1. Brazil’s Currency Crisis

2. 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. 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 1993 - Jun 1994

4. 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

5. 5

6. 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. 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. 8 Exchange Rate Evolution of the Nominal Exchange Rate 3.13 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00 3.20 3.40 3.60 3.80 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 4. 2002

9. 9 Real and Risk Premium

10. 10 Changes in International Reserves US$ million 200120022003 DecJan-JulAug-DecYearYear I - Reserve position (end of the previous period) 37 234 35 866 39 060 35 866 37 742 1. Net Purchases (+)/sales (-) of Banco Central -950 -2 605 -5 134 -7 739 0 2. Banco Central's foreign operations -417 5 798 3 816 9 615 -13 984 Disbursements0 14 762 6 600 21 362 6 650 Bonds0 3 940 0 4 000 IMF 9 972 6 000 15 972 0 IBRD/IDB850600 1 450 2 650 Amortizations-156 -6 778 -1 092 -7 870 -16 074 Bonds, MYDFA and Paris Club -156 -2 393 -915 -3 309 -4 582 IMF -4 384 -177 -4 561 -11 492 Interest100 -2 211 -1 691 -3 902 -4 560 Expenditure-50 -3 090 -2 358 -5 448 -5 960 Reserve interest earnings 150879667 1 546 1 400 Other-361240240 II - Total Banco Central operations (1+2) -1 367 3 193 -1 318 1 875 -13 984 III - Reserve position (end of the month) 35 866 39 060 37 742 23 758 (-) Loans from IMF 8 313 14 453 20 276 8 784 (-) Sovereign Buy Back (exceeding value) 0 1 457 2 385 1 957 (-) Difference of parity -284 -404 -269 IV - Net reserves position (IMF concept) 27 837 23 553 15 485 13 286

11. 11 Warning Signs!

12. 12 Over Selic Deflator: 12 month - IPCA 5 10 15 20 25 30 35 40 45 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): 19.07 Average (Jul 99–Jul 02): 10.22 Real Interest Rate ex-post

13. 13 Current Debt Numbers Indicator Jan/03 Dec/02 12 Mths 12 Mths (In billions of reais) Jan/03 Dec/02 ====================================================== Nominal Budget Deficit 9.17 22.1 68.18 61.61 Debt Payments 17.63 17.4 123.69 114.00 Budget Surplus Exc. Debt 8.46 -4.7 55.41 52.39 ====================================================== Indicator Jan/03 Dec/02 Nov/02 Jan/02 (In billions of reais) ====================================================== Total Public Debt 1,163.2 1,132.9 1,138.2 905.7 (% of GDP) 73.2% 71.9% 73.8% n.a. Net Public Debt 888.9 881.1 869.5 685.3 (% of GDP) 55.9% 55.9% 56.4% n.a.

14. 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. 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. 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. 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 1998- January 1999, financial investors positioned themselves to take advantage of an expected devaluation:  Cost to CentralBank: $6 billion in January 1999