Brazil crisis underlines the need for new solutions

The crisis in Brazil shows up the failure of the global decision-makers to learn from the Asian and Russian crises. Despite talk of a 'new financial architecture', the International Monetary Fund (IMF) and the US Treasury are still insisting that ailing developing economies stick to the discredited policies of free capital flows, high interest rates and budget austerity. The result for Brazil has been disastrous. New policies and models are called for, that include measures to stabilise the currency and regulate capital flows.

by Martin Khor

AS the world watches whilst Brazil desperately tries to extricate itself from a deepening financial crisis, the spotlight falls again on this key question: what should a country do to prevent a potential currency problem from becoming an economic meltdown?

The East Asian crisis that started in mid-1997 and became full blown last year, and the Russian crisis that exploded in the second half of 1998, should have provided enough lessons to prevent or at least reduce the size of yet another crisis in yet another country.

Many serious analysts (and at least one major institution, the UN Conference on Trade and Development or UNCTAD) had concluded that the crises had been caused by the nature of the modern global financial system.

Because of financial deregulation in most countries, money is allowed to flow into and out of countries. Because they adhere to the principle of allowing almost total freedom of capital mobility to the market, these countries exposed themselves to extreme volatility of funds entering and exiting, and thus to high economic instability.

Moreover, new financial instruments (such as derivatives, futures contracts and short-selling of currencies) and new financial institutions (such as highly-leveraged hedge funds) meant that a few big players could influence and also manipulate financial markets.

Thus, currency and stock-market values could be determined not only or even primarily by 'free'-market forces that reflect the fundamental conditions of trade, production and financial balances, but could be manipulated and set by big financial players.

Free capital mobility

The East Asian countries adhered to free capital mobility. Due to liberalisation, Indonesia, Thailand and Korea also built up high short-term private-sector external debts.

The Asian countries had also enjoyed stable currencies, but these came under speculative attacks and after futile attempts to maintain the exchange rates, they floated the local currencies, which then devalued drastically.

The countries lost many billions of dollars of foreign reserves firstly through the unsuccessful attempts to defend their currencies, and secondly through the massive exit of funds held by foreigners (as credits or shares) as well as locals.

The capital flight worsened the currency depreciation and depleted the foreign reserves, making it more difficult or impossible for the countries to service their external debts.

The IMF was called in but it made the crisis worse. In exchange for 'rescue packages', comprising huge loans, it insisted that the countries keep their financial system open and indeed further liberalise and thus allow even more freedom for the inflow and outflow of funds.

That meant that the exchange rate would continue to be subjected to speculation and further depreciation, since the countries were in a condition of financial panic, with the herd instinct prevailing, and every creditor or investor wanted to bring their money out.

In order to counter this stampede for the exit door, the countries were asked by the IMF to instil foreign investor confidence by jacking up interest rates, imposing a credit squeeze, closing some ailing banks, and cutting government spending.

But these measures induced a much sharper recession than would otherwise have taken place. The deterioration of the real economy eroded confidence further and led to more depreciation.

Some of the countries (Korea and Indonesia, and later Russia) then fell onto a situation where they could not service their foreign debts. Korea reached an agreement with its foreign creditors to roll over some of the maturing debts after the government agreed to guarantee the repayment of loans belonging to Korean banks.

Many Indonesian companies have defaulted on their foreign loans and the government is still struggling to find a comprehensive solution. Russia declared a moratorium on payment of foreign (as well as domestic) debt, causing losses and a near-panic among foreign institutions.

There was some hope that the global power brokers would now bring some order to the spreading financial chaos when the US President and Treasury Secretary spoke last year of their intention to draw up a new financial architecture.

But the only thing 'new' coming out of that effort was that the IMF would now give a rescue package to deserving developing countries before they fell into a crisis, rather than after, when it was too late. Presumably, the promise of a large loan would help fend off currency speculators and thus save the country from a devaluation.

Besides this change in timing, the rescue package would remain the same, even though the content of the package had already proven to be poisonous in the recent Asian and Russian cases.

In ruins

Brazil became the first beneficiary of this 'new scheme'. The same old policies of strictly maintaining a regime of free capital flows, attempts to defend the currency, high interest rates, credit squeeze and austerity budget, combined to induce a recession without being able to save the country from massive capital flight and now a sharp devaluation.

The new scheme turned out almost exactly like the old scheme, and has now produced the same disastrous results in Brazil.

The 'new financial architecture' lies in ruins, as does the reputation of the IMF as well as the US Treasury that in truth designed the IMF packages and the new architecture.

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%.

But the efforts have been in vain, so far at least. The Real fell from the pre-depreciation level of about 1.20 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).

By the end of January, the Real had dropped to more than 2.10 before recovering to about 2.00 to the dollar. Brazilian officials and the IMF agreed the fall has been much sharper than what is justified by fundamentals. But 'overshooting' in currency depreciation has now become a standard feature of currency crises since the Thai baht fell in 1997.

Capital flight is continuing, although at a lower rate. Just prior to the devaluation, about US$1 billion a day was leaving the country. For many days after the devaluation, about $300-400 million was leaving daily, according to reports.

The arithmetic does not look good for Brazil. It has a large external debt, valued at $228 billion in mid-1998. The sharp currency depreciation will make it that much more difficult for Brazil to service its foreign debt. 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 $70 billion at the end of July 1998 but fell to $42.6 billion at the end of October. To stem the tide, the IMF pumped about $10 billion to boost the reserves, but funds continued to exit. At the end of January, the reserves were reported to be about $36 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. After the flotation of the Real, the government had 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.

Deja vu

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 freefall. Fearing that the Real will depreciate further, people are continuing to take their money out. There is of course a feeling of deja vu, as the current Brazil drama looks like a rerun 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 far worse.

In Brazil, 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 them 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.

The government budget cutbacks, demanded by the IMF, will add to the contraction. Growth will turn not only negative: the Gross National Product (GNP) may spiral downwards out of control. Market analysts are already predicting a 5% fall in GNP (compared to the government forecast of a 1% fall). Even that will probably prove too optimistic.

The public at least (if not the policy makers) in Brazil and its neighbouring countries are now searching for options for tackling the crises of currency instability and capital flight and the looming debt repayment problem.

So far Brazil has chosen the path of maintaining capital mobility, and having a free float for the Real (with some attempts to intervene when it falls below a certain level).

This will entail high (and higher) interest rates for some time, which might choke off the lives of companies, banks and the real economy, without any guarantee that capital flight will stop or that the currency will stabilise.

Brazil could opt for a Currency Board arrangement to fix its exchange rate and thus prevent the nightmare of continuous depreciation.

But this has its problems. Firstly, the IMF would probably object (as it objected when Indonesia's President Suharto had seriously entertained the idea). Secondly, it would require very high interest rates at this time of crisis to prevent loss of foreign reserves, and this would induce intolerable levels of recession.

Thirdly, as the model adheres to free capital mobility, there could still be high volatility in the flow of funds. Fourthly, the country would give up its ability to set monetary policy as the supply of money would be determined by the volume of dollars or foreign currencies in its reserves. Finally, the Central Bank will no longer be able to be the 'lender of last resort.'

With such disadvantages in a Currency Board system, what else can a country do to stabilise its currency and stem capital flight?

An obvious alternative model is the set of measures recently taken by Malaysia. In turn, Malaysia had taken several elements of its new system from the existing system in China.

The main feature is simply for the country's Central Bank to fix the local currency at a certain rate with a chosen reference currency (in the case of Malaysia and China, the US dollar was chosen).

The Central Bank will exchange the local currency with the US dollar at that rate with commercial banks, and it also requires banks and foreign exchange shops to stick to this rate.

In order to limit volatility of capital flows, Malaysia continues to allow its currency to be freely converted to foreign currencies for purposes of trade and foreign direct investment (or for 'current account' uses) but imposes restrictions for some other purposes for which capital seeks to enter or exit. For example, foreign portfolio investors have to maintain their funds for a year, and residents are restricted on the amounts they can take out and on the purposes for which they can be taken out.

An example

To prevent manipulation by currency speculators, the ringgit is de-internationalised, as the trade in ringgit outside Malaysia is not recognised. Measures were also taken to stop the trade abroad of stocks in the Malaysian stock exchange.

These measures are not that radical and the content cannot pose such a threat to other countries. After all, no one is condemning the Chinese authorities for maintaining their system, and indeed China is lobbied constantly not to give up its peg to the dollar.

Malaysia's adoption of Chinese-style measures was criticised by the global financial establishment because it provides an example to countries that have already liberalised that they can choose to re-regulate their financial system to prevent or at least offset the vicious cycle of depreciation, capital flight, high interest rates and deflation.

It is worthwhile for Brazil and other countries facing financial crisis to look closely at the Chinese and Malaysian models.

And even more importantly, it is time that the IMF and the rich countries that are the IMF's major share-holders show some goodwill in allowing developing countries under the IMF's influence to adopt currency exchange and capital controls when they are in danger of coming under speculative attacks.

After all, the IMF-US solutions don't work and have led one country after another into the abyss of financial chaos and economic deflation. With the old model so discredited by events, the global power brokers should allow the poorer countries the possibility to try other models. (Third World Resurgence No. 102, February 1999)

Martin Khor is the director of Third World Network.