Brazil Crisis

7/28/2019 Brazil Crisis

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Brazil 1998-1999


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What is Balance of P. C.

When a country that has a large budgetdeficit, it has difficulty maintaining afixed exchange rate, ultimately facing a

balance of payments crisis. This means that foreign exchange

reserves are falling rapidly, or are being

maintained only by a level of foreignborrowing.
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Four Zones of Economic

DiscomfortBrazil has been located in Zone 3 for many years, with varying degrees ofunderemployment and current account deficits.


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Brazil in the 1990s

After a decade of inflation rates ranging from100% - 3,000% per year (1984-1994), Brazilscentral bank made an effort during the 1990s tocontrol inflation and public spending.

- Inflation dropped from an annual rate of 2,669% in 1994 to 10% in 1997

1994Brazil government reissued the real and instituteda crawling peg

The realwas initially pegged to the US Dollar, which allowed Brazils currency tocrawl upward against the $ at a moderate rate.


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Brazil in the 1990s (cont)

The new currency, combined with high interestrates stabilized inflation for the first time indecades but

..there were bank failures and unemployment all over thecountry.

Unemployment climbed from a low 6% in 1988 to 14% a decadelater.

Due to high interest rates, investors dumped money into the

Brazilian economy at extraordinary rates. The realnow faced real appreciation.

The rate of crawl of the exchange rate < (Brazilian inflation Foreign inflation)


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1997 - Foreign direct investment (FDI) grewby 140% over the year before. The table below shows the rapid increase in FDI and international

reserves.


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1998 - Investors expected Brazils central bank toeventually devalue the real.

Over the previous two years (98-99) the central

bank was able to use its foreign exchangereserves to prevent the currency from drasticallydepreciating.

In an effort to slow the outward flow of capital, the central bank raisedinterest rates.

Between 1996 and 1998, Brazils international reserves dropped by

$24 billion or 40%.

The IMF (International Monetary Fund) provided a$41.5 billion loan in 1998 to help Brazil defend itscurrency.

But markets remained hopeless and the plan failed.


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Current Account & Reserves In addition, Brazil was running consistent current account deficits starting in

1995.

As seen in the table below, Brazil started depleting its reserves in 1997 and1998 to finance the current account deficit.


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1999 - Brazil owed $244 billion (46% of GDP) toforeign creditors. Despite efforts to raise taxes and control government spending,

Brazils yearly governmental budget deficits remained in the 6-

7% range throughout the 1990s.

The current account was in deficit, exchange ratereserves were declining, and unemploymentreached its highest level in over a decade.

January 1999 - The central bank decided todevalue the realby 8% and allowed it to float so itwould no longer be pegged to the U.S. dollar. Bythe end of the month, the realdepreciated 66%

against the U.S. dollar.


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Waiting to happen

Brazils actual economic data leading up to the

devaluation is consistent with the balance ofpayments crisis model; rapid expanding current account deficit

constant government spending

The Russian Financial Crisis in 1998 Russias 1998 default on its debt had international investors in panic. Investors

that previously had confidence in Brazils economy suddenly lost faith in the

governments ability to maintain the reals crawling peg.

The B.O.P. crisis model is the best way to analyzeBrazils devaluation. In all, investors had good

reason to believe that the central bank could nolonger maintain the crawling peg.


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The DD-AA Model


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The DD-AA Model

This model assumes an initial starting point at fullemployment (point 1); however, with anunemployment rate above 14% in 1997 and 1998,it is likely that Brazils output was well below full

employment. With IMF support it is possible that Brazil could

have avoided devaluation. In addition to building reserves, the central bank may have hoped that

the devaluation would increase output to full employment levels.


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The Aftermath

While currency devaluation might help a country improve itsCA deficits and return the economy to full employment, thereare some negative aspects; Brazils large public debt held in U.S. dollars was instantly increased

with the depreciation.

Once the realwas devalued, the central bank lost its credibility and hadlittle choice but to form some sort of floating rate.

Which makes it difficult to revert back to a fixed rate system that only functions ifinvestors trust the central bank and become less risk averse.

The devaluation also tensed relations with neighboring countries likeArgentina who are deeply affected by Brazils economic policy.

On the positive side, each year since the devaluation, thecurrent account has improved and in 2003 it was positive for thefirst time since the early 1990s.


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Conclusion

Looking at Latin Americas unstable economic history, itsobvious that a fixed exchange rate was not the only cause ofBrazils economic woes of the 1990s, nor is a floating exchange

rate going to fix all of Brazils economic issues.

Under this floating rate system, the government will now betempted to print money freely in order to pay off debt. Inflation isthe primary reason that Brazil adopted a crawling peg in the firstplace. Instead the Brazilian government must control its public debt and budget

deficit spending.


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Conclusion

Recently Brazils government has taken spending

more seriously. In 2005 foreign debt was at its lowest point since 1997

In addition, the 2004 budget deficit was at a low 3% of GDP.

Brazil has also managed to keep their exchange rate undercontrol. Low inflation

disciplined fiscal policy

a floating exchange rate

Although Brazil still has budget deficits and owes a sizeable

amount to creditors, the country has taken steps toward morestable economic policy. Brazilians can only hope that thesepolicies lead to economic growth for Latin Americas largest

economy.

Brazil Crisis

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