SUNS  4357 Thursday 21 January 1999

Geneva, 19 Jan (Chakravarthi Raghavan) -- It would be tempting to say, after the floating of the Brazilian Real and its devaluation, that the other shoe has dropped -- excepting, as an international official put it, there are far too many shoes, and far too many wobbly legs (in the South and the North) in the global financial system.

If wisdom and intellectual humility is not in such short supply in Washington (and its institutions, national and global), and if the "Asian" vice of "saving the face" has not become so dominant an
influence on the leaders of the IMF and the US Treasury, there could be a course reveal in global policy and the world could inch back from the brink of a major crash.

As the financial crisis, beginning in Thailand in 1997, spread across the world last year, in spurts, it appeared for a brief while that the crisis may be contained, and Latin America could escape.

But that hope has been belied by the developments in Brazil.

As was feared by many non-orthodox economists, the financial crisis has now hit Brazil, forcing that government to abandon the dollar-anchoring of its currency (in the fight against inflation) and let the Real float and find its own market levels, without expending the reserves.

While the stock markets in Brazil and elsewhere have gained, and there is some amount of euphoria, much is going to depend on what would happen now to the real economy in Brazil and elsewhere in Latin America, as also in North America and Europe.

It is possible that after an initial hiatus, the Real could find its real level (supportive of Brazil's trade and economy) and the interest rates could come down, and the Latin American giant could weather this crisis and resume growth. But this path is full of imponderables, and depends too much on the fickleness of the "market" and greed of those operating in it to extract their pound of flesh.

After the successful Real plan (of his predecessor) to put an end to the hyper-inflation in Brazil, President Enrique Cordozo had anchored the government's economic policy on holding the line on the currency, and using the exchange rate policy (a pegged currency, subject to a gradual devaluation of seven percent annually, envisaged under the IMF programme), to hold the line on inflation and prevent the economy from slipping back into the hyper-inflation of the 1980s.

For a while in 1994, as the 1995 UNCTAD Trade and Development Report noted, the Brazilian economy seemed to be on the same course as that of Mexico and Argentina, before Mexico, end-1994, abruptly allowed a peso devaluation. Till then, little attention was paid in Brazil to the rapid overvaluation of its currency, fixed in nominal terms, and the worsening external balance due to pressures from the real side of the economy. The Real plan had generated an impressive expansion of domestic demand and increase in production and sales by firms, in spite of the surge in imports.

But with the Mexican crisis, the Brazilian scene changed abruptly: the capital account turned negative while the trade deficit widened rapidly with surge in imports.

In response, Brasilia made a major policy shift - paying full attention to the exchange rate and the trade balance. It announced a policy of central bank intervention within a narrow band, with a progressively declining lower one. This was followed by a big increase in dollar demand. But the Central Bank sustained the exchange rate near the pre-announced lower level of the band.

The exchange rate policy of a floatation band with fixed nominal upper and lower bounds, resulted in a 10% devaluation of the nominal exchange rate, and was followed by a subsequent further devaluation under market pressure. At the same time, the government reversed the policy of rapid
trade liberalization, using trade measures to curb imports, and an attempt was made to slow the economy to reduce inflationary pressures and check the deterioration of the trade balance.

As the TDR-1995 put it, about Brazil's prospects: much depended on how far Brasilia would be able to exploit the advantage of its being "late" in "structural adjustment reforms", and how far it could use its greater scope (than other major regional economies) to use trade measures to deal with external and domestic imbalances - to curb imports and reduce inflationary pressures. And since at that time, Brazil's economy was not dollarized, any devaluations would not have the same financial implications as in Argentina and Mexico. The country's privatization plans could also help reduce government deficits and debt.

But, after a while, the government gave in to the demands of the global financial markets, in order to attract foreign funds, and since July 1997, has been struggling from the repeated bouts of contagion effects of the Asian crisis, which hit Latin America periodically.

But unable to hold the line, given the deterioration in its real economy and the rising opposition from domestic industry and commerce (hit by the high real rates to hold the line on the Real) Brazil, has
now allowed the currency to float, rather than lose its reserves.

While the currency has devalued sharply, there are some competent experts who think the Real is in fact (at its new levels) undervalued.

Other things, being equal (which it seldom is in real life), it could help Brazilian exports, make imports costlier and have positive effects on its trade balances and balance-of-payments.

Till now Brazil used the exchange rate to hold the line on inflation. But with the abandonment of the exchange-rate anchor, other measures would be needed - fiscal (Federal and States), spending) and monetary measures.

Already, a rise in interest rates (in the short term) is being envisaged to hold the line on exchange markets and inflation. But its impact on the real economy and how much damage and punishment it could take is not clear.

Having been forced to acquiesce in the "floating" of the Real, the International Monetary Fund and the US Treasury (whose policies and prescriptions have once again failed) are pressing on Brasilia to maintain high interest rates (to restore market confidence and keep the foreign funds flowing in).

But if the interest rates do not come down, Brazilian industry and commerce, and the people and real economy, would be hit, and Brasilia could end up with the worst of all the worlds - unless it institutes pragmatically exchange and capital controls.

But the effects of the developments in Brazil will have major impacts on regional and other developing economies, and the markets, in the South as well as the North.

Currently, the US economy, and its stock markets, are behaving (in the words of American columnist, William Pfaff) as if history, and geography and the laws of gravity and theories of economics don't count and what goes up will keep on going up, and the American consumer will
keep on borrowing and spending.

But can it continue for ever?

Merrill Lynch, in its mid-Jan weekly economic & financial commentary,  projects the US as the "colossus of the world economy", and notes that Europe growth is rapidly slowing down, but the consensus forecast is for the US to have a 2.6% GDP growth in 1999.

Even before the Real devaluation, the general expectation was that Brazil would face a recession. Merrill Lynch's economists now forecast a 4.4% GDP drop in 1999, and some global contagion effects as a result of the Real floatation. And given Brazil's history of hyper-inflation, these economists estimate that while an inflationary spiral is not inevitable (if appropriate policies are followed), the risk is not insignificant and "there is a possibility that capital controls will be
imposed".

Merrill Lynch also expects the Argentine economy to be hit and shrink by two percent (as against their earlier projections of two percent growth).

As for the effects on the US, the forecasters say that the trade effects will be negative, but limited; exports to Latin America as a whole accounts for 15% of US exports, but had already been slipping,
and hence the additional trade impact should not be that large. But the effect on earnings of US corporations (which get 30% of earnings from overseas, and many of whom have major operations in Brazil), will be to depress earnings.

Capital markets elsewhere have so far not been affected, but the bond markets have seen a widening of quality spreads. These spreads which had risen after the Russian crisis last summer, but had begun to come down with the US Federal Reserve's easing and cuts in interest rates in
three instalments. But the spreads still remain high - with the spread between BAA corporate ratings and US Treasuries now at 218 basis points. Liquidity is also scarce in credit markets.

In Brazil, with the devaluation, there would be a higher burden of fiscal adjustment, and reducing the fiscal deficits would become a higher priority in terms of the orthodox economics.

Of the domestic debt of $300 billion in Brazil, some $60 billion is said to be indexed to the value of the dollar; an appreciation of the dollar visavis the real means that to this extent at least the cost of
servicing the domestic debt and hence of the fiscal deficit would increase.

The Brazilian government could use the new situation to pressure the Brazilian Congress to act (as Cordozo wants) to cut the deficit, but there are some political question marks.

It is possible, as Brazilian policy-makers hope, the economy would stabilise and the interest rates might come down. But it is an 'if', and if it does not, the recession could worsen, in turn increasing the fiscal problems.

It is the kind of dilemma that all developing economies face - reconciling their external sectors and policies with growth in the domestic sector.

It is easy for the IMF or the US Treasury to blame the Brazilian Congress or the States, but Washington cannot use the US Congressional actions and inactions to justify its inactions, and blame Brazilian democracy.

The Brazilian developments shows the failure, almost spectacular, of the IMF-US Treasury policies.

For a while in 1998, it appeared that the Asian crisis was "contained" and Latin America including Brazil will emerge with little cost, and would continue to attract foreign investment and capital flows.

But the Russian moratorium and devaluation, even if that was a development that would have come irrespective of the crisis in Asia, put an end to these hopes, and the US Treasury and the International Monetary Fund scrambled to erect a firewall around Brazil.

In effect, the IMF programme and the IMF package was a "lender of last resort" attempt -- making funds available to Brazil before a crisis hit the country, unlike what happened in Asia, and IMF funds, along with that from the G-7 countries, were made available (subject to conditionality) before a currency crisis hit Brazil.

But this very first attempt of the IMF, in its ambitious attempt to maintain its turf by taking on a new role of lender-of-last-resort has failed. Part of the reason is that the IMF does not have the unlimited
resources (of a domestic lender of last resort) to make available, and thus end any panic or run on banks.

The Financial Times columnist Martin Wolf has suggested that the collapse of the Real plan is the last nail of the pegged exchange rates, and that floating exchange rates are the only option. He argues that while floating rates impose costs in terms of volatility, these costs are much smaller than those of the foreign exchange and debt crises of the past few years because of the pegged currencies. He goes on to argue that when countries give up the pegged currency and rely on
floating exchange rates, this raises the question whether it is not time to think of a reduced role for the IMF, and not vest it with any lender of last-resort-facility.

But given the ravages to their fragile economies (and trade, industry and economic development and growth in real economy), from both the volatility of floating and the costs of pegging, developing countries may also need to rethink their current policies of "opening up" of
their financial sectors.