Brazil is holding a national election in October, but regardless of who wins-leftist or centrist-the country is hurtling toward an economic crisis. The $30 billion line of credit from the International Monetary Fund, announced on August 7, buys the country time, but it does not solve the problem. Brazil's foreign debt, except in the most implausible of positive economic circumstances, is simply unsustainable in the years ahead. The debt must be restructured and the repayment schedule stretched out to ease the annual drain on the Brazilian economy. The chances of having to do a major debt restructuring by the end of 2003 are high, predicted Morris Goldstein, a senior fellow at the Institute for International Economics in Washington, "and that is regardless of who wins the election," he added. The IMF deal and Brazil's next president may be able to affect the timing of the coming crackup, and the fiscal and monetary policy nuances of dealing with it, but they can't avoid the train wreck. Treasury Secretary Paul H. O'Neill's soothing comments during his recent visit to Brazil were a long-overdue U.S. effort to calm skittish international financial markets, and they were especially welcome after O'Neill's intemperate criticism of Brazil in late July helped cause the Brazilian currency, the real, to lose nearly a third of its value. But now it is time for O'Neill to turn his tough-love rhetoric on Wall Street. U.S. banks and investment houses, which readily lent Brazil money in the past, stand to lose tens of millions of dollars if that debt is restructured. It is little wonder that they led the chorus of Chicken Littles demanding that the IMF put together its loan package for Brazil. O'Neill, never one to mince his words with improvident borrowers, needs to be equally tough on improvident lenders and demand that they renegotiate the terms of their loans to Brazil.
When the Argentine economy fell into disarray last fall, the Bush administration could afford to take an arm's-length stance because there was little threat of the financial contagion's spreading to other markets in Latin America. But this time, the administration cannot afford a hands-off policyBrazil's economy accounts for a third of the Latin American market; the financial markets in Uruguay are seizing up; Latin America is officially in recession; and political instability is plaguing Peru and Venezuela.
Wall Street wants the three major Brazilian presidential candidates to sign a pledge before the election committing themselves to free-market principles and debt repayment if they are elected. The candidates are balking, unwilling to tie their hands before they know the magnitude of the crisis they face. The Bush administration could help secure that pledge if it spent some of its jealously guarded political capital to pressure Wall Street to accept some temporary financial losses by restructuring Brazilian debt after the election. It wouldn't be easy, and it wouldn't be popular in financial circles. But that's what real leadership requires.
"Brazil has a legacy problem," said Arturo Porzecanski, chief economist for emerging markets at ABN AMRO in New York City. "They took on a lot of debt in the '70s and then again in the '90s. And when you have a lot of debt, the meter on the taxi keeps running. You have to be very careful, because every day something is falling due."
Brazil's public debt-that owed by various arms of the government-is equal to 57 percent of the economy and could grow to 92 percent by the end of 2007, according to estimates by New York investment firm Morgan Stanley.
Other nations have had larger debt burdens, but the underlying economic dynamics that will determine whether Brazil can sustain that debt are largely negative. Economic growth slowed from 4.4 percent in 2000 to possibly no better than 1 percent this year. Foreign direct investment-which serves as an infusion of new cash-has slowed. And there is a strong correlation between the ups and downs on Wall Street and worldwide foreign-investment flows. This linkage suggests that the recent slump in New York foreshadows a further contraction in the availability of foreign funds for Brazil. Brazilian exports have slumped despite a weakening currency, thanks to reduced foreign demand. The interest rate the government is paying on its debt is nearly 17 percentage points over what the U.S. Treasury pays on its debt, an unprecedented spread. And the portion of Brazil's debt tied to adjustable interest rates has grown substantially, making debt servicing much more sensitive to the volatility of interest and currency exchange rates.
"The bottom line," Goldstein said, is this county has way too much debt. You have to be able to tell a good story to make this debt look sustainable." The Brazilian economy would have to rebound to a 4 percent growth rate or so-generating more revenues to service the debt. Interest rates would have to fall substantially and the real would have to strengthen-to lower the cost of the debt. And the new government would have to cut spending-to reduce the need for new borrowed money. That perfect alignment of financial stars is probably less likely than a transit of Venus.
Fortunately, the news in Brazil isn't all bad. The new agreement with the IMF gives Brazil access to $6 billion in new money this year and $24 billion more if needed later. The amount is larger than Wall Street had expected and should have a soothing effect, helping to bolster the real and to lower the interest rate Brazil must pay to raise international capital. The Brazilian central bank has also been given permission to dip more into its reserves to defend the real. And although Brazil's problems could still pull down the rest of Latin America, Morgan Stanley believes that other major emerging market economies-such as Mexico, because of its integration with the United States, and Russia, because of its burgeoning oil revenues-are largely immune from a new contagion.
And, of course, it is best to treat any scare talk with some skepticism. "In Brazil," said Brazil's ambassador to Washington, Rubens Barbosa, "very few people believe we will have to restructure the debt." Wall Street's nervousness is mostly self-interest. After the Argentina crisis hit last year, many U.S. financial institutions sold Argentine bonds and bought Brazilian bonds. Citibank and J.P. Morgan Chase, for example, are heavily exposed to Brazilian debt. Painting a particularly bleak picture of the future to build support for this huge new IMF loan to Brazil helps protect the big New York banks' assets.
Whatever the real depth of the Brazilian crisis, it is undeniable that the outcome of the presidential election will affect the current volatility of the real and the prospects for dealing with the debt. The election is October 6, with an October 27 runoff of the top two candidates if, as is likely, no one gets more than 50 percent of the vote. Luiz Inacio Lula da Silva, of the left-wing Workers' Party, currently leads in the polls. Ciro Gomes, a former finance minister who is the candidate of three center-left parties, is second. And the governing party's candidate, Jose Serra, has recently slipped to third.
But nearly half of the electorate has yet to make up its mind. With candidates allotted television advertising time based on how their parties fared in the last election, and Serra assured of 47 percent of the ad time and Lula only 24 percent, the election could go to any of the top three contenders.
Hopeful Wall Street analysts note that Brazilian voters have rejected populist candidates in each of the last three elections. But polls also show that four out of five Brazilians want a change in economic policy, not necessarily the endorsement of conservative fiscal and monetary policy that Wall Street might desire. Moreover, observed Brazil expert Kenneth Maxwell, a senior fellow at the Council on Foreign Relations, "everybody else gets elected in October as well-senators, congressmen, governors, and municipal officials. The old power blocs will be returned to office. If you have a relatively weak president with little support in [the Brazilian] Congress, that would be a sure formula for an inability to push through policies" to deal with the debt.
So what to do? The IMF deal should avert a pre-election crisis, such as a run on the real. Such a run would worsen conditions in Brazil, perhaps ensure Lula's election, and increase the odds he might seek radical solutions, such as renouncing the debt. At minimum, a currency crisis would straitjacket the ability of whoever is president to cut government spending in order to curb the debt.
Wall Street's push to get the presidential candidates in Brazil to sign the pledge on free-market policies is a tactic that has been used before. In 1997, presidential candidates in South Korea made a similar commitment, to good economic effect. But simply continuing free-market policies in Brazil will not be enough. To stabilize the debt as a portion of the economy and to see a sustainable reduction in the premium Brazil pays to borrow abroad will require not only some concessions by that nation's debt holders in New York, but a substantial increase in Brazil's budget surplus. And that will almost undoubtedly require politically unpopular belt-tightening by the new Brazilian president. Brazil bears watching, closely.