New York Times January 16, 1999

Why Brazil Did What It Did and What Options Are Left

By SYLVIA NASAR

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On Wednesday, Brazil drew a line in the sand in front of its embattled currency, the real. On Friday, it erased that line, sending the sand scattering, as it allowed the real to trade freely against other currencies.

That abrupt reversal came after investors doubted the Brazilian Government's ability to defend the currency following the resignation of Brazil's hard-money central bank chief, Gustavo Franco, and the 9 percent devaluation in the real's value on Wednesday.

After Friday's surprise move, the real tumbled another 8 percent, but stock markets from Toronto to Santiago surged in apparent relief that Brazil would no longer waste billions of dollars propping up the currency.

For a day, at least, Brazil did not threaten to spin out of control, taking the rest of Latin America down with it.

But throwing in the towel on its old policy of pegging the real to the dollar is only a stopgap. Now the Brazilian Government and international finance policy makers must wrestle with what comes next.

Brazil has the same choices that other countries with tottering currencies have had. It can continue allowing the currency to trade freely, or it can try to set a new trading range and maintain that range by buying reais in the foreign exchange market.

Or it can follow the more radical example of its neighbor Argentina, and set up a currency board, which would peg the real to the dollar at a fixed rate of exchange.

Such options are likely to be discussed this weekend, when Brazil's Finance Minister and central bank chief meet in Washington with officials from the International Monetary Fund and the United States Treasury Department.

Whatever Brazil's decision, it will reverberate throughout the world.

The impact will be felt most heavily in Argentina, Brazil's biggest trading partner and, like Brazil, a country that has only recently recovered from years of hyperinflation. Should the Brazilian currency be allowed to trade freely, it is unclear how the Argentine peso could keep its dollar peg when most of its exports and imports will be priced in a currency that can fluctuate wildly in value. Currency volatility is the last thing Latin American economies need, as they enter a period of slowing growth and rising unemployment.

For American investors and businesses, the Brazilian eruption is the latest chapter in a contagious currency crisis that started in Thailand in July 1997 and spread as far as Russia last summer. If the turmoil leads to a prolonged downturn on Wall Street or cuts heavily into American exports, the robust economy in the United States could turn anemic. Here is a brief guide to what is at stake and what might happen next:

Q. Why is Brazil so important?
A. Brazil is the biggest economy in Latin America, about twice as big as Mexico's. While it buys just 3 percent of United States exports, its economic health is vital to a region that accounts for one-fifth of United States exports.

But Brazil looms even larger in the minds of international investors for the simple reason that it was one of the last large countries to go down the road of free trade, privatization and hard money. If that approach fails in Brazil, the ideal of a unified global economy knit together by trade and investment is threatened.

That is one reason that the I.M.F. cobbled together one of the biggest rescue packages in history, and one factor in the Federal Reserve's decision to lower interest rates in the United States three times last fall.

Q. What's a devaluation?
A. Both devaluation and depreciation refer to a decline in the value of a currency. The distinction is this: when a government has declared that it is pegging its currency to another and will defend it by any means necessary but lets it fall anyway, that is a devaluation; when the falling currency is that of a country that allows the market to set its value and its value falls, that is a depreciation. One involves a broken promise; the other doesn't.

When Brazil announced its devaluation, overseas investors saw it as a sign that the Government was caving in to political pressure from unions and big business to put its anti-inflation strategy on the back burner and to fight unemployment instead.

Q. Why did Brazilians make the choices they made?
A. Brazil pegged its currency to the dollar in the first place as a way of convincing investors at home and abroad that it would no longer tolerate the chronic inflation that has plagued it for decades. When the so-called Real Plan was enacted in 1994 inflation was running at more than 3,000 percent. Like Russia and scores of other developing countries, Brazil had long financed huge Government commitments mainly by printing money rather than collecting taxes.

But fixing the exchange rate and getting inflation down initially proved easier than scaling back Government commitments. Brazil has a social security system that allows workers to retire after 20 years, often with pensions higher than the pay workers were earning on the job. What is more, it takes the equivalent of a constitutional amendment to lay off public workers.

At the same time, Brazil's economy has been stagnating, unemployment is at near-record levels, exports are falling and the trade deficit is way up. Tight money was not only hurting exporters by keeping the currency strong but was keeping interest rates high (around 30 percent).

Remember the early 1980's, when the United States had a big budget deficit and the Federal Reserve's chairman, Paul A. Volcker, declared war on inflation? Interest rates were sky high, the dollar was extremely strong and American manufacturers were screaming murder.

Now, Brazil's industrialists and unions are the ones who are screaming. They want a weaker currency to stimulate exports by making their goods more competitive on the world market -- even at the cost of more inflation, lately running less than 3 percent a year.

Newspapers in São Paulo, the industrial center of Brazil, had been calling for Franco's head for months.

Q. What did Brazil hope to accomplish?
A. The devaluation was supposed to buy time. If investors had gone along, bond prices might have stabilized or gone up, interest rates might have leveled off or fallen, and exports might have received a lift. But the strategy fell apart almost as soon as it was introduced for the same reason it failed in Thailand, Russia and elsewhere. Investors at home and abroad simply were not convinced that the first devaluation would be the last. They saw it as a sign of more to come.

Any investor holding a currency she thought was going to be worth less tomorrow would sell immediately.

With foreigners and, increasingly, domestic investors taking large positions against the real, Brazil faced a nasty choice. It could try to stem the tide by using its hard-currency reserves. Unlike Mexico in 1994 or Russia in 1998, Brazil had roughly $40 billion in reserves as well as a $30 billion credit line from the I.M.F. Or it could let the currency fall to whatever value the market placed on it, making no promises to exchange it for dollars at a particular rate or to defend it if it fell below a certain level. It chose the latter.

Q. What are Brazil's options now?
A. A jet flying at 40,000 feet can fall 10,000 feet and still avoid disaster if the pilot manages to regain control of the aircraft. Everything depends on Brazil's regaining control of its economic policy.

For the moment, at least, it has. But to resolve its currency crisis, Brazilian policy makers must choose among several long-term strategies.

Brazil could simply announce a new fixed rate -- or more accurately a new range of rates -- tied to the dollar to replace the old range of rates. As with the old regime, the new currency system could be devalued by a specified, tiny amount every few days, but no more than that.

The central bank would promise to use monetary policy and foreign exchange reserves to support the value of the currency in the foreign exchange market. But this would work only if Brazil could keep investors convinced that it was going to keep its promises more faithfully in the future.

With good reason, the Finance Minister of Mexico noted at the height of his country's currency crisis that only the most extreme exchange rate regimes -- in other words, those that essentially remove any discretion -- truly rule out the threat of speculative attacks. A permanent floating rate, the system that the United States and most other rich countries have embraced, is one such extreme. The other, chosen by Argentina and a number of former Soviet republics, is to adopt a system that virtually rules out devaluation by putting foreign exchange policy in the hands of a currency board.

Letting your currency fluctuate with supply and demand has the definite advantage of allowing the currency to adjust to shocks like, say, a collapse in commodity prices. Further, a country does not risk speculative attack because it has not promised to exchange r its currency for a specified amount of dollars.

Alas, Brazil is not a good candidate for a permanent floating exchange rate scheme.

For starters, where Brazil goes, Argentina must follow.

Argentina, Brazil's biggest trading partner and a fellow recovering inflation addict, would be forced to abandon its fixed rate currency strategy -- a strategy that seems to be working well and one that lots of investors are counting on.

The Brazilian Government's huge domestic debt, around $270 billion, also poses an obstacle. Because the Government could not persuade investors to lend it money except by providing very short maturities and promising to index much of the debt to dollars, every time the exchange rate fell, the Government's obligations would jump. A big drop in the currency would mean instant default, just as it did in Russia last summer or in Mexico in 1995.

Another option for Brazil, a currency board, is the most radical, but has some strong supporters both within Brazil's central bank and in the I.M.F. It is a desperate measure that involves giving up all pretense of controlling one's own currency and in effect replacing the central bank with a board that includes some foreigners. On the other hand, Argentina, which has such a board, has been able to borrow on world markets at the modest rate of 8 percent this week.

Under a currency board, the supply of reais in circulation would have to be fully backed by dollars and convertible, on demand, at a fixed rate of exchange. In effect, Brazil would be handing over control of its money supply -- which would fluctuate with the amount of dollars available -- to Alan Greenspan, the chairman of the Federal Reserve.

Currency boards have long been considered an appropriate strategy for small economies that rely heavily on international trade. They do not eliminate the need to solve the fiscal imbalance, but simply take away the option of printing more money to finance shortfalls -- yet another hard choice for Brazil.

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