Brazil has become remarkably complacent about the longer-term reforms that build economic growth in the long-term.
BY THOMAS J. TREBAT
The timing of the crisis in the U.S. subprime market is ironic for Brazil, which must feel as though it cannot catch a break in the globalized financial economy.
The U.S. crisis, which could easily lead to a generalized credit crunch and recession, arrives ten years to the month after the Asian financial crisis that hit Brazil hard. In truth, the 1997 Asian crisis was severe by virtue of events that followed in time, i.e., the 1998 Russian default and the collapse of Long-Term Capital Management (LTCM). But the events in Asia ten years ago this summer were a vivid reminder for Brazil that integration into the global financial markets had a huge downside. You could easily be blindsided.
So it is only natural for Brazilians to wonder whether history is repeating itself. Does the present market crisis portend greater difficulties and, if so, how immediate and how serious?
In my view, the answer is that Brazil is nowhere near as financially vulnerable now as it was ten years ago, even one as ominous as the present. Some revaluation of Brazil risk is bound to occur, especially currency weakening and wider sovereign spreads. In fact, these knock-on effects are already occurring as global risk aversion sets in, but these should be manageable. Brazil is not likely to be caught up directly even if, as I expect, the credit crisis spreads.
That is the good news, but the changing global environment is fraught with longer-term dangers for Brazil.
The real underlying risk for Brazil is that today’s financial crisis will morph into tomorrow’s global economic slump, a worrisome possibility. If this scenario unfolds, Brazil is going to regret not having focused nearly as much on deeper structural reforms of its flawed economy as it did on reducing its vulnerability to imported financial disasters. Slowly and over time, Brazil could pay a heavy price in terms of lost economic growth.
It is important to review why the short-term dangers are minor for Brazil and why it is the medium-term outlook that is the concern. This turns out to be a story of what Brazil did and, importantly, did not do during the last ten years of crisis, adjustment and reform.
BRAZIL & THE ASIA CRISIS: AN ACCIDENT WAITING TO HAPPEN
From an economic perspective, Brazil on the eve of the Asian crisis in mid-1997 looked somewhat similar to the Brazil of mid-2007.
Following the successful launch of the Real Plan in 1994, Brazil was showing signs in 1997 of recovery, just as it is now. Real GDP growth was rebounding, inflation was low, unemployment was down and standards of living were improving. Brazil was making headlines with landmark structural reform programs. Foreign direct investment had increased from zero in 1994 to $23 billion in 1997.
Then, following dislocation in the foreign exchange market of Thailand in July 2007, the roof started to cave in for Brazil.
By the late 1990s, the euphoria that greeted the 1994 Real Plan long since had given way to the new economic reality of fiscal deficits, an overvalued currency and a growing external debt financed by Wall Street investors. Once investors were hit by Asia and Russia and frightened by the meltdown at LTCM, they quickly turned on Brazil. In Brazil, this triggered a dismal cycle of capital outflows, interest rate hikes and even more capital outflows until the 1999 devaluation episode.
The really surprising part of the story that unfolded post-1997 is how Brazil summoned the political will to respond to endless crises. Under two vastly different presidents (Cardoso and Lula), a political consensus was forged around a set of tough economic measures to make these recurring financial crises a thing of the past.
HOW DID BRAZIL DO IT?
In the late 1990s, two key vulnerabilities stood out like sore thumbs.
The first vulnerability was the fiscal risk, related to the size and the composition of the public sector debt, especially the very high proportion of Brazil’s domestic public debt linked to the exchange rate. Devaluations in Brazil were all too quickly converted into full-blown debt crises because the weakening of the currency caused the debt in dollars to rise and sowed panic among investors.
The second great vulnerability was Brazil’s current account deficit, the high external debt and the thin cushion provided by foreign exchange reserves. In these circumstances, any interruption in the flow of global financing to Brazil immediately placed great pressures on the exchange rate as panicky investors rushed for the door.
It was the combination of these fragilities – fiscal and external - that caused the devaluations, which prompted the higher real interest rates, and which undermined growth.
Brazil’s actions to confront these problems is a complicated story. (..)
KEEP THE FISCAL PRIMARY SURPLUS HIGH TO SERVICE DEBT
Brazil made a major effort to raise the level of the primary fiscal surplus (government expenditures net of interest payments minus government revenues). Brazil has stuck to that fiscal discipline through thick and thin (...), albeit with too much emphasis on a large tax take and too little on expenditure control. Still, the fiscal results have been impressive and sustained for a long time. (As of July 2007, the primary fiscal surplus is running at an annual rate of 4.3 percent of GDP.)
REDUCE THE NET DEBT-GDP RATIO
The devaluation of the Real in 1999 caused the net debt to GDP ratio to rise to dangerous levels for a relatively poor economy. (...) The debt ratio [has been reduced] from a peak of about 55 percent in 2003 to about 45 percent today. The truly remarkable accomplishment has been to eliminate entirely the dollar-linked portion of Brazil’s domestic debt. In addition, Brazil has switched from a huge net debtor in terms of its external public debt to a net creditor, i.e., its international exchange reserves are now well in excess of outstanding public external debt in dollars.
ACHIEVE A BALANCED ACCOUNT
The long-term solution on the external side was thought to include policies that emphasized a freely floating exchange rate, implemented in 1999, and policies to encourage export growth, these latter only partially implemented. Luck wound up playing an important role. In recent years, Brazil has generated unprecedented trade surpluses which, in turn, have wiped out the perennial deficits in the current account. Some could argue that the turnaround on the external side is a temporary factor owing to huge, but unstable, Chinese demand for commodities. While this has an element of truth, Brazil’s trade position in 2007 is now so comfortably in surplus that it is unlikely to be eroded quickly by a cooling in Chinese demand.
In sum, Brazil, by persistence and dint of good fortune, is in a vastly different position to confront today’s subprime crisis than it was in 1997. Economic growth is recovering. (The forecast 5 percent GDP expansion for 2007 is almost twice the average rate of growth registered in recent years.) International reserves in the Central Bank are in excess of $160 billion, a more than adequate safety cushion even if some of Brazil’s external creditors seek to head for the exits. The Central Bank, in the midst of the subprime crisis, is actually lowering interest rates, not increasing them to stem capital flight.
From a capital markets perspective, it seems reasonably clear that the impact of the subprime crisis is likely to be limited to some widening of Brazil sovereign debt spreads, a weakening of the currency and postponement of private investment projects. All of that involves a cost to Brazil, but the cost seems manageable.
SO WHAT ARE THE REAL RISKS?
The real problem for Brazil will set in to the extent that today’s subprime crisis becomes tomorrow’s generalized credit crunch and hard landing in the U.S. economy. While not a certain outcome, this scenario has a much higher probability of occurring over the next six months than anyone would have imagined. This scenario would translate for Brazil into lower commodity prices, less foreign investment and a less favorable export outlook.
In other words, the scary global scenario that lurks beyond the horizon will unfold slowly for Brazil and be reflected in a weakening of the rate of economic growth. True, every country, even China, will be affected to some extent by this sort of global scenario. Why should Brazil be singled out if all are in the same boat?
The answer is that Brazil, especially during the last three or four years under Lula, has become remarkably complacent about the longer-term reforms that build economic growth in the long-term. Not a single major economic reform has been accomplished or even attempted in Brazil in the last five years. (A social security reform passed in congress in 2003, but it was never implemented.)
What is missing in Brazil is an aggressive pro-growth agenda to replace the cramped, crisis-avoidance agenda that has been hardwired into the government mindset over these last ten years. The list of growth-impeding challenges that Brazil has not tackled in any meaningful way is a long one, too complicated to deal with here, but it includes the crushing tax burden, the incomplete trade opening, the dysfunctional regulatory system, glaring inadequacies in energy and transport infrastructure, not to mention the educational lags, which have also gone largely unaddressed.
None of this agenda has been the subject of meaningful government action, or even enlightened discussion, during most of the last ten years, a truly huge repercussion of the Asian crisis. Yes, Brazil is likely to avoid a direct hit from the subprime mess. However, if the “Goldilocks” global economy of the last five years does give way to a much darker period, Brazil will pay a heavy price in terms of lost economic growth and diminished human development for what it did not do during ten years of crisis and adjustment following the Asian crisis.
Thomas J. Trebat is executive director of the Center for Brazilian Studies and the Institute of Latin American Studies at Columbia University. He wrote this column was originally published as a Persctive on the Americas by the Center for Hemispheric Policy at the University of Miami. Republished with permission.