To understand the turbulence of the past four years, one must go back to 1994, when Brazil introduced the stabilization program and currency reform known as the Real Plan. The program was centered on an ingenious currency reform and the use of an exchange rate anchor. In addition, the authorities tightened monetary policy, began to take steps to reduce fiscal vulnerabilities, and outlined an ambitious reform agenda.
The Real Plan achieved impressive results. Inflation dropped from almost 2,500 percent in 1993 to about 22 percent in 1995. Economic growth remained strong, and the share of the population living below the poverty line dropped from 19½ percent to about 14½ percent.
However, the plan did not bring about the structural improvement in the fiscal accounts necessary to sustain Brazil’s economic policies over the long term. The combination of a fragile fiscal position and the loss of competitiveness associated with the exchange rate peg eventually created a large current account deficit and combined with high interest rates to cause a surge in government domestic and external debt. In addition, a growing share of the domestic debt was linked to the overnight interest rate or to the exchange rate to facilitate its rollover, especially after the Asian and Russian crises raised concerns about the economic prospects for emerging markets in general and for Brazil in particular.
Brazil seeks IMF help
After the Russian default in 1998, market perceptions of Brazil’s vulnerabilities led to increased capital outflows and bets against the exchange rate peg. The Brazilian central bank reacted by raising interest rates to more than 30 percent in September 1998 and to more than 40 percent in October, but the country still lost about $25 billion in reserves during those two months. The situation had become critical, and the government started discussions with the IMF, presenting it in October 1998 with a comprehensive adjustment program to address the crisis. The IMF’s Executive Board approved financial support within a few weeks.
A three-year Stand-By Arrangement with the IMF was the centerpiece of a $41 billion official financing package from multilateral and bilateral sources—one of the largest support packages ever put together by the IMF. The program was premised on the notions that confidence would return and that a gradual, controlled depreciation of the real could be sustained through ample official financing and a strong policy response that included an increase in the public sector primary balance (from zero in 1998 to 2.6 percent of GDP in 1999, 2.8 percent in 2000, and 3.0 percent in 2001); maintenance of a tight monetary policy; and additional structural reforms to safeguard the soundness and increase the efficiency of the financial and public sectors.
Setbacks and a crumbling peg
The calming effect of this initial program was short-lived, however, as markets soon questioned the commitment of the Brazilian congress and state governments to the program. In December 1998, congress failed to pass a critical component of the fiscal package (pension reform legislation), and in early 1999, the important state of Minas Gerais threatened to suspend servicing its debt to the federal government.
Renewed and intense pressure on the currency forced the central bank to allow the real to float. This disorderly exit from the peg caused the real to overshoot (it lost about 50 percent of its value in a few months), hurt economic activity, and propelled unemployment to a decade-high 8.3 percent in April 1999.
Facing the threat of escalating economic instability, the government and the IMF worked together to adjust Brazil’s policy strategy and, in March 1999, put in place a revised and strengthened program. Its main components were an even tighter fiscal stance (targets for the primary surplus were raised by up to a half percentage point of GDP); the introduction of an inflation targeting framework to replace both the exchange rate peg as the nominal anchor for the economy and the central bank net credit target generally used in IMF-supported programs; and a lower floor on net international reserves to accommodate limited interventions by the central bank in the foreign exchange market. In addition, overnight interest rates were temporarily increased to 45 percent.
|Public sector primary balance (percent of GDP)||2.9||–0.2||3.2||3.5||3.7|
|Current account balance (billion U.S. dollars)||0.6||–26.5||–25.4||–24.7||–23.2|
|Public sector net debt (percent of GDP)||34.6||35.2||53.6||51.8||55.6|
|Real overnight interest rate (percentage points)||23.1||21.7||15.3||10.7||9.0|
|Consumer price inflation (percent)||1,269.0||9.7||8.9||6.0||7.7|
The fiscal austerity measures and strengthened program yielded positive results, quickly restoring confidence in the spring of 1999 and creating conditions for interest rate reductions through the remainder of the year. Despite much turbulence and a 48 percent depreciation of the real, Brazil’s economic performance in 1999 as a whole was significantly better than expected. Real GDP grew almost 1 percent (instead of declining sharply as widely predicted by economic analysts and as assumed under the IMF-supported program), consumer price inflation remained in the single digits, and inflows of foreign direct investment reached $29 billion, virtually the same as the year before. Other elements contributed to the program’s success as well. First, most of the private sector was hedged at the time of the devaluation, and, second, the domestic banking system had been strengthened by a program—orchestrated by the central bank in 1995—of mergers and closures of private banks in difficulties.
In 2000, economic performance improved markedly, consolidating the success of the new exchange rate and inflation targeting regime supported by strong fiscal discipline. Real GDP growth reached 4½ percent, inflation slowed to the targeted level of 6 percent, foreign direct investment reached a record $32.8 billion, and the unemployment rate declined to 7 percent. The fast recovery of economic activity, capital flows, and other key indicators suggests that austerity measures implemented within a coherent economic policy framework that restores private sector confidence may have, at most, a short-lived contractionary impact on economic activity.
Another round of shocks
Despite the success of the program, two important sources of vulnerability remained: the large external financing need and the structure of the domestic public debt. These vulnerabilities turned into major sources of instability when shocks hit the Brazilian economy at the beginning of 2001. Poor growth prospects for the world economy and rising concerns about Argentina signaled a decline in capital flows to emerging markets as well as potentially weaker Brazilian exports. The situation was aggravated in May, when the news emerged that an imminent domestic electricity shortage could severely disrupt production. Markets became concerned that a large external financing gap would emerge, which put pressure on the real.
The Brazilian central bank responded to the instability by initiating another cycle of monetary tightening. Subsequently, as the real continued to slide, the central bank announced that it would sell $50 million in the spot market every day until the end of 2001. By preannouncing sales of a constant amount of dollars, the central bank characterized the policy as a way to ensure market liquidity and help close the projected private sector financing gap, because the total amount of these daily sales was equivalent to market estimates of the financing gap at the time of the policy announcement. The central bank also increased the occasional sale of dollar-indexed domestic bonds to help satisfy the increased demand for hedge and avoid a sharper depreciation of the real.
With the three-year Stand-By Arrangement scheduled to end in December 2001, the authorities sought its cancellation and requested a new arrangement with the IMF to run through December 2002. Despite some calls for “shock therapy” or other less conventional policy measures, the Brazilian government and IMF staff remained confident in the overall economic strategy of President Fernando Cardoso’s administration, agreeing that “more of the same” was the preferred line of action. In September 2001, the IMF’s Executive Board approved a new Stand-By Arrangement, which again raised the fiscal targets in the context of a broader strategy to engineer a declining debt-to-GDP ratio in the medium term. The new program made an additional $14.7 billion available to Brazil, and the floor on net international reserves was lowered to give the central bank more scope for intervening in the foreign exchange market, if necessary, to avoid excessive exchange rate volatility and overshooting relative to fundamentals. Later in the year, additional monetary tightening was introduced through more stringent reserve and prudential requirements, which, among other things, reduced the ability of banks to keep open foreign exchange positions.
Markets welcomed the new Stand-By Arrangement but did not immediately return to normalcy. The currency—which had depreciated steadily from the beginning of the year—continued to weaken through October 2001, and the Brazil EMBI spread increased from less than 700 basis points in early February 2001 to almost 1,200 basis points in October 2001.
Weathering another storm
Finally, the government’s IMF-supported strategy proved its merits. Beginning in the last quarter of 2001, a sequence of favorable news added the final ingredients for a reversal of expectations in favor of Brazil. Despite the economic slowdown, clear signs emerged that the public sector primary surplus would surpass the more ambitious target set in the September program; the pass-through from the currency depreciation to domestic prices was contained and inflation remained under control; inflows of foreign direct investment beat all expectations; the energy-rationing program averted any significant disruption in production; and the monthly trade balance shifted into sizable surpluses in the last quarter of 2001. The real strengthened from about R$2.83 per dollar in late October to R$2.32 per dollar in December, despite a worsening situation in Argentina, suggesting part of the earlier depreciation reflected an overshooting associated with undue market pessimism. More recently, there are signs that economic activity has begun to recover and that inflation this year will be lower than in 2001. In the first quarter of 2002, the Brazil EMBI spread had returned to around 740 basis points (slightly below its end-2000 level), suggesting that Brazil had won another battle on the long road to stability and growth.
Brazil’s success in strengthening its fiscal performance, stabilizing the exchange rate, and keeping inflation under control after the mini-crises of 1999 and 2001 does not mean that it can expect clear sailing ahead. Brazil continues to face important constraints to achieving higher and sustainable economic growth while keeping inflation down. The external financing requirement is still relatively high and could increase with the acceleration of economic activity, putting additional pressure on the exchange rate and thereby threatening fiscal sustainability and the inflation targets. Brazil intends to tackle these problems by continuing to implement structural reforms that could allow further and substantial improvements in the external position. It will also continue pressing for greater trade integration in the region and for the removal of trade barriers in industrial markets. In addition, the ongoing financial sector reforms should stimulate domestic savings and help reduce external financing requirements.
The share of the domestic public debt that is linked to the overnight interest rate or to the exchange rate remains above 75 percent. Brazil’s public finances therefore continue to be vulnerable to negative shocks that might affect the exchange rate, require strong monetary tightening, or both. This, in turn, reduces the margin for the possibility of applying countercyclical fiscal policies, with additional implications for economic growth. To tackle these problems, Brazil is determined to maintain a strong primary fiscal position that would allow for a gradual but steady improvement in the composition of the domestic debt through reduced reliance on interest rate-and exchange rate-indexed debt.
Photo credits: Denio Zara, Padraic Hughes, Pedro Márquez, and Michael Spilotro for the IMF, pages 161, 163, 168–71, and 175; government of Ghana, page 162; Paulo Whitaker for Reuters, page 165–66; Claro Cortes for Reuters, page 174–75; AFP, page 176.