Just when it seemed the worst was over for Asia, a new and potentially huge crisis has developed in Brazil. The devaluation of the Brazilian real recently marked the failure of the IMF-style policies in that country, and raised the spectre of a financial meltdown in the world's eighth largest economy. Martin Khor gives the background to the crisis.

By Martin Khor

January 1999

The devaluation of the Brazilian currency (the real) recently caused shockwaves around the world, raising fears of a new round of financial instability that could delay a recovery in Asia.

The Brazilian crisis is also a blow for the International Monetary Fund and the Group of Seven developed countries, which had insisted that developing countries like Brazil should still allow the free flow of capital into and out of their economies, despite the damaging effects.

With the IMF's free-market model even more in tatters, there could well be a shift of world opinion in favour of Malaysia-style exchange controls for countries wanting to insulate themselves from volatile capital flows.

The developments in Brazil are a blow to hopes that the global economy was beginning to become more stable, following the rollercoaster ride of the past 18 months that began with the Thai crisis, spread to other Asian countries and hit Russia in 1998.

Throughout this period, Brazil had also been subjected to speculative attacks. Its Central Bank spent US$9 billion of foreign reserves to defend the real in October 1997.

Then in October 1998, it faced another serious round of capital flight. The real would have been devalued then, except for a pledge by the IMF and the G7 countries that they would put up a mega loan of US$41.5 billion for Brazil.

It was meant to be a new kind of IMF deal, one put in place for a country in trouble BEFORE a crisis strikes, so as to prevent a financial meltdown and devaluation, rather than previous IMF deals which were made after the outbreak of crisis.

It was crucial for the IMF's already tattered reputation (and more importantly, for the credibility of the free-market policies it advocates) for Brazil to stand up, stick to the IMF's usual conditions, and avoid a financial crisis.

Another big failure would bring the free capital mobility model, already being blamed by so many experts for the Asian debacle, crashing down.

For there were voices within and outside Brazil that called on the government to impose some controls on the exit of funds, to prevent an impending and uncontrollable exodus of capital.

But the authorities decided to stick faithfully to the IMF-style policies of maintaining free capital flows, cuts in government spending and other reforms, and at the same time defending the value of the real.

It was a gamble that was bound to fail. Brazil has a huge external debt, being US$228 billion in mid-1998. To be able to service this requires large amounts of foreign exchange.

At the end of July 1998, Brazil's foreign reserves stood at US$70 billion but due to continuous outflows the level fell to $45.8 billion at end-September and $42.6 billion at end-October.

An injection of an initial $9 billion from the IMF package helped to shore up the reserves, but the flight from Brazil continued. According to a Financial Times report, foreign reserves fell by $7 billion between November and December and a further $1 billion left the country in the early part of January.

Thus, despite the IMF's loan, the question of whether Brazil could meet its external debt obligations became more acute.

Brazil also faced the familiar problem that has dogged all Asian countries that have followed the IMF line. To get the IMF's loans, the client country must meet stringent conditions, the main ones being an austerity budget (or cuts in government spending) and high interest rates (in order to maintain investor confidence in the local currency).

But these policies are a recipe for disaster in the real economy of production and jobs, as they squeeze credit going to businesses and consumers, and they cause a slowdown in overall spending and thus in output.

To defend the currency, interest rates in Brazil shot up to 40% and more. To meet the IMF conditions, Brazil planned to cut its federal budget deficit from 5.6 to 3.6% of Gross Domestic Product (GDP) between 1998 and 1999.

The effect would be to induce a recession, estimated as a drop in the 1999 GDP of 1% by the government, and of 4% by independent analysts.

The recession-creating policies have met with protests from labour unions, Senators and opposition parties. It left observers wondering whether the IMF reforms could be carried through.

Then, on 7 January, the trigger for the crisis was pulled. The state government of the large Minas Gerais province declared a moratorium on its US$15.3 billion debt with the federal government.

This raised fears that other states would follow suit, and that the federal government would not be able to implement its austerity programme, thus risking the continuation of its IMF loan package.

As confidence ebbed, the stock markets fell continuously through the week. The outflow of funds became a haemorrhage, with more than US$1.2 billion leaving the country on 12 January alone.

As panic emerged, the government felt it could no longer afford to defend the level of the real. On 13 January, the Central Bank president (who had followed the fixed-exchange-rate policy) resigned.

The new president Francisco Lopes announced that the real would be traded at a new and wider band of 1.20-1.32 reals to the dollar. He said Brazil had US$45 billion in reserves and could draw on $70 billion to defend the real.

But the real fell to 1.31 to the dollar, at the top of the new currency band, amounting to a devaluation of 8-9%. Though banks sold dollars at this rate, most currency exchanges were refusing to sell dollars at any price as they anticipated a further fall in the real, according to news reports.

It was clear that Brazil would not be able to defend its currency at the new band. It is worth recalling that in the early stage of its crisis in 1997, Indonesia also widened the band of the rupiah's rate with the US dollar, but was unable to defend it. The rupiah eventually went into a free fall, falling up to 80%.

On 15 January Brazil gave up its effort to maintain the band and instead floated the currency. It fell past the 1.50 level (a further 15% depreciation). It is anyone's guess to what extent the real will fall before it reaches bottom.

In any case, this is only the start of the Brazil crisis. It has already caused stock markets around the world to decline.

Significantly, the Dow Jones industrial index fell 228 points (or 2.4%) on 14 January, causing some to ask whether this is the pin-prick to the Wall Street stock-market bubble.

There are anxieties that Brazil will become the Thailand of South America, in that its currency's devaluation will have a domino effect on Argentina, Chile and other countries in the region.

If the contagion spreads, then there may be another bout of confidence loss in emerging markets generally. In Asia, the worry is that this development could put a spanner in the works of the much-hoped-for economic recovery.

Everyone should therefore stay tuned in on what happens in Brazil in the coming days. - Third World Network Features

About the writer: Martin Khor is Director of the Third World Network.