Global Political Economy
Dr. Roy Nelson
Thunderbird School of Global Management
Michael Gray
Ismael Groves
Lucas Hendee
Zachary Parnell
Eduardo da Silva
David Wilson
Introduction
When outlining the reasons Brazil had a major economic crisis in 1999, it is fairly easy to absorb the core economic issues that resulted in the catastrophe. What’s more difficult to understand is the political and cultural environment that had been woven into this crisis and how those factors affected the country’s economy during the crisis and even today.
According to Dr. Roy Nelson, “Causes and Consequences of Brazil’s 1999 Devaluation of the Real”, internal budget deficits are typical problems Latin American countries face. The most obvious solutions governments have in combating budget deficits are to “cut spending, raise taxes, or print more money” (Nelson 1). This scenario was no different for Brazil in the 1990s. It will become evident that the first two options were difficult to implement politically for Brazil, as in most countries. And the final alternative – printing money, though relatively simple to execute can cause high levels of inflation for a country’s currency. What was Brazil’s solution? The Real Plan of 1994.
Finance Minister, who later became president, Fernando Henrique Cardoso initiated the Real Plan (under President Itamar Franco) which aimed to fix the Brazilian Real to the US Dollar at roughly a 1:1 exchange rate. The Plan also stipulated that the Brazilian Central Bank was not allowed to print more money indiscriminately. Subsequently, the Bank was forced to buy up reais with hard currency reserves to keep the exchange rate stable. Lastly, the Bank was required to hold a significant amount of hard currency reserves to exchange investors if a large amount of reais were dumped on the domestic market.
Soon thereafter Brazil began experiencing a worsened budget deficit as well as a balance of payments problem as the US dollar rose significantly in price (Nelson 2). Brazilian exports became far too expensive to sell to the world while consumers in Brazil could afford much more imported goods than ever before. This type of current account deficit required a massive amount of foreign investment, raising the capital account, in an effort to create a balance of payments. Sadly, once investors realized that Brazil’s Central Bank may be running out of hard currency reserves, capital flight ensued.
These core components have made up currency crises on multiple continents. So, how did Brazil get into this mess? And why is Brazil one of the strongest economies in the world today in spite of the crisis?
Brazil before the Crisis
When attempting to understand Brazil it is important to keep a few key facts in mind. Though Brazil was discovered in the 1500’s by Europeans, it is a fairly new democracy. Throughout the past half millennia Brazil has experimented with nearly every political system save communism. Most notably in the recent past Brazil has had to contend with several military dictatorships. These dictatorships directly influenced the country’s economic policy. The military had nationalized industries, banned labor unions, and disbanded all political parties except two – which remained under their control (Meade). From the 1930s to the late 1980s, various military leaders found their way in and out of power. The government sporadically returned to civilian leadership throughout this time, but whenever economic, social or political instability occurred, military takeover ensued. Coups eventually led to a military dictatorship that lasted from 1968-1983 with ever increasing repression, and suspension of civil liberties.
It is out of this history that the 1988 Constitution was born. The Brazilian people were intent on changing the military’s behavior and did so by adopting a new Constitution.
The Constitution of 1988 focused on the separation of powers, and the “control” of the military. With it came the first free national election (The World Factbook – Brazil.) One of the main focuses of the newly elected government was economic stability and creating economic growth. As an understanding of the Brazilian government’s decisions and interactions with the IMF is developed, it is important to keep in mind Brazil’s history of military intervention in the wake of troubled times.
Causes and Short Term Events Leading to the Crisis
As previously mentioned, Brazil had struggled from a budget deficit for years. It’s only remedy would be to print more money – a consequential remedy that inevitably leads to heightened levels of inflation. In 1994, Cardoso built the Real Plan under the approval of President Franco. The Plan’s focus – the Real was to be fixed to the US Dollar. Other stipulations included that the Central Bank was not allowed to print more money haphazardly and would have to maintain sufficient hard currencies if investors were to dump reais on the economy (Nelson 1). Within just a few years, it was obvious that the real was tremendously overvalued as the USD soared with substance; this overvaluation made Brazilian exports increasingly less competitive and created a balance of payments deficit. In January 1998 it became evident that Brazil’s financial markets were headed towards trouble, as the country maintained a seven percent budget deficit. The situation led the country to increasingly rely on foreign direct investment and short term funds to attract capital into the country.
In addition to government debt and decreased exports, the Brazilian stock and bond market continued to slide. Most analysts agree that this should be attributed to the rise in the presidential polls of Luis Inacio “Lula” da Silva, whom the international business community perceived as being less market oriented than Cardoso(Weisbrot). Furthermore, the fact that none of the four candidates running for president endorsed the fiscal and monetary policies the IMF placed as conditions for the $30 billion rescue package, further eroded investor and creditor confidence in Brazil.
In the weeks leading to his re-election win, Cardoso laid out an ambitious program of federal spending cuts. According to the Minister of Finance, Pedro Malan, “The measures amounted to R$26 billion, aimed at transforming an estimated deficit of R$11.6 billion for 1999 into a surplus of R$16.4 billion in the federal government alone, with states and municipios to produce a surplus of R$3.6 billion, with the same figure expected from state enterprises” (Flynn 290). Due to Cardoso’s announcement of these severe measures, as well as the intense pressure investors had placed on the Brazilian economy by dumping 8 billion in stocks and bonds (during a 5 day period in September 1998), the IMF moved on its rescue package after being summoned by Brazil in September 1998.
IMF Terms, Conditions, & Economic Reaction
The Brazilian government initiated working with the IMF on an assistance program early September 1998 when the real was “under attack”, as described by Cardoso in his book “The Accidental President of Brazil” (Cardoso, Kindle Version). However, only after Cardoso was reelected in October did the negotiations become more aggressive.
The IMF-led financial assistance and adjustment program was finalized in November 1998, and it was approved by the Executive Board on December 2nd, 1998. Unlike other IMF interventions which stipulated a flexible currency policy, the Brazilian intervention called for a real crawling[1] peg exchange rate policy. This aimed to keep inflation low – initially the main objective of the Plano Real. Pedro Malan and the IMF agreed to revisit the monetary policy at a later date.
Although Brazil had already initiated a very aggressive privatization process and held high interest rates to control inflation and prevent outflow of money, its budget deficit was far too high. The IMF program included a strong and front-loaded fiscal adjustment policy expected to occur in early 1999 with wide structural reforms in the financial sector and labor markets.
The main objective of the fiscal adjustment policy was to stabilize the ratio of net public debt to GDP by the year 2000. The plan also accounted for a continued reduction of net public debt to GDP assisted by primary forecasted surpluses of the consolidated public sector corresponding to 2.6 percent of GDP in 1999, 2.8 percent in 2000, and 3 percent in 2001. By reducing the net public debt, the Public Borrowing Requirements (PSBR) would also decline significantly to roughly 4.7% of the GDP in 1999, 3% in 2000 and 2% to 2001 (IMF Press Release No. 98/59).
The structural reforms needed to be implemented to address inherent weakness in “the budget process, the tax administration, public administration, social security, and the efficiency of public expenditure especially in the social area” (IMF Press Release No. 98/59).
It was agreed that the IMF would make available a total of $41 billion (Figure 2) in financial assistance to support the program of adjustment and structural reform mentioned earlier. This figure was to be available very quickly. Most of the loans were available at high interest rates at a short term, to reduce moral hazard.
Although credit lines were made available by the private sector, they did not participate by making any financial contribution.
Shortly after the IMF assistance program was drafted the business community voiced major objections to the IMF’s decision to support the crawling peg of the real. Matters seemed to worsen when the Brazilian government was faced with another major challenge. On December 2, 1998, the Brazilian congress failed to pass a bill proposed by Cardoso to increase pension contributions. As stated by Cardoso, “Congress essentially torpedoed our deal with the IMF” (Cardoso, Kindle Version). The stock market plummeted almost 10% the next day.
On January 4, 1999, matters worsened causing a significant increase of capital flight and panic in the international and domestic financial community. Itamar Franco, then governor of the state of Minas Gerais and former president of Brazil, appeared on national television to announce that his massive state would fail to pay its federal debt. In short, he stated that Minas Gerais, Brazil’s second largest state, was bankrupt and asked for a 90-day-moratorium. Six other state governors joined Itamar and announced the same regarding their respective states.
In reaction, the world financial markets panicked – $1 billion was leaving Brazil on a daily basis. On January 13, 1999, the government, in an attempt to stop capital flight, increased the crawling peg narrow band to allow the real to a higher devaluation. It didn’t work. The trading of Brazilian bonds was lifted all over the world due to investor’s anticipation of the real’s sharp decline in value. In two days, the government went through $14 billion in reserves, draining hard currency reserves. Finally on January 15, it was finally decided to allow the real to float freely. Cardoso stated in his book the following, “The real, the biggest symbol of my government and the anchor of our economy, was left to fend for itself. All of Brazil held its breath” (Cardoso, Kindle Version).
In consequence of the new flexible exchange rate, the real lost two thirds of its value in less than two months. Brazil was heading into a depression. However, contradicting many economists’ pessimistic predictions that Brazil was going to face a deep and long lasting recession, both the economy and the real quickly bounced back. The GDP in 1999, which was predicted to have a 3.8% decrease actually had a minor 0.81% expansion.
The IMF and Brazil met again to revise the program in March 1999. They discussed incorporating the following conditionality list:
- Inflation targeting as the main basis of the IMF program in Brazil.
- Interest rates to be adjusted flexibly as an instrument to prevent the uncontrolled rise of inflation.
- Continue ongoing efforts to further strengthen and modernize the financial system, including the federal and state banks and non-bank financial intermediaries.
- Work with Congress to approve proposals for strengthening the central bank’s operational independency; fixed term mandates for its president and the other member of board of directors.
- Continue commitment to further reduce the ratio of the public debt in 2000 and 2001.
- Attain larger primary surpluses than what was agreed on the original program to compensate for the adverse impact of the currency depreciation on the public debt.
- Continue programs of wide structural reforms in several areas such as privatization (expanded to energy and financial sectors), tax, administrative, social security, change in law proposal for fiscal responsibility, social policies, etc. (IMF Survey volume 28, no. 3)
Despite many critics’ suggestions that the IMF-Brazil program was another example of poor intervention as it failed to defend the crawling peg of the real, the IMF strategy was flexible and quick when addressing the Brazilian crisis. The terms of the loans with its aggressive front-loaded nature and its “punitive” interest rates were important to address moral hazard. Also, the IMF phased from a semi-fixed currency regime into a flexible policy gradually, which helped to minimize the full impact of the transition.
As indicated by Cardoso, Brazil needed to go through these serious reforms to achieve sustainable growth. Cardoso, as expected, was blamed for the decline in standard of living and insecurity in the financial arena. He never achieved a similar popularity level as during the October 1998 reelection. At the end of August 1999, he had only 12% of approval and a 59% disapproval rate.
Impact of Conditions of IMF
The conditions the IMF imposed upon the Brazilian government had a wide ranging effect on the overall business environment, both directly and indirectly. The conditions that pertained to the financial and banking sectors had a direct impact. Whereas, the overall set of conditions played an important role in Brazil’s decision to float its currency. The direct impact on the banking sector is most apparent when examining the effects of privatization. The indirect impact of the conditions can be seen when exploring the chain of events that began with the Brazilian government’s decision to oppose some of the public sector cost cutting conditions. This led to additional capital leaving the country and ultimately a floating currency (Doctor and Paula 5). The currency devaluation had a direct impact on the agricultural sector in Brazil, among others.
Beginning in the mid-1990s, Brazil implemented a program known as Program for Reducing the Presence of the State Public Sector in Banking Activity (PROES) to privatize the Brazilian banking system (“Brazilian Payment”). This program was later heralded by the Brazilian government as a key element in their effort to meet the IMF’s conditions on privatization (Government of Brazil). These efforts are noteworthy for their impact on the business environment for two reasons. First, any time a government privatizes an industry it is going to increase the number of private jobs in the country. Secondly, over the mid to long term, privatizing the banking industry will make a country more appealing for investment. This is because more of the country’s debt will be held in the private sector, meaning that the state will be less burdened with debt. As a general macroeconomic philosophy, any time a country can reduce its debt, the more stable it is thought to be.
Therefore, Brazil’s compliance with IMF conditions on privatization directly impacted the business environment, both within the banking sector and as an economy as a whole. While the IMF’s privatization conditions had a direct impact, the conditions relating to public spending had a more nuanced impact. As previously mentioned, these conditions ultimately led the devaluation of the real. The Brazilian agricultural sector, as an example, benefited greatly from the currency devaluation because it increased their competitiveness in the international export market. Due to improved competitiveness, Brazilian farmers were able to export significantly higher quantities of their exports, e.g. Brazil doubled its coffee exports in the first quarter of 1999 compared to a year earlier (Bolling 49). Brazilian farmers would have faced a far larger drop in income had the government not “floated” the real. Due to the effects of the El Niño weather phenomenon, the world saw a bumper crop season in almost all of Brazil’s major agricultural exports (Bolling 49). As expected, the increased quantity of agricultural exports drove down prices. Despite the fact that Brazilian farmers exported more products in terms of tonnage in 1999, they saw revenues drop by 11% compared to a year earlier (Bolling 46). One can only imagine how poorly the Brazilian agricultural sector would have performed had it continued to attempt compete with the previously inflated real. In that regard, the agricultural sector can be seen as a snap shot of the currency devaluation’s effect on the greater business environment. Improved competitiveness on the international market is going to benefit every industry.
Over the next several years, the conditions imposed by the IMF and the overall state of the world economy had mixed effects on the Brazilian business environment. Much to the surprise of many analysts, the Brazilian economy returned to growth immediately and inflation was kept under 10 percent (Doctor and Paula 5). This return to growth can be at least partially explained by three variables, all of which were previously discussed here. Privatization efforts and the favorable exchange rates that were generated from the floating currency resulted in increase in foreign direct investment and a trade surplus for Brazil (Doctor and Paula 6-8). However, Brazil’s efforts to abide by the IMF’s conditions did not do enough to make Brazil immune to the ebb and flow of the international market. According to Doctor and Paula, Brazil benefited greatly from a strong commodities market over the next several years, but did not experience the same level of growth as other emerging markets due to international economic fluctuations and concerns over incoming President Lula (5-6). Despite the shortcomings, it is important to remember that the changes in the Brazilian political economy likely protected Brazil from an economic catastrophe, where it defaulted on its debts and its exports fared poorly.
Resolution of Crisis
Brazil’s recovery was a success due in large part to compliance to IMF conditions, market-friendly domestic financial policies, presidential leadership, a surge in commodities exports, and low U.S. interest rates.
As noted previously, the IMF’s conditions provided opportunity for Brazil to stabilize its financial market, particularly by retaining foreign direct investment. Although investors were skeptical of Lula’s potential impact on the economy prior to his taking office in January of 2003, high interest rates battled inflation and kept investors around while Lula worked to continue the efforts of Cardoso’s administration. Reflective of the urgency of the time, Cardoso ordered a team of 51 people to ensure a smooth transition of power to Lula’s administration, in large part to avoid further financial turbulence (Flynn, “Brazil and Lula” 1246). In the first couple of years of his presidency, Lula felt all the pressure of conforming to IMF conditions, particularly since he was a leftist who promised myriad social programs that the government simply could not afford. Lula’s restraint was answered with plenty of criticism from his supporters and even his own party, but he continued on the path to economic recovery, ensuring his country that change would come in due time (Flynn, “Brazil and Lula” 1228-29). He was further criticized for having no control over Congress, thus lacking real political power (Flynn, “Brazil and Lula” 1226). Meanwhile, Henrique Meirelles, President of the Central Bank, and Antonio Palocci, Minister of Finance, worked with Lula to maintain the confidence of the IMF and investors by cutting R$14 billion from the federal budget (Flynn, “Brazil and Lula” 1229). Many in Lula’s political party defected, disillusioned with what had become of the party (Flynn, “Brazil and Lula” 1257). So, as IMF critics might have anticipated, the continued compliance to IMF conditions that set the foundation for economic recovery came at a great political cost to Lula. Add to that an unprecedented crisis of corruption within his regime in 2005 and the threat of impeachment for Lula himself, and one might understand why Lula once considered not running for re-election in 2006 (Flynn, “Brazil and Lula” 1233-35). However, he did, and his second term saw much brighter days than his first, including expansions of social programs such as Bolsa Familia that has helped lift millions of Brazilians out of the poor and into the middle class.
While battling inflation with high interest rates, Lula and his administration benefited from high global commodities prices and low U.S. interest rates that both aided in greatly increasing exports (Rathbone). While in the early stages of the global commodities boom, Lula’s administration had already pulled the country out of trouble and was so successful that on December 13, 2005, they announced they would prepay $15.5 billion to the IMF (“The Americas: Kirchner and Lula”). By February 2006, the country’s balance with the IMF was settled (Guerrero; “Brazil: Transactions”). Brazil had achieved the independence that so many Latin American countries had not by severing its obligations to the IMF. Lula and his administration largely maintained market-friendly financial policies before and after settling obligations to the IMF suggesting that the conditionality of the repurchases may not have been the only driving factor for these public servants. By continuing their policies and expanding some public social programs, they led their country into a position of economic envy by the time the global financial crisis hit in 2008. In September of 2008, Lula was quoted as saying that the U.S. financial crisis was U.S. President Bush’s crisis, not his (Kraul 1). However, it was only a matter of months before journals started reporting that the global crisis had reached Brazil and its economy would not be immune to it (“The Americas: The credit crunch”). Brazil’s economic contraction during the crisis was brief and shallow and Brazil, along with other emerging economies, led the world out of the recession. In a grand assertion of its economic prowess, Brazil loaned $14 billion to the IMF in late 2009 (Rathbone). Roughly eleven years after receiving one of the largest ever IMF support packages, Brazil settled its balance with the IMF. Not even four years after that, the country drew from its surplus reserves and lent funds to its old creditor.
As Brazil’s economic strength today is a result of market-friendly fiscal policies and restraint in public spending, so too will its immediate future require nothing different, including careful monitoring of interest rates, which are currently attracting foreign investors and strengthening the real. As a result, imports are rising at nearly twice the pace of exports, threatening the country’s balance of payments (Rathbone).
A run-off election for president on October 31, 2010, will tell who will carry the torch forward as Lula’s successor. Whether it be Dilma Rousseff, whom Lula endorses and whom received 46.9% of votes on the October 3 general election, or former Sao Paulo governor Jose Serra, the successor has large shoes to fill as Lula’s approval rating soars near 80% and the country asserts itself in the global arena and will host high-profile events such as the World Cup in 2014 and the Olympics in 2016 (“Brazil’s presidential election”). Brazil looks bright today. The country of the future has finally arrived.
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