Brazil in the 1997-1999
Financial Turmoil
Fourth
Country Meeting of the NBER Project on John McHale Project Directors: Martin
Feldstein and Jeffrey Frankel In February 1999, following months of speculative
pressure and in spite of a large IMF rescue package, the Brazilian Real was
devalued. Brazil's turmoil was the latest episode in the financial contagion
that began with Thailand's devaluation in July 1997, spread to other Asian
countries such as Korea and Indonesia, and worsened with Russia's devaluation
and default. Although Brazil was a victim of the unsettled international
capital markets, it did have fundamental problems. Its innovative Real Plan led to a
dramatic decline in inflation, but also to an overvalued currency and current
account deficit. Moreover, inadequate fiscal consolidation led to fears of
default, high interest rates, and a consequent debt spiral. On April 14th and 15th (2000),
a number of distinguished Brazilian and international academics, current and
past high level officials of the Brazilian government, and leading figures
from the international investment community, gathered at the Royal Sonesta
Hotel in Cambridge to discuss the Brazil's recent crisis. The program opened
on with (an off the record) dinner speech on April 14th by Arminio Fraga
Neto, Governor of the Central Bank of Brazil. This report summarizes the main
proceedings from April 15th. These proceedings were divided in
four sessions, covering the events the followed the Real Plan, the
crisis period, the counterfactual of what would have happened if fiscal
retrenchment had been pursued, and the events since the February 1999
devaluation. The format for each session was a number of short presentations
by leading experts bringing diverse viewpoints, followed by a free ranging
general discussion. The day's debate provided a great deal of information and
many spirited exchanges. For those who were not able to attend we hope that
that this report gives the essentials and flavor of the discussion. Session 1: Disinflation and Exit
Strategy Chair: Jeffrey Frankel Panelists: Edmar Bacha: BBA Securities Gustavo Franco: PUC-Rio John Williamson: Center for International
Economics To provide background for the conference's
discussion of the turmoil period, the first session considered the successes
and limitations of the Real plan and its aftermath. The
panelists were asked to consider a number of questions. Was the post-plan
real appreciation caused by inflation inertia or nominal appreciation? Was it
wise to pursue a gradual realignment strategy instead of a policy of prompt
realignment or a totally fixed exchange rate? What were the fiscal and real
activity costs of gradual realignment? What was the perceived benefit of
gradual realignment in terms of avoiding a persistent inflation backlash? Edmar Bacha opened
with a reminder that the first of the modern efforts to reduce inflation came
as far back as 1985. In the following years a number of plans were tried and
abandoned. He noted that Brazil was a peculiar case of a highly indexed
economy that was "never dollarized." The main obstacle to doing
away with inflation, he opined, was the difficulty of suppressing the indexation.
In 1994, with inflation accelerating, a new reform
plan based on the idea of a parallel currency that would eventually shift to
a real currency was formed. The monetary reform was to involve no wealth
confiscations; and the government would only do what was pre-announced. Once
again, however, the momentum of wage inflation posed a problem for the
reform. In early 1995 there was an opportunity to fix some of the flaws
(e.g., by refusing to follow through with planned wage increases in the public
sector.) But the government chose not to do so, actually granting a large
increase in the minimum wage (and by extension in pensions). With the new exchange rate regime proving too
inflexible to avoid large imbalances in the external account, the government
finally did away with wage indexation in March 1996. After this, according to
Bacha, there was a much better chance that monetary policy would be able to
hold prices down. Gustavo Franco divided
his presentation into a number of points. · He first
observed that Brazil had endured seven years of hyperinflation before the Real plan.
Hyperinflation is a serious disease "taking one generation to develop,
and one generation to deal with," he said. · Initially
there was a high risk of a backlash, with an election close and the favorite
candidate from the workers' party. · In
addition to monetary reform there was also a heavy agenda of structural
reforms. This lead to difficult issues of sequencing. The two reform
processes were intertwined. · "We
had luck," Franco said. It proved possible to pass key constitutional
amendments. And no one could have imagined that the finance minister would
last. · He
reminded the group that the plan began with a floating exchange rate, and
evolved into a band system. Things began well with an initial nominal
appreciation. However, pressure developed to stop the appreciation. A floor
was placed on the number of domestic currency units per dollar. After the
Mexican crisis, pressure mounted to put a ceiling on the dollar exchange
rate. Thus a de facto band system had emerged. Later the band was allowed to
drift. Franco described the newly evolved regime as a "mitigated
float." · Turning
to capital controls, Franco said the government was committed to the
principle that every dollar that came in had the right to go out. The real
issue related to the rights of domestic savers in a country with a real
threat of electing a left wing government. The government was worried that if
savings left they might not come back. · From
mid-1996 onwards the rate of depreciation was 7 to 8 percent year. Taking
into account the initial overvaluation the authorities had to decide on
whether to keep to this rate of drift or pursue something more drastic. The
complicating factor was the interest rate and its relation to the fiscal
situation. With gradual devaluation a high rate was "needed to cover the
arbitrage," Franco said. · If the
devaluation had not taken place Brazil would have ended up with the same real
exchange rate as it has now. In Franco's view, a dramatic fall in the
exchange rate would make a new band system likely. · On the
question of the advantages of flexibility versus the need for an anchor,
Franco expressed the belief that rigidity was useful insofar as it forced the
political agenda towards "doing the right things." He said that
everyone who went to the president arguing for devaluation complained about
this pressure (e.g., the pressure for social security reform). "For a
long time," he added, "complacency was avoided by the discipline of
the peg." John Williamson spoke in
approving terms about the Real plan, the
essence of which he described as taking the unit of indexation and converting
it into the unit of account. He pointed out with evident satisfaction that
there had been a conference at the Institute of International economics
exploring this idea. Unfortunately, Brazil did not pursue the idea in its
earlier reform plans. But Williamson said it "worked like a dream in
1994," ideally suited as it was to Brazilian conditions. There remained, however, the issue of the exit
strategy. They needed to build a regime that would allow depreciation in the
future. Williamson said he favored some sort of band system. Turning to the
actual band system that was pursued, he noted that the wide band was not operative.
He expressed the view that making the narrow band the operational target was
a mistake, and added that he felt the "crawl was too slow." More
speculatively, he conjectured that a faster rate of depreciation of the
central rate would have been possible without a higher interest rate if a
wider band had been operational. He concluded by expressing skepticism about the need
for a "strong nominal anchor," pointing out that the devaluation
did not lead to a big rise in prices. Such a rise in prices should have
happened if the nominal anchor "theology" was correct. General Discussion The general discussion began was preceeded with a
warning from the chairman that comments should be limited to period before
mid 1998. Eliana Cardoso commented first, noting that Chile still has a fully
indexed economy, and it has managed to be more stable than Brazil. Gustavo
Franco responded that there still is some indexation in the Brazilian system.
A little does not hurt, but beyond a certain level it is "poisonous,"
he said, adding that Chile remains "within these bounds." Eustaquio
Jose Reis said that the difference between Chile and Brazil is the importance
of trade in the economies. The traded sector is much larger in Chile. He said
that exchange rate stabilization is much less suited to Brazil, and expressed
surprise that it worked. Andres Velasco countered the assertion that
indexation is widespread in Chile. Under military governments, he pointed
out, wages were allowed to fall in real terms. Cardoso disagreed with Velasco
on the limited indexation in Chile, pointing to financial contracts. Velasco
accepted that it was true for financial contracts, but reiterated that it was
not true for wages. Paulo Leme turned the discussion to fiscal issues,
noting that there was a good fiscal adjustment initially, but by the fourth
quarter of 1997 fiscal problems had emerged. He believes that there was a
good opportunity to push for fiscal adjustment at that time. The opposite
happened, however, and the fiscal situation got worse. Gustavo Franco
concurred, saying that the deficit needed to be kept at 3 ˝ percent of GDP.
But the fiscal balance went the other way despite the large number of
tightening measures that were undertaken. The central bank was surprised by
the inability to meet the target, he confided. And added that the markets
were not impressed when Brazil tried to put together a further fiscal package
after Russia. Pierre Oliver Gourinchas asked about the
communications between the central bank and the government. Franco responded
that there were discussions. He said that what bothered the president was the
trend in interest rates not exchange rates. The focus of the discussions was
on timing. The belief was that nothing should be done about devaluation in
the midst of the crisis. Assaf Razin observed that Israel's stabilization was
fiscally based even more than it was exchange rate based. He added that
Israel also had an indexing system in wage negotiation. It was suspended in
1985, but it came back in full force. Nonetheless, Israel was able to reduce
inflation, though it did return. Continuing on the fiscal theme, Eliana Cardoso
pointed out that there had been fiscal subsidies to various institutions.
These were not part of the budget. As a result, it is not enough to look just
at the budget numbers. Andres Velasco expressed disagreement with the view
that a fixed exchange rate induces fiscal discipline. Declining reserves
under a fixed exchange rate regime tends not to cause alarm. Exchange rate
depreciation, in contrast, does get attention, he said. This led to a lively
exchange, with Marcio Garcia agreeing and Richard Cooper saying that recent
evidence suggests otherwise. Márcio Garcia pointed out that, in the months
previous to the devaluation, the perception one got by reading the Brazilian
press was that the unpopular high interest rates, lack of growth and growing
unemployment were all Central Bank´s fault due to the mismanagement of the
exchange rate. That stood in marked contrast with Argentina, where the pain caused
by the currency board were endured by the population as a necessary one.
Therefore, he concluded, in Brazil the quasi fixed exchange rate seemed to
have failed in gathering the necessary political support to induce fiscal
discipline. Zia Qureshi commented that the inflation outcome was
not all that bad. But added that the exchange rate is not the only possible
nominal anchor. He asked if it could have been replaced with something else.
John Williamson responded that it was not an exchange-rate-based stabilization.
Based as it was on a parallel currency, it was something quite different.
Posing the question, "Can one get by without a nominal anchor?"
Williamson's own answer was--no. Richard Cooper responded that the US does
not have a nominal anchor. Later Gustavo Franco said that the only way that
you can avoid having an anchor is to have a budget surplus. Cooper disagreed
with this statement if it was meant to "apply to the world," but
allowed that it was possibly applicable to Brazil. Franco assented that it
need not be true as a general statement, but it had been crucial for Brazil. Ilan Goldfajn wondered what it meant to have a band
when you are not using that band. Gustavo Franco disagreed with the
implication that it was not a band. Jeffrey Frankel interjected "that
one percent is not a band," reasoning that exchange rates under the
Bretton Woods system were pegged only within a one percent range. Franco
admitted that they had felt that one percent was a lot of room to work with,
but "that they had underestimated the difficulties of working with the
markets." On the question of the size of the overvaluation,
John Williamson expressed the view that it was relatively minor. They would
have gotten away with it, he speculated, if the world had not been so
turbulent. Eduardo Borensztein asked the panel about the
effectiveness of capital controls in Brazil's situation. He added that he was
not implying that all controls should be removed, but said that it is
important to be aware of their limitations. Gustavo Franco responded that
capital controls were never meant to be an instrument to prevent a crisis.
John Williamson also expressed skepticism about the efficacy of capital
controls, stressing that you should neither overstate what they can do, nor
underestimate the damage that they can cause. Responding to a question form Pierre Oliver
Gourinchas, Franco recounted that there was discussion on what the lowest
possible interest rate would have been in 1997 under different monetary
regimes. He added that the binding constraint on interest rates is fiscal;
now the central bank can lower the interest rate, but there is a limit
imposed by fiscal and balance of payments situations. At the beginning of the
Real plan, he added, there was no net foreign investment. In
response to the reforms there has been a significant increase in foreign
direct investment, which makes in safer to run a current account deficit. Session 2: Crisis and Defense Chair: Andres Velasco (New York University and
NBER) Panelists: Peter Garber (Deutsche Bank) Thomas Glaessner (The World Bank) Luiz Correa Do Lago (PUC-Rio and Lorentzen Group) For the second session, attention shifted to the
difficult period that followed the Asian crisis and worsened with Russia's
devaluation and default. Participants were asked to reconsider a set of
questions that had occupied the minds of financial market participants and
policy makers as Brazil struggled to defend its currency. Was the 1998 impact
on Brazil an example of pure contagion? Was the G-7 "paying for
time," and did it work? Compared to other crisis countries, how exposed
was Brazil to speculative attack? Did it stand a better chance of defending
the peg with high interest rates? How did the health of the financial system,
the public debt problem, and the degree of capital account freedom contribute
to the crisis? Would a firmer commitment to the peg have avoided the crisis?
Did Brazil fold under overwhelming external pressure or did it invite the
attack with its indecisiveness? What have we learned about the value of
"preventative" rescue packages? In a May 1998 report on Brazil, Peter Garber
recalled that Deutsche Bank was cautiously optimistic about its
prospects. Given the global regime, at that time they did not see a
tremendous urgency to deal with the exchange rate, though they did believe it
was overvalued. They also saw a need to accelerate fiscal reform and were
worried about the short maturity (and indexed nature) of the debt. This relatively relaxed attitude changed following
the Russian crisis, as inferences about IMF (and US government) policy was
made. Up to then the belief had been that Russia was of major geopolitical
significance to the US, and that is what kept the money in. After the Russian
crisis private banks negotiated with the Russian government about a
restructuring of the debt. A key issue in these negotiations was that foreign
investors would be treated on equal term with domestic investors. According
to Garber, the Russians were perceived to be negotiating in good faith. A restructuring
was agreed to that offered a reasonably high coupon, allowing investors to do
well if things turned out well. This program, however, was not acceptable to
the IMF, Garber reported. Their main concern was that it would "blow out
the fiscal program," and they insisted that a much lower coupon would be
paid. In essence, the fund was closing the gap by expropriating the foreign
investors. In Garber's view, this was a new policy for the IMF,
and investors had to consider how far the policy would be pushed. Old
calculations of risk-return tradeoffs could not be used. A high yield would
not be enough to attract foreign investors given the newly perceived danger
of expropriation, thus undermining an possibility of an interest rate defense
of the currency. As investors looked around to see what other
countries might be affected by this new policy stance, Brazil came to be
compared to Russia along such dimensions as the maturity of the debt and the
slowness of fiscal adjustment. It was inferred that any future program of
debt restructuring would also hit foreign investors. In the end the fund gave up its harsh talk about
forcing losses on creditors later in the year, Garber said. In the case of
the Brazil program the harsh terms were not demanded, though as a matter of
general policy such talk still lingers. He summed up by reiterating that the
"whirlwind" that followed Russia was in part the price of demanding
that investors pay. Thomas Glaessner comments
were addressed to the "Was Brazil an example of contagion?"
question, looked at from the point of view of a then financial market
participant. (He was then with then with the Soros Fund). He said that the
perception was the currency was overvalued, and that there were doubts the
necessary adjustments though deflation would have been politically possible.
That did not seem to fit with the pragmatic approach Brazil usually took.
There were also doubts about the willingness of President Cardoso to follow
through. Fiscal concerns, near-term and structural, loomed
large in the deliberations, and lots of attention was given to debt dynamics.
He also agreed with Garber that IMF policy towards Russia had changed
perceptions. The debt problem created a situation in which raising interest
rates was problematic; and the lack of a clear explanation of what the
policies were made the situation worse. The travails of Long Term Capital
Management (LTCM) made matters worse, as banks were cutting credit lines to
both countries and hedge funds. In sum Brazil faced a combination of
problems--investors' need to reduce leverage, the Russia problem, a fiscal
problem. Glaessner concluded by saying that it is too simplistic to view
Brazil's difficulties as purely contagion. Luiz Correa do Lago began
his presentation by reporting that by the time of the Russian Crisis,
Brazilian exporters believed that the problem of the appreciation of the
exchange rate existed but was being dealt with through gradual but steady
devaluation in a context of almost zero inflation. He noted that Brazilian
industry was experiencing a large increase in productivity and that there was
a perception that the banking system was in good shape. There were grounds to
hope that contagion was not inevitable, notably in view of the high level of
international reserves and of the fact that Brazil had survived the Asian
crisis reasonably well. On the negative side, however, he pointed out that
the absence of fiscal restraint and the mounting public debt were undermining
credibility both domestically and externally. This was compounded by a
perception of the disassociation between fiscal and monetary policy makers.
The only possible policy response appeared to be an increase in interest
rates, but the private sector was unsure what impact this would have, as it
might only aggravate the government deficit. What really concerned the
private sector was that it seemed unlikely that true fiscal restraint could
be successfully implemented. In response, investors and large companies
attempted to hedge, purchasing dollar-indexed government bonds ( -by the way
an imperfect hedge as exchange variation is taxable in Brazil). However, a
devaluation of the size that eventually occurred was not anticipated. Correa do Lago closed by saying that the
average cost of debt to large Brazilian companies was basically determined by
their access to international markets and to BNDES loans, which were key
elements in their investment decisions, noting that before the Russian Crisis
the level of interest rates on those loans had not been prohibitive and was
not directly linked to the level and fluctuations in the cost of the
domestic public debt. General Discussion Eduardo Fernandez-Arias commented that while the
source of international financial contagion after the Russian default was
exogenous to emerging countries, contagion affected countries differently
depending on their fundamentals, so it is wrong to say that it is a pure
contagion problem. This touched off a debate on how to define contagion.
Peter Garber, expressing uncertainty on how to interpret Fernandez-Arias'
comment, noted that the conditions that Brazil faced changed. "You
could," he offered, "call this contagion or not." Andreas
Velasco suggested that it is best to identify changes in fundamentals as
exogenous. This led to considerable murmurs of disagreement. Richard Cooper said he was fascinated by Garber's
characterization of Russia. Among the G-7, he said, it was Germany that was
most out front in providing help. It was not true that the US had a
commitment to bail out Russia under any circumstances. This was an inference
of the financial community. The financial community makes its own
inferences--these are not fundamentals--and they can change very quickly,
said Cooper. But he added that Brazil was in a very fragile condition, and in
difficult circumstances this leads to crisis. "You cannot have an
avalanche without a steep slope," he concluded. Jeffrey Frankel reported how things had looked from
the viewpoint of the Clinton administration after the Russian devaluation and
default, noting that the G-7 responded to the systemic crisis with a number
of initiatives. At a September 14 speech to the Council of Foreign Relations,
the President called the international financial crisis the worst of the
post-war period, made a number of proposals, and labeled Congress
irresponsible for failing to approve the IMF quota increase and New
Arrangements to Borrow, which it subsequently did. Most importantly, the Fed
lowered interest rates, followed by virtually all other major central banks.
One goal of the campaign was to reverse the impression in some quarters that
politicians in the major industrial economies had not been paying attention
to the crisis in emerging markets. Frankel posed the question: Did these
actions make a difference by buying time (for deleveraging, etc.)? Taking up
the leveraging point, Thomas Glaessner said that leverage was between 3 to 1
and 5 to 1 at many hedge funds. LTCM's high leverage, he said, was the
exception and not the rule. Pierre Olivier Gourinchas turned the questioning to
bank runs and multiple equilibria. He asked about the perceptions of market
participants: "Did they run because everyone else in running?"
Peter Garber responded that he did not see it as a run problem. Rather he
believes there were fundamental problems. Brazil, he said, did have high
reserves and an IMF program without punitive terms. But it was not clear that
this would be enough. Gustavo Franco raised the issue of burden sharing.
He recalled that he first heard the words burden sharing in the context of
Russia at the spring meetings of the IMF in 1998. He thought it unfair that
Brazil was compared to Russia. For Brazil he believed it was inappropriate to
approach banks before a crisis and talk about burden sharing. The important
thing was to avoid a burden in the first place. Nouriel Roubini agreed that
there are big differences between countries that are in crisis situations
that determine the possibilities for bail-in programs--for example, being
illiquid as opposed to being insolvent. A complex application of the doctrine
of private sector burden sharing is required. Continuing on the theme of the
need to differentiate, Takatoshi Ito said that he little sympathy for
investors who had lost in Russia. It was "a real moral hazard
play," he complained. He added that Russia might have been a blessing in
disguise, leading the private sector to reduce its reckless lending. Peter
Garber said that Russia was a "double whammy"--both a direct loss
and a change in policy as a result of the changing of the voluntary contracts
between Russia and its creditors. Graciela Kaminsky reported commented on research
that has been done on the channels of contagion. Event analysis does not
point to a large impact of LTCM. By the time of the LTCM problem the developing
markets had collapsed and were recovering; developed markets were the ones
collapsing, she said. Shang-Jin Wei pointed out the striking differences
in the trends of capital flows of different types. Session 3: What Would Fiscal
Retrenchment Have Accomplished? Chair : Eduardo Loyo Panelists: Eliana Cardoso (World Bank) Marcio Garcia (PUC-Rio) Paulo Leme (Goldman Sachs) Fiscal issues were at the heart of the financial
turmoil that engulfed Brazil in 1998. The third session debated whether the
difficulties could have been avoided if the spiraling of the deficit and debt
could have been avoided. Was it all a fiscal problem? How did fiscal
retrenchment impact domestic absorption? How did fiscal retrenchment (or the
lack of it) affect the dynamics of the public debt? Could greater
retrenchment have avoided the devaluation? What is the appropriate public
debt management under external speculative pressure? Eliana Cardoso began
the session with a discussion of the three views as to the underlying nature
of Brazil's vulnerability. One view was that a fiscal deficit was always a
problem for Brazil, and what made Brazil vulnerable was the overvalued
exchange rate. The second view was that the problem this time round was the
fiscal deficit. The third view was that Brazil was made vulnerable by both
its fiscal deficit and overvaluation. Turning to the question of whether a
fiscal contraction would have solved the problem, she noted that the key
question was how tough the fiscal policy would have to be. She observed
wryly, that for fiscal solution to have solved the problem, the country would
have to have been other than Brazil. Cardoso recalled that the average real interest rate
was 22 percent over the crisis period. It was high both because of the fiscal
situation and the need to maintain the exchange rate. "What was the
alternative?" she asked. One possibility was higher inflation though
reduced sterilization of capital inflows. This was not considered acceptable
given the goal of reelecting the president and the fact that inflation was
highly politically unpopular. "Who was right?" Cardoso asked. She
observed that those who called for devaluation are now chanting victory. They
claim that all that was needed was a different exchange rate regime. Others
say--"It's still too early to tell." Marcio Garcia provided
a brief technical discussion of debt dynamics in the second half of the
1990s. He stressed that the main culprits were high interest rates--caused by
the weak fiscal stance and the weakly credible exchange rate regime--and the
accumulation of assets of doubtful value. He then turned to explanation of the high interest
rates, noting that the rate is the sum of the international rate, the forward
premium, and what he called the "Brazil risk." He showed that both
the forward premium (future divided by spot) and the "Brazil risk"
tended to rise in times of international financial turbulence. Focusing on
the forward premium, he noted that it can, in turn, be divided into the
expected depreciation and "exchange rate risk." On his reading of
the empirical evidence, fiscal retrenchment is central to reducing both
exchange rate risk and "Brazil risk." Finally he turned to debt maturity, arguing that the
maturity of the debt must be lengthened. To do this the debt must be indexed
to prices, interest rates or the exchange rate. To bring inflation down under
an inflation-targeting regime interest rates must sometimes be raised. With
interest rate indexing of the debt, however, this would significantly
increase the fiscal burden, leading to a potential lack of credibility of the
inflation commitment. With the IMF putting limits on exchange rate link debt,
the remaining option is inflation-linked debt. He observed that there is
strong demand for such debt from the financial markets, as many players
(pension funds, insurance companies) have long-lived liabilities that are
indexed to the price level. He stressed that investment requires long term
financing, and that public securities act as a benchmark for other markets (mortgages,
corporate bonds, etc.). Therefore, waiting for the time when it will be
possible to issue long bonds denominated in domestic currency may present to
heavy a toll on Brazilian economic growth. Paulo Leme opened
by saying that financial markets viewed Brazil's stabilization as successful.
But the key question related to how it was it working given the deterioration
in the fiscal accounts. A number of factors drove the deterioration of the
primary balance, including inherited increases in public sector wages,
increases in investment, and a reverse Tanzi effect. The restructuring of the
debts of the state governments also made the debts more transparent in the
balance sheets. So, although money was not printed to cover the deficits, a
lot of debt was created. This caused a crowding out of the private sector,
which was forced to borrow abroad. This borrowing was in turn encouraged by a
stable exchange rate. As confidence ebbed, the authorities created more
"dollar hedge" to allow private capital to stay in the country.
Eventually, however, this was seen as not being enough, as investors came to
see debt default as very likely. At the time, Leme said he was almost alone
in disagreeing. He felt that defaulting would have been very costly to the
government, including the cost of restructuring the banking system. Leme closed on a cautious note, saying that the
recent improvements are temporary, and that a lasting improvement in the
fiscal position is imperative. General Discussion Assaf Razin expressed amazement about the size of
the spread between lending and borrowing rates in Brazil. He wondered if this
came from a policy of high reserve requirements. He also asked what impact
this had on saving and investment. Eliana Cardoso reported that spreads increased
in 1994/95 as reserve requirements increased and banking became a more risky
business. Eustaquio Jose Reis offered that there was a dramatic reduction in
saving, but this might have been due to a decline in the precautionary saving
motive as inflation decreased. Marcio Garcia added that hyperinflation
destroys credit markets. Credit had been so expensive that nobody wanted to
use it. This is changing, he said, and the percentage of credit in GDP has
risen. Now the price of credit matters more, he added. Ilan Goldfajn reported on work that tries to explain
the spread. He noted four factors: reserve requirements, the lack of
competition, taxes, and the fact that the judicial system has not been kind
to the recovery of collateral. He also asked about foreign exchange linked
debt, wondering what the optimal level was. "Should it be zero?" he
asked. Gustavo Franco pointed out that a large spread is
not a recent phenomenon. Historically, the main reason was inflation. More
recently the large spread is due to taxes of various types. He also informed
the group that the main use of the revenues from the reserve requirements was
to fund various redistributive schemes. Suman Bery noted that we usually think of the
primary surplus as the driver of debt dynamics. But he reminded the group
that the work of Garcia and Bevilaqua accorded a much larger role to interest
rates. Given the size of the increased interest payout, he also asked that
more attention be paid to the impact of the increase in income received by
the holders of the debt instruments on aggregate demand. Paulo Leme reported
evidence that the income increase goes mainly to consumption. Addressing the options outlined by Eliana Cardoso,
Zia Qureshi asked if the option of relying on a sharp increase in interest
rates while also seeking fiscal tightening was internally consistent when the
fiscal position is very sensitive to the Gustavo Franco pointed out that there are deeper
causes behind the deficit than high interest rates, giving the example of
agricultural subsidies. Turning attention to the debt structure, Eliana
Cordoso observed that the maturity of the debt is endogenous. The maturity
tends to become short close to a crisis, she said, and added
"governments don't borrow short because they like it." Andreas
Velasco countered that borrowing long is an option, but governments have to
pay for it. Cordoso agreed there is some choice, but it's limited. Paulo Leme
added that what is needed is to build the low-inflation credibility of the
central bank. With greater credibility, the ability to place long-term paper
would improve. Session 4: Devaluation and
Fallout Chair: Martin Feldstein (Harvard and NBER) Panelists: Suman Bery (The World Bank) Ilan Goldfajn (PUC-Rio) Nouriel Roubini (US Treasury Department and
NBER) The day's last session turned to impact of the
February 1999 devaluation. Among the questions posed to the panelists: Why
has the pass-through from the exchange rate to prices been so small? Why has
the contractionary impact of the devaluation been so small? How fast could
interest rates have been reduced? Was it worth defending the peg for so long?
What would have been the outcome of letting the peg go earlier? And what has
been the impact of the Brazilian devaluation on the region? Suman Bery opened
the session noting that the 1999 devaluation was but a "waystation"
in a lengthier process of structural reform. He agreed with Gustavo Franco
that an enormous task still lies ahead. He added that whatever triumphalism
there is about the success so far, it does not come from the Brazilian
officials. Reflecting on the day's discussion, Bery noted that
word credibility had been used a lot. One of the reasons the malign effects
of the devaluation were limited was an evident commitment by Brazil to
globalization which had become increasingly evident over the 1990s. Such a
commitment was not consistent with the inflationary closed-economy regime
that had existed previously. In responding to the devaluation, the
authorities had substantiated their commitment that capital and trade
controls would not be imposed; also the fiscal package that had passed though
the Congress following the shift to a floating regime had additionally
signaled broad-based political support for the model. As a result of this
hard-won credibility, economic agents (particularly labor) had not responded
by demanding indexation, as had been feared. In that sense, the aftermath of
the devaluation provided proof that the regime change had indeed taken root. Notwithstanding the success with the devaluation,
Bery closed by highlighting the enormous agenda ahead. To be seen as an
economy on a sustainable growth path there must be fiscal reform--including
reform at the sub national level. "It is a long-run job," he said,
"and he hoped that the crisis was just a hiccup along the way." Ilan Goldfajn
concentrated his remarks on two of the questions posed by the organizers. Why
was the pas-through so small? And why was the contractionary effect so mild
in relation to the expectation? He observed that the pass though was large in
Mexico, and that there was reason to believe that it would be worse in
Brazil. But it has not turned out that way. To explain why he turned to the
results of some cross-country regression analysis. The results suggest that
Brazil devalued when conditions were favorable to a low pass-through. For
example, Brazil was in recession, with GDP shrinking by 0.12 percent in 1998,
and inflation was less than 2 percent. Turning to the issue of the mild recession, Goldfajn
observed that it had been a "pre-announced crisis." The government
allowed investors to hedge their positions. By bearing this cost the
government transferred a large part of the cost to future generations. Nouriel Roubini set out
to touch on all the questions posed for the session. · On the
pass-through, he reminded the gathering that while it has been large in
Indonesia, it has been small in other crisis-affected countries. · Turning
to the impact on the real economy, Roubini observed that while Asia had
significant (though short) contractions, in countries such as Italy and the
United Kingdom devaluations had been expansionary. Why was Brazil not like
Asia? Among the factors he thinks are important: substantially reduced
indexation; a credible policy of tight money (with credibility enhanced by
the reputation of Central Bank head Armino Fraga Neto); a recession had
compressed aggregate demand; and the positive impact on confidence of
adjustment to the primary fiscal balance. He added that financial sector
weakness had been a key problem in Asia, but was less severe in Brazil,
partly due to the greater presence of foreign banks. Banks were allowed to
hedge their positions using the government's reserves at a significant fiscal
cost. So there was a significant amount of bail out. Also the banks were
holding a large amount of public debt that turned out to be extremely
profitable. · On
interest rates, Roubini believes that high rates were needed to restore
credibility. The experiences of Korea, Thailand and Brazil show that this is
necessary. · Was it
worth defending the peg for so long? No, answered Roubini. The Real plan was
beneficial, but there remained the issue of the "exit strategy."
"It should have been let go earlier," Roubini said. "But not
in the middle of the Asia/Russia crisis." By early 1999, leverage in the
world financial system had been reduced, so letting go of the peg was
feasible. If, on the other hand, the currency had been let go when reserves
were high but the banks' positions were unhedged, then the damage to the
banking system would have been greater. · On the
regional impact, Roubini thinks that there has been a significant negative
impact on Argentina and Uruguay. He also noted that a number of countries
were cut off from international capital markets in 1999, but he finds it
difficult to tell how much of this was due to Brazil. General Discussion Session Chairman Martin Feldstein began the
questioning by asking how Brazil managed to allow domestic players to hedge
before foreign speculators came in and exhausted the reserves. Roubini
answered that there was a significant outflow of reserves to finance the
"exits" of foreign investors. Suman Bery observed that there was a
lot of arbitrage borrowing when the exchange rate regime had credibility. The
situation became more doubtful after the Russian default, when Eurobonds
issued by Brazilian corporates took a hit. This opened up attractive
repurchase possibilities which were exploited. While the Central Bank lost
reserves, arguably the national balance sheet improved. On the pass-through question, Eliana Cardosa
reminded the group that the impact had been modest following devaluations in
1979 and 1983. In was only large in 1993. She said that people forgot to look
at the older pre-hyperinflationary episodes. Andres Velasco questioned what he saw as the
conventional wisdom on the timing of the devaluation. The view could be
summed up as "They should have done it sometime, but not the week after
Russia." He said that this is not what theory suggests. The message that
he takes from the theory is "that it is better to do it when the world
is collapsing." Roberto Rigobon disagreed, pointing out that Venezuela
devalued after the Mexican crisis and blamed it on Mexico and then devalued
again in March. "It was devastating to Venezuela's reputation,"
said Rigobon. Assaf Razin wondered which generation of currency
models applied best to Brazil. There wasn't a banking problem and the real
devaluation appears to have generated output gains. The first generation
crisis models (a la Krugman) seem to apply, he concluded. Edmar Bacha directed attention to the significant
overshooting of the exchange rate after the devaluation. He said that this
didn't happen in Europe. Part of the explanation, he contended, was that the
US Treasury and the IMF were appalled at what the Brazilians did. The lack of
coordination made Washington angry, and they showed their anger through the
press. The initial reaction of the market was that there wasn't a lender of
last resort. Nouriel Roubini observed that overshooting occurs in many
countries. What was particular about Brazil was that there was a great degree
of uncertainty about what the regime would be. Once the uncertain was
resolved, things stabilized, he said. Marcio Garcia asked why the Brazil risk
appears to have remained so high, with the spread over treasuries of
Brazilian bonds remained larger than those of their Argentinean counterparts
even after the devaluation. Ilan Goldfajn answered that there is great
uncertainty about what the steady state level of interest rates is. Suman
Bery said that the underlying sources of country risk had kept evolving over
the Real plan. At the time that the international support package had been
organized (in late fall 1998), the dominant view was that the Asian crises
had reflected liquidity concerns. This had been a large part of the
"precautionary" element in the initial package designed by the
Fund. In his view a significant fraction of the remaining country risk today
relates to doubts about whether there can be sustained fiscal adjustment at
low inflation. There is a need for additional expenditure adjustments to
convince markets that Brazil is serious, Bery added. But on the positive
side, he said that there are degrees of freedom, both fiscal and monetary,
that did not exist a year ago. Andreas Velasco said that while it is true that
"the world didn't end last year," it is also true that growth will
not be good this year. The key question, he said, is how do we get Brazil
growing again. Ilan Goldfajn countered that it is not fair to compare Brazil
with Asia given the depth of the recessions they bounced back from. |
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