Last Samba?

The Brazilian Real was hit by speculators who were betting that Brazil would be the next developing economy to go down the tubes victim of the Asian malaise. Brazil is no Russia however. Being one of the ten biggest economies in the world, a debt default in Brazil would bring down all South and Central American economies, pulling into recession the U.S. economy.

Basil M. Karatzas

Brazil has been the latest victim of the Asian flu, the turmoil in financial markets that started in the summer of 1997 from the "tiger economies" of the Pacific Rim and spread to Russia and the equity markets across Europe and the Americas. The tremors of this Asian contagion were so severe that they have made international markets strategists wonder whether this is only a bad case of flu.

Brazil was assumed suspect by association of possibly defaulting on its debt payments. Its currency (Real) was hit by speculators who were betting that Brazil would be the next developing economy to go down the tubes. The odds that Brazil would become the Russia of the South America were so strong, that just in September and October of this year, approximately $50 billion dollars in hard currencies flew out of Brazil. To put this into perspective, it is equivalent to about one billion dollars per diem, or 70% of Brazil's foreign currency reserves.

However, Brazil is no Russia. Brazil is extremely rich in numerous natural resources, including world class production of agricultural products such as coffee, citrus and sugar. Partially based upon agriculture and partially based upon industry, Brazil's Gross Domestic Product (GDP) for 1997 was a staggering $820 billion, which increased by 3.2 percent units over the previous year. On the other hand, Russia presents a miniscule world economy (Russia's 1997 GDP was $230 billion), smaller than the state of Connecticut, and it has an obsolete industry that produces no exportable products.

Not only has Brazil one among the ten biggest economies in the world, but it also is geographically close and financially even closer to the United States. A debt default in Brazil will bring down all South and Central American economies, which consequently will pull into recession the U.S. economy per se. The Brazilian economy consists of 43% of the GDP of all South American countries. Reportedly, U.S.-based banks have loaned approximately $34 billion in commercial loans to Brazil and Brazilian interests, while Brazil's debt to the outside world is approximately $194 billion (about 23% of the GDP).

In addition, Brazil has done tremendous steps forwards in the last decade in terms of modernizing its economy. Although still a lot is left to be desired in terms of open market conditions, distribution of wealth and mainly current accounts deficits, Brazil has managed to tame four-digit inflation rates to, a still high, but respectable 15%. In contrast, Russia has no traces of democratic tradition (from czarism to communism and now to "duma-ism"). Moreover, corruption levels in Russia not only dwarf Brazil' own corruption problems but they occasionally make Al Capone look like an angel. A tangible example of modern distribution of wealth in Russia is the "privatization" method whereby most of the state companies were simply bequeathed to former party Cossacks.

Brazil also happened to be lucky in the sense that its turmoil came after the International Monetary Fund (IMF) and the world community had climbed a few steps on the "Economy Salvation" learning curve. In the financial packages that were allotted for the tiger economies and Russia, the installments of the loans were mainly back-loaded. In other words, the loans were reactive: most of the installments of package aid were mainly available at the end of the term of the arrangement. This obviously was more sort a "last rites" approach than the drastic therapeutic medicine required, as proven in the case of Indonesia and Russia. In the case of Brazil, the loan is front-loaded, assuming certain conditions are consummated.

From the $42 billion package arranged with the IMF and the Inter-American Development Bank, up to $37 billion can be available in the first twelve months of the arrangement through the Supplemental Reserve Facility. This gives Brazil the luxury to sustain extensive attacks on its Real and be proactive before major financial problems emerge. In exchange for these special terms, Brazil has promised to a) expedite domestic financial reforms, upon their fulfillment are based future installments of the loans, b) abbreviate the payback period, and c) pay higher interest rates (approximately five percent higher than the rate at which the U.S. Treasury finances its debt). However, unlike Mexico who had to collateralize its loans from the U.S. in 1995 with its oil exports, Brazil did not have to make such a commitment.

Cuts and Reforms

Is the Brazilian economy out of the woods? Has the storm calmed down and from now on smooth sailing should be on the horizon? Current reality in the world equity markets suggests that the worst has passed. For instance, the Dow Industrials jumped from a negative year-to-date performance in October to new highs in November as if the Asian flu, and Russian and Brazilian concerns have been resolved permanently. Equity markets, nevertheless, are known for pendulous behavior and today's assumed "happy-end" scenario might seem too precarious in a few days.

The Brazilian economy is not out of the woods yet by any means. The country has to finance an astronomical debt of $300 billion dollars. Despite progress that has been achieved since current President Cardoso introduced the Plano Real in 1994 as a Finance Minister, the debt is excessively high by any measure. As Brazil's synonym (hyperinflation) has calmed down, an excessive debt and the associated need to finance such a high debt might bring the country to the brink of a financial calamity.

President Cardoso in order to secure financing from the IMF and mainly the U.S., had to introduce plans of domestic spending cuts and social reforms. In the proposed three-year austerity plan, approximately $84 billion in social and other benefits were trimmed. While these will hurt across the board, it is the poorer strata of the population that will especially feel the heat. In a country already notorious for uneven distribution of wealth, further cuts for the poor might incite social unrest, increased crime rates and further bounce back of foreign investment.

In a country that made enormous steps in the last decade in terms of developing the economy, the recently "middle-classified" population who were able to find jobs and get a taste of a westernized economy, going back to poverty conditions might push them to be more vocal and un-cooperative for the required reforms. A little taste of capitalism is a dangerous thing, and it is expected that 1999 will be a recession year in Brazil.

It is still early to annunciate whether Brazil will survive unscathed this turmoil. There are tremendous fiscal (debt, etc) and social (poverty, illiteracy, etc.) issues to be resolved before the road to financial happiness can be savored. Brazil, nevertheless, is a richly dowered country with natural resources. Moreover, Brazilians have proven time and again that they are capable of surviving perturbations and worth of attracting foreign investments. After all, adjusting for political risk, Brazil offers a much higher reward-to-risk ratio for foreign investors than other much touted countries, such as Russia and China.

Basil M. Karatzas is graduating in May 1999 with an MBA degree in international Business from Rice University, in Houston, TX. Basil also serves as President for Platinum Holdings International, an international management and capital consulting firm, and can be reached at karatzas@rice.edu  

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