratings agency downgraded Brazil's foreign debt rating, and the Bovespa, Brazil's leading stock index, fell by just over 27 percent in the week before Brazil's announcement to float its currency. At the same time, short-term interest rate futures doubled to 56 percent.
Important political developments also preceded Brazil's announcement. Conflict increased between state governors and the federal government over the issue of state-level debt owed to the federal government. Following the lead of newly elected Itamar Franco, governor of Minas Gerais, the opposition-controlled state government of Rio Grande do Sul sought relief from federal debt payments, gaining a state Supreme Court injunction allowing it to temporarily suspend a 31.2 million real payment. This conflict raised concerns over the federal government's ability to meet its fiscal targets as well as its capacity to mobilize political support for further economic reforms. Another salient development was the unexpected resignation of central bank president Gustavo Franco, one of the designers of the Real Plan.
It is too early to gauge the full impact of the central bank's decision to change its foreign exchange policy. One can, however, begin to map out some of the implications that the real devaluation will have for Brazil as well as the rest of Latin America and the United States.
The effects on Brazil
The decision to float the real ended the growing uncertainty over Brazil's currency regime. The move to a free float should help Brazil lower interest rates and achieve a sustainable recovery in the near term. At the same time, though, the devaluation has negative implications for Brazil's short-term economic performance.
Even before the devaluation, most private forecasts projected a recession for Brazil in 1999, largely because of the country's austerity measures and the high-interest-rate environment. Growth forecasts are now being lowered further, and Brazilians will experience an even more difficult year than expected. The consencus forecast for Brazilian real GDP growth was revised down to -3.9 percent from -1.5 percent in December.
One of the most obvious effects of the devaluation is the increase in Brazil's foreign debt burden, mostly from the private sector since it has a much greater short-term foreign debt exposure than does the country's public sector. Leading Brazilian companies have long borrowed abroad in order to obtain better terms than have been available domestically, and those companies will now have to adjust their payments for the changes in the exchange rate.
Brazil's underlying fiscal imbalances will be aggravated as a result of the devaluation. While the bulk of public sector debt is real-denominated, it is nonetheless vulnerable to foreign exchange swings as well as prevailing economic conditions.
In recent months, the federal government has issued short-term domestic debt indexed in foreign currency but payable in local currency. This type of issue helps attract investors who might otherwise be skittish about the real. The devaluation increases the debt burden in reais because it is paid out in local currency but valued in foreign currency. Much of the public sector's domestic debt is also keyed to short-term interest rates, which have remained high for some time.
Interest rates may not immediately come down because the central bank may want to keep rates high in the short term to help stem capital outflows, which have continued despite the float (see Chart 1). While high rates help entice investors to maintain their capital in Brazil, they also tend to dampen economic growth. There are also potential trade-offs between supporting domestic recovery with lower interest rates and keeping any resurgent inflation at bay.
The devaluation also has important implications for Brazil's exports. Although exports from Brazil will increase in 1999 as a result of the devaluation, Brazil cannot ship enough abroad to offset the effects of the recession. Exports represented only 6.7 percent of Brazil's GDP in 1997. There is still considerable uncertainty over the outlook for global demand. Continued growth in the United States, Europe and the rest of Latin America will be pivotal for Brazilian exports. Data for 1997 showed exports to these markets representing 1.2 percent, 1.8 percent and 1.9 percent of Brazilian GDP, respectively.
Short-term economic conditions have deteriorated as a result of the devaluation; for example, unemployment in São Paulo, Brazil's leading industrial city, is already very high at 18 percent. It is unclear whether this deterioration will lessen President Fernando Henrique Cardoso's political support. Most observers correlate the Real Plan's success in reducing inflation with President Cardoso's strong political support over the last four years. The deepening financial difficulties, however, have already facilitated more rapid legislative approval of the president's proposed fiscal reforms.
The impact on Latin America
While most countries in Latin America have been achieving progress with economic reform during the 1990s, the Asian-induced turmoil of 1997 and the Russian default spillover in August 1998 precipitated additional policy responses in the region. These new measures included raising interest rates to stem capital outflows and instituting budget cuts to account for decreased government revenues. The combination of monetary and fiscal tightening, as well as the steep drop in commodity prices in 1998 — especially for oil and metals, which a number of Latin countries depend on for export earnings — had led to a deterioration in the region's economic outlook for 1999.
Overall, the decision by Brazilian authorities to float the real will have a negative impact on the region's outlook. The 1999 outlook for Latin America prior to the devaluation was already rather negative. The near-term implication of the deeper-than-expected recession in Brazil is for even slower growth in selected Latin American economies, most notably in Argentina. The 1999 forecast from Consensus Economics was revised down to -1.2 percent in February from 0.5 percent in December. In 1998, regional growth was 2.2 percent and in 1997 it was 5.4 percent.
Recent events in Brazil have increased speculation of a contagion effect that could harm other Latin economies. While Brazil is the largest economy in the region, its connection to other Latin American economies has perhaps been overstated, particularly as related to trade.
Except for Argentina, trade ties between Brazil and the rest of Latin America are limited, suggesting that the devaluation in Brazil will not have a severe impact on regional trade balances. Argentina, which sends some 30 percent of its exports to Brazil, has a small export sector as well (about 8 percent of its GDP). Nonetheless, many analysts have revised down Argentina's 1999 GDP growth projection to less than 1 percent, while some are even forecasting a mild recession for the year. The automotive and other manufaczturing sectors in Argentina will be particularly affected by a recession in Brazil.
Future regional performance may depend heavily on the ability of individual countries to differentiate their economic fundamentals from Brazil's or insulate themselves from any contagion effects. In recent months, continued uncertainty about emerging markets in general and Brazil in particular has tended to cast a shadow on financial markets throughout Latin America (see Chart 2).
Mexican authorities have already publicly noted their "negligible" trade relationship with Brazil, emphasizing instead its strong connection to the U.S. economy. Argentina, meanwhile, can draw upon the considerable policy credibility it has gained over the last several years, especially regarding the maintenance of its "convertibility plan," which links its peso to the U.S. dollar and prohibits money growth not backed by foreign reserves. Argentine authorities can also point to a greatly strengthened banking system with significant foreign participation.
IMF authorities have already expressed willingness to assist Mexico and Argentina with additional funding should these countries need it. Argentina still has a $2.8 billion IMF facility, on which it has not drawn, as well as a $6.1 billion credit line with a consortium of international banks.
And for the United States . . .
Throughout Latin America, economic liberalization, among other developments, has increased the trade ties between the region and the United States. While total U.S. exports have grown 45 percent over the last five years, U.S. exports to Latin America have risen 81 percent. This growth has pushed Latin America's share of total U.S. exports from 17 percent to 21 percent, just under the individual shares of Europe and Canada. While the growing trade relationship with Mexico explains much of the rise, trade with the rest of the region is expanding rapidly as well.
Although direct U.S. trade exposure to Brazil is not significant (some 2.3 percent of U.S. exports go to Brazil), the impact of the real devaluation slightly worsens an already poor U.S. export outlook. Other factors, such as the beginnings of recovery in several Asian economies, could help mitigate the negative implications of weaker demand from Latin America. U.S. exports to Latin America were already weakening prior to the devaluation in Brazil (see Chart 3).
Financial ties between the United States and Latin America have also grown, and direct U.S. investment in Latin America has risen from $17 billion to $23 billion during the last four years. Brazil is now the leading destination for U.S. direct investment to the region, surpassing Mexico in 1995. Commercial bank lending from the United States to Latin America has also picked up. In mid-1994, total U.S. bank exposure to Latin America was $41 billion. By September 1998, that figure had risen to $65 billion, with Brazil accounting for 28 percent of the total.
Economic growth in the United States' Latin American trading partners will likely be weaker in 1999 than anticipated prior to Brazil's currency devaluation. The devaluation's overall impact on the U.S. trade outlook is therefore expected to be modest, though negative on balance.
Although the trade impact by itself is not likely to be overwhelming, the devaluation of the real will be felt more acutely by sectors with heavy exposure to Brazil. For instance, Florida's tourism-related businesses may suffer as a result of fewer visitors from Latin America. In addition, Florida's exports, totaling $2.6 billion in 1997, may decelerate since Brazil is the main destination for the state's exports. Another area of potential spillover to the United States is the impact on corporate earnings and equity values for companies that are heavily involved in Brazil. At the same time, the devaluation in Brazil should improve the longer-term outlook by promoting lower interest rates.
In Brazil the devaluation will worsen an already negative outlook in 1999. Moreover, the move propels the country into another period of uncertainty, the full impact of which cannot yet be known. The devaluation should improve the outlook for long-term growth by making lower interest rates and increased exports more attainable.
While the devaluation in Brazil will have a limited but negative impact on the rest of Latin America, the outlook for the region in 1999 remains decidedly negative. Real economic growth looks set to decelerate throughout Latin America, and some countries, such as Brazil, will likely experience outright recession. The implications for the U.S. economy, which has deepened its ties with Latin America over the last decade, are modestly negative.
This article was researched and written by analysts in the Atlanta Fed's Latin America Research Group.