Brazil’s Currency Crisis

2 Brazil: Recent Problems (2002) 40% devaluation of the Real against the dollar Large public debt (~60% of GDP), default risk substantial….Debt tied to exchange rate Risk premium on Brazilian bonds (yield above US Treasury bonds) : ~ 20% Investors demand higher interest for rolling over debt, especially if currency continues to devalue To stabilize debt/GDP ratio, larger and larger primary surpluses needed Contractionary monetary policy to halt creeping inflation and devaluation  high unemployment, contraction in GDP, low investment, low consumption Flight of foreign capital, Large foreign debt

3 Brazilian currencies REAL, Jun 1994 – present MIL-RÉIS, Oct 1833 – Oct 1942 CRUZADO NOVO, Jan 1989 – Mar 1990CRUZADO, Feb 1986 – Jan 1989 CRUZEIRO, Oct 1942 – Feb 1967 CRUZEIRO, May 1970 – Feb 1986 CRUZEIRO, Mar 1990 – Aug 1993 CRUZEIRO NOVO, Feb 1967 – May 1970 CRUZEIRO REAL, Aug Jun 1994

4 Brazilian Currency: Abandoning the Fixed Exchange Rate J anuary 13th Gustavo Franco, Brazil’s central-bank governor, resigned and his successor allowed the country’s currency, the real, to devalue by over 8% against the dollar, despite 41.5billion in IMF reserve help. Introduction of emergency taxes to pay back public, dollar-linked debt 50% of GDP then Public Debt : 62% of GDP 07/2002

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6 Brazilian Banks vs. Argentinean Banks Argentina:  Bank Deposits and Loans dollarized  Huge problems when the Peso devalued Brazil  Bank Deposits and Loans not dollarized  But, 30% of Banks’ assets (300% of their net worth) in government bonds

7 Reserve Requirements and Tight Monetary Policy in Brazil 10/11/2002 “The nation's currency, the Real, posted its biggest one-day gain in 10 weeks after the central bank ordered commercial banks to set aside the equivalent of $1 in equity for each dollar they hold. It was the second time this week Brazil raised the reserve requirements to discourage banks from buying dollars. “ 10/14/2002 Overnight interest rates: Increased 3 percentage points, to prop up the Real and to halt inflation. New rates: 21%.

8 Exchange Rate Evolution of the Nominal Exchange Rate Jan-98 Jun-98 Nov-98 Apr-99 Sep-99 Feb-00 Jul-00 Dec-00 May-01 Oct-01 Mar-02 Aug-02 R$/US$ Change in the Exchange Rate Regime Inflation Targeting World Economic Slowdown Technology Stocks Crisis September 11th Energy Crisis Election Concerns Concerns Daily figures updated up to September

9 Real and Risk Premium

10 Changes in International Reserves US$ million DecJan-JulAug-DecYearYear I - Reserve position (end of the previous period) Net Purchases (+)/sales (-) of Banco Central Banco Central's foreign operations Disbursements Bonds IMF IBRD/IDB Amortizations Bonds, MYDFA and Paris Club IMF Interest Expenditure Reserve interest earnings Other II - Total Banco Central operations (1+2) III - Reserve position (end of the month) (-) Loans from IMF (-) Sovereign Buy Back (exceeding value) (-) Difference of parity IV - Net reserves position (IMF concept)

11 Warning Signs!

12 Over Selic Deflator: 12 month - IPCA Sep-95 Mar-96 Sep-96 Mar-97 Sep-97 Mar-98 Sep-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jul-02 % p. a. Average (Aug 95–Jun 99): Average (Jul 99–Jul 02): Real Interest Rate ex-post

13 Current Debt Numbers Indicator Jan/03 Dec/02 12 Mths 12 Mths (In billions of reais) Jan/03 Dec/02 ====================================================== Nominal Budget Deficit Debt Payments Budget Surplus Exc. Debt ====================================================== Indicator Jan/03 Dec/02 Nov/02 Jan/02 (In billions of reais) ====================================================== Total Public Debt 1, , , (% of GDP) 73.2% 71.9% 73.8% n.a. Net Public Debt (% of GDP) 55.9% 55.9% 56.4% n.a.

14 Inflation 02/24/2003  Central Bank Target Rate: 8.5%  Actual Inflation now : Six-year high of 14.5 %  Expected to edge higher  Monetary Contraction to slow down inflation Short term rates raised to 26.5% from 25.5% on Feb 22 nd

15 Lessons From Brazil Root of the Problem Root of the problem: Fiscal deficit and contingent (dollar denominated) liabilities Root of the problem  Mexico: Trade imblanances  Thailand: Banking crises Mexico’s fiscal problems posed policy dilemmas:  Interest rates  Exchange rates  Capital controls

16 Lessons From Brazil: Deficits and Debt CA deficit finances by short term inflows Public deficit financed by debt: (High interest rates on debt!) Ratio of net public debt /GDP doubled between December 1995 and January 1999 Despite economic growth of about 3 % per year.

17 Lessons From Brazil Speculative Attack 1. Overvalued currency  Capital flows in turn supported the overvalued currency and large current account deficits. 2. Growing trade imbalances  caused by overvaluation and  rising debt service (1)+(2) fueled speculative attacks against the real.  January January 1999, financial investors positioned themselves to take advantage of an expected devaluation:  Cost to CentralBank: $6 billion in January 1999