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BRAZIL LEADING THE WORLD TO DEFLATION?

The crisis developing in Brazil has taken a turn for the worse, with the currency falling sharplyand funds still leaving the country. Recently, Malaysian prime minister Datuk Seri Mahathir Mohamad warned Malaysians to beware of a global deflation. MARTIN KHOR reviews what is happeningin Brazil, what problems lie ahead and what the effects may be on other countries.


The Brazilian financial crisis took a turn for the worse last week, increasing the possibility that the country and the Latin American region will plunge into recession and add on to global economic gloom this year.

When Brazil floated its currency, the real, it was hoped that the devaluation would be kept to a small or moderate rate. Towards this aim, interest rates were jacked up several points and are now above 40 per cent.

But the efforts have been in vain, so far at least. The real fell from the pre-depreciation level of about 1.21 to the US dollar to 1.31 (when the band within which the currency was traded was widened) and then to about 1.50 (when the free float was announced).

In early January  it continued to fall and was trading at 1.72 , which meant it was now 35 to 40 percent more expensive to buy the dollar.

Capital flight is continuing, although at a lower rate. US$400 million left the country, compared to more than a billion dollars a day just prior to the devaluation.

The arithmetic simply does not look good for Brazil. It has a large external debt, valued at US$228 billion in mid-1998. To service that it requires large reserves of foreign exchange, but the reserves have been dropping rapidly due to capital flight.

The reserves were at a respectable US$70 billion at the end of July last year, but fell to $42.6 billion at the end of October.

To stem the tide, the International Monetary Fund pumped about $10 billion to boost the reserves, but funds continued to exit. With the exodus of the past ten days, the reserves would have dropped even faster to anywhere between $30-40 billion.

The question has already emerged whether the foreign creditors will agree to roll over the country's short-term debts, and whether Brazil can meet its commitments. The government assured that foreign loans would be serviced.

But if funds continue to flee the country, a point will soon be reached where there just will not be enough foreign currency to pay foreign loans that come due. This is where the crisis will reach the really acute point.

Brazil's current agony shows up again the bankruptcy of the approach taken by the IMF and the United States towards emerging economies in trouble.

When such countries face speculative attacks on their currencies, and when capital flight takes place at an alarming rate, they can either keep their financial system open to the free flows of funds, or else introduce some exchange and capital controls to prevent or reduce the exit of funds and to stabilise the currency.

Brazil, under IMF and US advice, took the first route. It has chosen to remain true to the orthodox principle of total freedom for financial flows, thus subjecting itself to as much outflow of funds as foreigners and residents alike wish to execute.

It has also tried to defend the currency level, using up foreign reserves to buy up the real when too much of the currency was being sold, and jacking up interest rates to make it attractive to keep funds in Brazil.

When the situation continued to deteriorate, the government had to abandon its defence of the real and the currency is now in the midst of a free fall. Fearing that the real will depreciate further, people are continuing to take their money out.

Indeed, if these anxieties remain or increase, even the high interest rates may not prevent a "rush for the exits" as each investor and depositor does not want to be caught in a situation where the country runs out of foreign-currency funds and they are then stuck with funds denominated in fast-depreciating reals.

There is of course a feeling of "deja vu", as the current Brazil drama looks like a re-run of what happened in Thailand, Indonesia and Korea. Those countries ran out of reserves and had to be "rescued" by the IMF, which then introduced policies (such as high interest rates, tight money, and an austerity budget) that made the problem even far worse.

Going by what happened in Asia over the past year and a half, Brazil is going to go through a wrenching time ahead. On the financial side, it is likey the real will slide some more, unless the IMF or Group of Seven countries come up with assurances of huge monetary support. This is unlikely since even the second installment of the IMF's overall US$41.5 billion package for Brazil is going to be delayed as the IMF ponders over whether the country has implemented the policies that make it deserving of more funds.

The already sharp currency depreciation will make it that much more difficult for Brazil to service its foreign debt. A point may come when the country approaches either a default and moratorium, or to prevent that, the convening of a conference with its creditors to voluntarily roll over the maturing debts.

Meanwhile, at the real economy of production, a recessionary spiral is already at work. The depreciation will make it difficult or impossible for companies and banks that took foreign loans to pay back.

The very high interest rates will also make it hard for all firms, big and small, to service their domestic loans. Significantly, the state governments will also find it a greater burden to meet their debt obligations to the federal government.

With the companie defaulting on their payments, the Brazilian banks will see their non-performing loans shooting up, thus putting great stress on the banking system.

The government budget cutbacks, demanded by the IMF, will add to the contraction. Growth will turn not only negative: the GNP may spiral downwards out of control. Market analysts are already predicting a five percent fall in GNP (compared to the government forecast of a one percent fall). Even that will probably prove too optimistic.

The Brazilian crisis will affect the rest of the world through several mechanisms:

** Other countries in the region, such as Argentina, Chile and Mexico, will be most directly affected. Their currencies will also come under stress. This will cause them to also jack up interest rates, thus contributing to a credit squueze.

Their exports to Brazil will certainly be hit, and that will add on to recession in the other Latin American countries.

** Already there are predictions that the Latin American region will suffer negative growth overall this year. This will hit the exports of countries outside the region.

** With another round of financial chaos, there could well be further skepticism about the wisdom of investing in emerging markets as a whole. That may dampen the flow of investment funds, including to Asia.

On the other hand, since there are limited investment opportunities around the world, some of the funds exiting from Brazil and Latin America may find their way to Asia.

** if the Brazilian crisis gets worse, it is likely to adversely affect the US stock market significantly, and probably the European markets as well. Even if the stock market bubble does not burst dramatically, and the decline is slow and gradual, the negative wealth effect will slow down growth in the rich countries and thus add to the dampening of world demand.

The above is a moderate scenario which is neither optimistic or pessimistic.

Of course the Brazil crisis could turn out to be more limited and shorter in duration than Asia's. Or its effects on the world economy may turn out to be more narrow.

On the other hand, events in Brazil could also turn out to be worse than expected, for the unexpected can also happen in these dramatic times. Who, for instance, could have predicted the recent events in Indonesia?

If Brazil goes through a meltdown nightmare, and financial markets elsewhere panic, we might see the Western economies joining the rest of the world in a spiral of falling output and rising unemployment. - (January 1999)

(Martin Khor is the Director of Third World Network)

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