Balance of Payment Crisis

1. Brazil 1998-1999 Balance of Payment Crisis

2. What is Balance of P. C. • When a country that has a large budget deficit, it has difficulty maintaining a fixed 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 foreign borrowing.

3. “Four Zones of Economic Discomfort” Brazil has been located in Zone 3 for many years, with varying degrees of underemployment and current account deficits.

4. Brazil in the 1990s • After a decade of inflation rates ranging from 100% - 3,000% per year (1984-1994), Brazil’s central bank made an effort during the 1990s to control inflation and public spending. • Inflation dropped from an annual rate of 2,669% in 1994 to 10% in 1997 • 1994 – Brazil government reissued the ‘real’ and instituted a crawling peg • The real was initially pegged to the US Dollar, which allowed Brazil’s currency to crawl upward against the $ at a moderate rate.

5. Brazil in the 1990s (cont) • The new currency, combined with high interest rates stabilized inflation for the first time in decades but… • ..there were bank failures and unemployment all over the country. • Unemployment climbed from a low 6% in 1988 to 14% a decade later. • Due to high interest rates, investors dumped money into the Brazilian economy at extraordinary rates. • The real now faced real appreciation. • The rate of crawl of the exchange rate < (Brazilian inflation – Foreign inflation)

6. Brazil in the 1990s (cont) • 1997 - Foreign direct investment (FDI) grew by 140% over the year before. • The table below shows the rapid increase in FDI and international reserves.

7. Brazil in the 1990s (cont) • 1998 - Investors expected Brazil’s central bank to eventually devalue the real. • Over the previous two years (98-99) the central bank was able to use its foreign exchange reserves to prevent the currency from drastically depreciating. • In an effort to slow the outward flow of capital, the central bank raised interest rates. • Between 1996 and 1998, Brazil’s 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 its currency. • But markets remained hopeless and the plan failed.

8. 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 and 1998 to finance the current account deficit.

9. Brazil in the 1990s (cont) • 1999 - Brazil owed $244 billion (46% of GDP) to foreign creditors. • Despite efforts to raise taxes and control government spending, Brazil’s yearly governmental budget deficits remained in the 6-7% range throughout the 1990s. • The current account was in deficit, exchange rate reserves were declining, and unemployment reached its highest level in over a decade. • January 1999 - The central bank decided to devalue the real by 8% and allowed it to float so it would no longer be pegged to the U.S. dollar. By the end of the month, the real depreciated 66% against the U.S. dollar.

10. Devaluation of the real • Soon after the real depreciated its value, recession followed as Brazil’s government struggled to keep the real from losing its worth. • Luckily, inflation did not rise. • The recession diminished as Brazil’s export competitiveness was renewed and investors slowed their withdrawal from the real, resulting in; • Increase in the money supply • Increase in reserves • Interest rates lowered

11. Waiting to happen • Brazil’s actual economic data leading up to the devaluation is consistent with the balance of payments crisis model; • rapid expanding current account deficit • constant government spending • The Russian Financial Crisis in 1998 • Russia’s 1998 default on its debt had international investors in panic. Investors that previously had confidence in Brazil’s economy suddenly lost faith in the government’s ability to maintain the real’s crawling peg. • The B.O.P. crisis model is the best way to analyze Brazil’s devaluation. In all, investors had good reason to believe that the central bank could no longer maintain the crawling peg.

13. The DD-AA Model

14. The DD-AA Model • This model assumes an initial starting point at full employment (point 1); however, with an unemployment rate above 14% in 1997 and 1998, it is likely that Brazil’s 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.

15. The Aftermath • While currency devaluation might help a country improve its CA deficits and return the economy to full employment, there are some negative aspects; • Brazil’s large public debt held in U.S. dollars was instantly increased with the depreciation. • Once the real was devalued, the central bank lost its credibility and had little choice but to form some sort of floating rate. • Which makes it difficult to revert back to a fixed rate system that only functions if investors trust the central bank and become less risk averse. • The devaluation also tensed relations with neighboring countries like Argentina who are deeply affected by Brazil’s economic policy. • On the positive side, each year since the devaluation, the current account has improved and in 2003 it was positive for the first time since the early 1990s.

16. Conclusion • Looking at Latin America’s unstable economic history, it’s obvious that a fixed exchange rate was not the only cause of Brazil’s economic woes of the 1990s, nor is a floating exchange rate going to fix all of Brazil’s economic issues. • Under this floating rate system, the government will now be tempted to print money freely in order to pay off debt. Inflation is the primary reason that Brazil adopted a crawling peg in the first place. • Instead the Brazilian government must control its public debt and budget deficit spending.

17. Conclusion • Recently Brazil’s 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 under control. • 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 more stable economic policy. Brazilians can only hope that these policies lead to economic growth for Latin America’s largest economy.