Brazil fight a REAL battle

Case conditions 1994
‡ ‡ ‡ ‡ ‡ ‡ ‡ Brazil economy close to collapse Hyperinflation: Major problem Zero investor confidence President Cardoso elected president Inflation brought down to 7% Real plan: Stable Brazilian Real Increased investor confidence: BOLSA up 158% from 1994

Current Problem
‡ ‡ ‡ Asian Financial crisis makes Brazilian Bolsa down by 29%. Capital flight: 10bn $ in 2 months Speculators believe that real is overvalued Banco Central do Brasil raised money market interest rates to 43% Continue privatization: FDI Budget reforms: 18bn $ spending cuts Strict control over ForEx market


To counter speculation
‡ ‡ ‡ ‡

How does Brazil hope to control its current account deficit through a tight monetary policy? What alternatives are available to control Brazil¶s current-account deficit? Tight Monetary policy‡ Will raise real interest rates ‡ Slow down growth, which should act to curb imports without affecting exports. ‡ However, increased real interest rates could also lead to a capital inflow. This can work against the theory.

How will Brazil¶s tight money policy affect its fiscal deficit? How will it affect Brazil¶s real (inflation-adjusted) interest rates, both short term and long-term rates? ‡ Tight monetary policy => Higher interest rates (Short term)
± Higher cost of roll over of government debts => Higher fiscal deficit


‡ If policy is credible; (Long term)
± Both nominal and real interest rates will go down ± As inflation goes down => reduced risk premium

‡ If policy is not credible; (Long term)
± Both nominal and real interest rates will remain high ± Brazilian government will have to monetize the growing fiscal deficit

Why have Brazil¶s interest rates generally fallen in recent years?
‡ Tight monetary control =>Hyperinflation controlled ‡ Currency pegged to dollar ‡ Lower inflation => reduced inflationary expectations which through the Fisher effect, led to lower nominal interest rates

How would reform and privatization of the social security system improve Brazil¶s savings rate? What would be the likely consequences of this improvement for Brazil¶s current-account balance and the real¶s value? ‡ Reforming the social security system => Reduce the government deficit => which would raise the net savings rate in Brazil and lower the current-account deficit ‡ Privatizing the system would raise savings => Forcing people to realize that the way to increase their retirement benefits is to save more today => lower the current-account deficit Real value would rise ‡ Investor confidence increases better governance ‡ Reduced risk of monetizing deficit (as fiscal deficit is reduced)

What are the costs and benefits of using currency controls to defend the real? Currency controls‡ On the positive side
± Reduce currency speculation and exchange rate volatility

‡ Costs incurred
± Would raise the cost of capital to Brazilian firms, making them less competitive and reducing Brazilian investment. ± They would also boost the cost of credit to consumers => slow down of economic growth and raise unemployment.


its neighbors and largest trading partners? ANSWER. dollar as well and so its trade and economy would not be as adversely affected as would Argentina¶s. which would be a huge shock to the economy. Brazil should cut its public sector. investors concerned about the government¶s ability to service its debts will demand still higher interest rates or just avoid buying government debt at any price. What are the costs and benefits of using currency controls to defend the real? Currency controls‡ On the positive side ± Reduce currency speculation and exchange rate volatility ‡ Costs incurred ± Would raise the cost of capital to Brazilian firms. adding to the risk of investing in Brazil and reducing the efficiency of its economic activity. What is the link between Brazil's budget deficits and its hyperinflationary environment? ‡ Brazil historically has monetized its huge budget deficits ‡ As the deficits rose => amount of money printed increased => In turn. absent this restructuring. Brazil¶s economy will be much healthier and stronger in the future. Either Brazil will default or it will have to cut its public sector deficit to a sustainable level and follow a sound monetary policy. Since Brazil is also an important trading partner for Chile. reduce tax rates and regulations. What mix of fiscal and monetary policy would you recommend to President Cardoso? Should he devalue or defend the real? The real issue is not defense of the real but rather whether Brazil will make serious structural changes in its economy. hyperinflation ‡ Increased the government¶s interest expense on its issued debt => led to still higher deficits 11. making them less competitive and reducing Brazilian investment.S. What would a Brazilian devaluation do to the currencies and economies of Argentina and Chile. Default will just push the problem back a few years. its economy will strengthen and the pressure on the real will diminish. ± They would also boost the cost of credit to consumers => slow down of economic growth and raise unemployment. Doing so will require a combination of spending cuts and tax increases totaling about 6% of GDP. In line with this view. So Brazil buys nothing by trying to avoid this economic shock because it will occur in any event. since the Chilean peso is free to float. nothing will save the real. particularly a major reduction in the size and cost of its public sector.What are the tradeoffs that President Cardoso must consider in deciding whether to accelerate the real's depreciation? Devaluing the real would: ‡ Jeopardize political stability and president¶s popularity ‡ High interest rates => recession ‡ Exports become competitive ‡ Real plan will be put off-track Alternative: ‡ Reduce budget deficit => Strong budgetary steps (mass protest) ‡ Float the real => increased currency volatility. Although the Brazilian economy would be thrown into recession. it will go into recession anyway because of the high interest rates needed to finance the budget deficit under the current system. it would be expected to fall in value against the U. 2 . added competition from cheaper Brazilian imports both at home and abroad. devaluation of the real would not affect the Argentine peso¶s value. At the same time. Since Argentina has a currency board. a return to the inflation of the past. In any event. This would have been due to: ‡ Real would have lost credibility => capital outflows accelerated ‡ Monetary discipline would have erode => higher inflation ‡ Increased prices of imported goods and goods that competed with imports ‡ Government would have been forced to raise interest rates to stem the daily devaluation ‡ Lack of credibility of government => the economic situation could get a lot worse in the future 9. The result will be a return to the old inflation-devaluation cycle. Such a regime in turn will force Brazil to largely eliminate its public sector deficit. The result would be an economic downturn in Argentina fueled by a loss of exports to Brazil. It would raise the risk on investing in Argentina since Brazil is Argentina¶s biggest trading partner. A currency board would eliminate the possibility of Brazil running an independent monetary policy but this is a good thing considering how Brazil historically has abused its monetary discretion. privatize social security. The impact on the Argentine and Chilean pesos will differ because of their different currency setups. and a contracting money supply and higher real interest rates in Argentina. Failure to make these changes will guarantee that Brazil will be forced to devalue the real in the future. The difference is that by instituting fundamental monetary and fiscal reform today. Brazilian devaluation would adversely affect its economy as well. it would have resulted in high inflation and high interest rates (as evidenced by the Asian countries). If it doesn¶t. Brazil will be forced by hard arithmetic to monetize its deficits once again: At the real interest rates currently prevailing±on the order of 25-30%±just servicing its debts will eventually take over 100% of Brazil¶s GDP (two-thirds of the government¶s debt floats with the current interest rate so a rise in rates boosts debt servicing charges and the budget deficit). Long before this happened the government would start monetizing the deficit again. whatever its current success in defending the real today. If Brazil reforms its public sector. and especially its social security system. However. and a flight of capital from the country Could Brazil have avoided the recessionary impacts of its monetary policy if it had devalued the real instead? No. The only route to macroeconomic stability in Brazil is a monetary regime that does not allow politicians discretion. and implement a currency board tied to the dollar like its neighbor Argentina. accelerate the privatization of its state-owned businesses.

Sign up to vote on this title
UsefulNot useful