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Unformatted text preview: c06.cs.qxd 3/10/04 10:22 AM Page 180 4% 'I 80 PART I 0 Environment of International Financial Management CASE 1.2 BRAZIL FIGHTS A REAL BATTLE In 1994-, with inflation running at close to 50 percent monthly and Brazil’s economy near collapse, Fernando Cardoso was elected president. A former socialist mugged by reality, Cardoso opened the economy, adopted a number of free—market policies, stabilized the currency, and brought inflation down to just 7 percent annually by 1997. Now the Asian financial turmoil is threatening President Cardoso’s proudest achievement and the cornerstone of his popularity: a stable Brazilian real. Fallout from the Asian crisis has been more acute in Brazil than else- where in Latin America, partly because speculators believe that the real is overvalued. They also see par- allels to Asia in Brazil’s large trade deficit financed by foreign capital inflows. The pressure on the real has been ratcheted up because Brazilian financial players are unusually aggressive and sophisticated, traits that are a legacy of the past three decades when rampant inflation and abrupt policy shifts forced traders to be brutally pragmatic and move quickly to survive. The speculators may have met their match in President Cardoso, however. Cardoso is unlikely to give up easily because he has staked Brazil’s for- tunes, and his own, on the Real Plan, which he had EXHIBIT I 2.1 AGAINST THE U.S. DOLLAR 6% introduced in 1993 while he was finance minister. Its linchpin is a crawling peg designed to end the cycle of runaway inflation followed by massive devaluations that has given Brazil thirty years of eco— nomic chaos and eroded living standards for much of the population. By permitting only a tightly con— trolled and limited 0.6 percent depreciation of the real against the dollar each month (see Exhibit 1 2.1), Cardoso has managed to halt Brazil’s hyperin- flation and bring a new confidence that is spurring foreign investment (see Exhibit 1 2.2 for statistics on the Brazilian economy). However, Brazil’s current account deficit is mounting, its foreign exchange reserves are falling, and financial markets are getting nervous that the real will suffer the same fate as that of the Asian currencies. The loss of confidence in the real is showing up in the form of capital flight, with $10 billion fleeing Brazil in the last two weeks of October 1997 alone. In addition, a fractious Congress has kept President Cardoso from carrying out the budgetary reforms that would allow him to control the fiscal deficits that have been the engine of hyperinflation and thereby institutionalize Brazil’s newfound macroeconomic stability. These reforms, which include revamping the tax, civil service, and social BRAZIL’S CRAWLING PEG LEADS TO A GRADUAL DEVALUATION OF THE REAL 1.15 1.1 5% 4; o\° - Change in dollar value of the real —°— Reais per dollar 1.05 o: a\° _i 'o 2% O (0 U1 Reais per dollar .0 co 1% Change in dollar value of Brazilian real 0 o\° —1% mmmmmmmmmmmmwwwww CI’Q’Q’Q’Q’Q’Q’Q’Q’Q’Q’Q’Q’Q’Q’Q’? CQLL>uC_U)O."'>OC.Dh‘->s mwNQm:%:m80wmmND-m -:u_§<§-: <0) ZD-Au_§<§ Source: International Financial Statistics, various editions, Jun-96 Jul-96 0.85 0.8 LDLDKDQDKDFFFFNFFFFFF ??9?9??????????? U70.“>UC.D"">~C_D)Q“> =w80mmmmfim:%:wso <w 291LE<2fi <w z 4% c06.cs.qxd 2/25/04 3:59 PM Page 181 4% Case Studies 18'] EXHIBIT I 2.2 KEY BRAZILIAN ECONOMIC STATISTICS (IN US. $ BILLIONS UNLESS OTHERWISE INDICATED) 1990 1991 1992 1993 1994 1995 1996 1997 Gross domestic $445.9 $386.2 387.3 $429.7 $543.1 $705.4 $775.4 $803.0 product Current-account —$3.8 —$1.5 $6.1 $0.0 —$1.2 —$18.1 —$24.3 —$33.8 balance Current-account —0.9% — 0.4% 1.6% 0.0% —0.2% —2.6% —3. 1% —4.2% balance (% of GDP) Budget deficit — 1.4% — 1.4% 2.2% —0.2% — 1.3% 4.8% 3.9% 5.9% (% of GDP) 1 Foreign investment2 $0.8 $3.9 $ 16.4 $15.8 $23.8 $25.8 $34.3 $55.1 Portolio $0.5 $3.8 $14.5 $15.0 $21.6 $22.6 $24.7 $37.2 Direct $0.3 $0.1 $1.9 $0.9 $2.2 $3.3 $9.6 $17.9 Reserves excluding $7.4 $8.0 $22.5 $30.6 $37.1 $49.7 $58.3 $5 1.4 gold Exchange rate (end 0.000064 0.0004 0.005 0.119 0.846 0.973 1.039 1.116 of period, reais/$)3 Inflation (consumer 1657.7% 493.8% 1156.0% 2828.7% 992.0% 25.9% 11.3% 7.2% price index) U.S. inflation rate 5.4% 4.2% 3.2% 3.0% 2.6% 2.8% 3.0% 2.3% (CPI) 1 A negative sign indicates a budget surplus. 7' Other components of foreign investment are relatively minor. 3 Exchange rate for the real prior to 1994 reflects the effects of two earlier currency replacements. Source: Current Bank of Brazil Bulletin, April 1998 and Economic Report of the President, February 1998. security systems, and privatizing key industries from telecom to mining, would allow Brazil to con- solidate the economic gains it has already made, give investors greater confidence in the economy’s future, and speed up Brazil’s growth rate. As of now, Brazil has a bloated public sector (government workers cannot be dismissed, regardless of perform- ance), large budget deficits (5.9 percent of GDP in 1997), protected industries, high tax rates with low tax collections, and one of the most unequal distri- butions of income and wealth in the world. One legacy of Brazil’s large budget deficits is that the country must now roll over about $20 billion a month in government debt. Nonetheless, until the Asian crisis hit, investors had responded to currency stabilization and the free-market reforms already begun by pushing up the Brazilian bolsa (stock market) by about 158 per- cent from January 1994, when the Real Plan took hold, to October 1997 (see Exhibit 1 2.3). However, contagion from the Asian crisis has recently pum- meled the bolsa, sending it down 29 percent from August through October. Although it now appears that Cardoso will have to wait until his second term in office to carry out most of the proposed reforms, he is nonetheless reputed to be preparing a new push on his long- stalled reform program. One of the stalled reforms is a bill to privatize the Brazilian social security sys- tem. This system, which pays out benefits to some workers in their 40s, is widely viewed as contribut- ing to a Brazilian savings rate of just 16 percent of GDP (to put this number into perspective, Asian countries average closer to 30 percent). Until the presidential election in October 1998, Cardoso expects to maintain a tight-money policy that will support the real and, it is hoped, prevent the trade deficit from spiraling out of control. In addition to raising interest rates, the government’s main weapon to stanch Brazil’s fiscal and trade deficits is a newly invigorated privatization program. In the first half of 1997, a large share of the $7.4 billion in foreign direct investment came in the form of purchases of state-owned businesses. Altogether, Brazil expects to take in an estimated $17 billion from privatiza— tions in 1997 and at least $22 billion in 1998. Fortunately, the government is making enough progress toward economic reform to continue to entice foreign investors, who appear mesmerized by Brazil’s enormous potential. With a population of 160 a c06.cs.qxd 2/25/04 3:59 PM Page 182 4% 'I 82 PA RT I 0 Environment of International Financial Management EXHIBIT I 2.3 BRAZILIAN BOLSA IN U.S. DOLLARS: JANUARY 1995—NOVEMBER 1997 180 160 140 120 100 Index value (January 1, 1995 = 100) an O 4 a: 0 2/28/95 1 2/30/94 4/28/95 6/30/95 8/31/95 1 0/31 /95 1 2/29/95 2/29/96 Source: Morgan Stanley Capital International. million and an estimated GDP of about $800 billion that has grown at an average rate of more than 4 per- cent annually since 1993 (see Exhibit 1 2.4), Brazil is by far the largest market in Latin America (represent- ing about 45 percent of total Latin American GDP) and provides a launching pad for investments throughout the region. Moreover, it is rapidly indus- trializing, as evidenced by the fact that industrial products now account for 75 percent of Brazil’s exports. Historically, coffee made up 80 percent of exports; now it accounts for only about 5 percent. Rather than devaluing the currency, the tradi- tional response by Brazilian governments faced with speculative attacks, Brazil’s central bank—the Banco Central do Brazil—has defended the Real Plan by doubling the basic interest rate to 43 percent (see Exhibit 1 2.5) and spending the nation’s dollar reserves to buy up excess reais (plural of real). In early November 1997, Cardoso also managed to push through Congress some budgetary reforms along with $18 billion in spending cuts and tax increases, equivalent to more than 2 percent of GDP. The real’s defense is not cost—free, however. The high real inter— est rates are expected to slow GDP growth in 1998 to 1.5 percent, from 3 percent in 1997. They are also pushing up the unemployment rate and worsening the credit quality of Brazil’s banks. Cardoso’s eco— nomic reforms have been attacked as benefiting the 4/30/96 6/28/96 8/30/96 1 0/31 /96 1 2/31 I96 2/28/97 4/30/97 6/30/97 8/29/97 1 0/31 I97 wealthy and coming at the expense of the poor, who are the first to lose their jobs. These charges are wor- risome in a presidential-election year. Some observers have argued that by increasing the pace of the deval- uations, Brazil could afford to lower interest rates and boost growth and jobs—and at the same time improve Cardoso’s prospects in next October’s presi- dential elections. However, many analysts believe that any significant deviation from the Real Plan, espe- cially before an election, would look like politics as usual and cast doubt on the sustainability of all eco- nomic reforms. Backsliding on currency stability is also likely to be unpopular. The Real Plan has made politicians and the populace aware of the strong link between devaluation and inflation. Thus, any policy changes that threaten the low inflation wrought by currency stability is likely to be politically risky. However, the recent austerity measures are also unpopular and are eroding Cardoso’s approval rat— ings. With a recession looming as Brazil enters into an election year, Cardoso’s supporters fear that rising joblessness will cut deeply into his electoral chances. Banks and other financial institutions have found that speculating against the real is an expen- sive and difficult proposition because the Banco do Brazil maintains a wide range of controls on the for- eign exchange market. One of the most onerous and costly requires that buyers of dollars deposit a large a c06.cs.qxd 2/25/04 3:59 PM Page 183 $ Case Studies 'I 83 EXHIBIT I 2.4 BRAZIL’S ECONOMIC GROWTH RATE: l990-l997 5.85% 6% 4% 2% 0% Growth in real GDP —2% —4% % 1990 1991 1992 1993 1994 1995 1996 1997 Source: Central Bank of Brazil Bulletin, April 1998. EXHIBIT I 2.5 BRAZILIAN INTEREST RATES 70% 60% — Money-market rate —I— Long-term interest rate 50% Percentage 20% 10% 0% Feb Apr Jun Aug Oct Dec Apr Jun Aug Oct Dec Apr Jun Aug Oct 1994 Dec 1995 Feb 1996 Feb Source: Central Bank of Brazil Bulletin, April 1998. portion of them in special, low-interest accounts who borrowed reais and converted them to dollars with the central bank. In times of intense specula- would start losing money the moment they tive pressure, the central bank has cut the interest deposited them with the central bank, unless the rate paid on these accounts to zero. Thus investors real fell enough to offset the loss of interest. 4% c06.cs.qxd 2/25/04 3:59 PM Page 184 4% 'I 84 PA RT [ 0 Environment of International Financial Managernent QUESTIONS 1. How does Brazil hope to control its current- account deficit through a tight monetary pol- icy? What alternatives are available to control Brazil’s current-account deficit? . How will Brazil’s tight money policy affect its fiscal deficit? How will it affect Brazil’s real (inflation-adjusted) interest rates, both short- term and long—term rates? . Why have Brazil’s interest rates generally fallen in recent years? . How would reform and privatization of the social security system improve Brazil’s savings rate? What would be the likely consequences of this improvement for Brazil’s current—account balance and the real’s value? Explain. . What are the costs and benefits of using cur- rency controls to defend the real? 6. 10. 11. Why might speculators View the real as being overvalued? Based on the data in the case, what is your best estimate as to the real’s degree of overvaluation? . What are the tradeoffs that President Cardoso must consider in deciding whether to accelerate the real’s depreciation? . Could Brazil have avoided the recessionary impacts of its monetary policy if it had deval- ued the real instead? . What would a Brazilian devaluation do to the currencies and economies of Argentina and Chile, its neighbors and largest trading partners? What is the link between Brazil’s budget deficits and its historical hyperinflation? What mix of fiscal and monetary policy would you recommend to President Cardoso? Should he devalue or defend the real? ...
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