The Brazilian Currency Crisis (1999)
Prepared for: Dr. Philippe Gregoire
Business 4079
International Financial Management
March 31, 2003
Prepared by:
Chris Alexander 0011569
Brad Bruce 0011669
Brady Dunne 0093282
Jenni Pajala 0121268
Table of Contents
Executive Summary
Introduction
Scope
Currency Crisis
About Brazil
The Brazilian Economy
Pre-Crisis Economy
How did the crisis begin?
1998
The Currency Crisis – 1999
How did the crisis go?
What actions were taken by the government?
Economic indicators
Contagion
Causes of the crisis
Inflation
Fiscal policy
Corruption
Post-Crisis Economy – 2000 and beyond
The impact and aftermath of the crisis
2000
Conclusions
Were the government’s actions successful?
Can a similar crisis be avoided in the future and what actions can prevent or mitigate such a crisis?
What lessons from this crisis can others learn so the same problem does not occur?
Appendices:
Appendix 1: Inflation In Brazil
Appendix 2: Brazil’s Fiscal Deficit
Appendix 3: Brazil’s Exchange Rate Band
Refrences
Executive Summary
This report deals with the 1999 Brazilian currency crisis by examining the causes, what happened during the crisis and what lessons can be taken away from this situation.
The analysis of financial, economic and political indicators has allowed us to summarize the events as follows. The maintenance of large current account deficits via capital account surpluses (as well as domestic inflation) became problematic as investors became more risk averse to emerging market exposure as a consequence of the Asian financial crisis in 1997 and the Russian bond default in August 1998. After crafting a fiscal adjustment program and pledging progress on structural reform, Brazil received a $41.5 billion IMF-led international support program in November 1998.
In January 1999, the Brazilian Central Bank announced that the real would no longer be pegged to the US dollar. This devaluation helped moderate the downturn in economic growth in 1999 that investors had expressed concerns about over the summer of 1998, and the country posted moderate GDP growth.
The Brazilian real’s fall in January 1999 was the result of an ill-conceived currency policy. Essentially, the problem can be traced to two factors. The first is that due to the overvaluation of the real, imports increased which lowered GDP and foreign direct investment. The second factor was the decline in private savings. A higher interest rate was needed to maintain capital inflows to support the exchange rate. Thus GDP decreased, as did savings.
Economic growth slowed considerably in 2001 - to less than 2% - because of a slowdown in major markets and the hiking of interest rates by the Central Bank to combat inflationary pressures. Investor confidence was strong at yearend 2001, in part because of the strong recovery in the trade balance.
The analysis of this situation showed that there were lessons to be learned which could help other countries in the future.
Introduction
Scope
This paper will deal with the 1999 Brazilian currency crisis. It will discuss Brazilian economy before during and after the crisis, as well as the role of the government. It will also analyze the events and financial and economic factors that caused the crisis and examine the lessons learned.
Currency Crisis
Many countries have at one time or another dealt with a currency crisis. A crisis only seems to occur for fixed rate or pegged currencies, since floating currencies are able to adjust on a relatively gradual, daily, basis to forces affecting them. A currency crisis is identified as an official devaluation or revaluation, or instances in which the currency is floated. It is also sometimes known as a balance of payments crisis.
About Brazil
Brazil, located in eastern South America, achieved independence from Portugal in 1822. Brazil enjoys over 7,000 km of Atlantic coastline and yet borders on every other South American country with the exception of Chile and Ecuador. It is considered to be a large country both in size (8,511,965 sq km) and population (176,029,560). The climate is mainly tropical and it is highly regarded for its natural wonders such as the Amazon River and Amazon rain forest (CIA World Factbook).
The Brazilian Economy
The Brazilian economy is the largest in Latin America and one of the 10 largest in the world. Brazil is part of the MERCOSUR trade agreement along with Argentina, Paraguay, and Uruguay. The Brazilian currency is the real. From October 1994 through January 14, 1999, the official rate was determined by a managed float. Since January 15, 1999, the official rate floats independently with respect to the US dollar. According to U.S. Customs statistics, the U.S. trade surplus with Brazil was $1.9 billion in 1999, down over 70 percent from 1998. In 2000, U.S. exports to Brazil increased 10 percent to $12.9 billion and imports from Brazil rose 23 percent to $13.2 billion.
Recent statistics (2001) show Brazil’s current situation:
- GDP: purchasing power parity = $1.34 trillion
- GDP per capita: purchasing power parity = $7,400
- GDP real growth rate = 1.9%
- Population below poverty line = 22%
- Inflation = 7.7%
- Unemployment = 6.4%
Brazil’s largest trading partners (for both imports and exports) include the US, Argentina, Germany, Japan and Italy (CIA World Factbook).
Pre-Crisis Economy
How did the crisis begin?
Most of the economic and financial analysts globally never argued in the late 1990s whether the Brazilian real would be devalued, only on the timing and by how much (Eiteman, Stonehill, Moffett). At the time of the introduction of the real in July of 1994, its value had been artificially maintained by the Brazilian government in order to try stabilize expectations for economic and financial growth. The devaluation of the Brazilian real eventually became a reality from the government’s inability to resolve continuing current account deficits and domestic inflationary forces.
1998
Rising instability in Russia created difficulties for Brazil’s economy and negative perceptions of the credibility of the emerging economies. With this in mind, investors around the world changed the composition of their portfolios toward high quality, lower risk assets and thus, greatly curtailed the access of developing countries to foreign savings. These negative expectations of the Brazilian economy led the government to adopt severe fiscal measures with a conservative approach to monetary policy. At the same time, toward the end of 1998, the government started to progressively rebuild the country’s reserve position and preserving exchange policy with the help of the International Monetary fund.
The restrictive economic policy produced a decrease in the level of activity and investment indicators mainly in the second half of the year. In the first six months, interest rates gradually subsided and foreign capital flows remained steady as accumulated product increased by 1.32 percent (1998 Annual Report). In the second half of the year, however, the impact of the Russian crisis on capital flows forced the authorities to reverse monetary policy, while adopting emergency structural measures of a fiscal nature. Restrictions on foreign credits and an increase in internal interest rates put a damper on internal economic activity.
Inflation continued to decline in 1998 as a result of such factors as lesser internal demand, an adequate supply of farm products, lower fuel prices and the enhanced foreign competition created by the process of economic liberalization that has marked recent years.
The balance of payments closed in 1998 with a deficit of US$36.1 billion. Major players in this deficit was the net capital outflow of US$16.5 billion from the credibility crisis and the current account deficit of US$33.6 billion, equivalent to 4 percent of GDP.
- Economic indicators
Listed below are some measures of Brazilian Economic Performance Indicators for 1998:
(Bozano Simonsen, Brazil Research, 1999)
- Change in real gross domestic product for 1998 is -0.5 %
- The inflation rate (CPI) decreased from 4.8% in 1997 to -1.0 % in 1998
- The real interest rate increased from 19.0 % in 1997 to 30.5% in 1998
- The trade deficit as % of GDP increased from 6.1% in 1997 to 8.2 % in 1998
- International reserves (billion US$) decreased from 52.2 in 1997 to 40.0 in 1998
- The exchange rate R$/$ (end of period) depreciated from 1.117 in 1997 to 1.207 in 1998
The Currency Crisis – 1999
How did the crisis go?
In January of 1999, Brazil redefined its exchange system and adopted a free floating rate as a means of coping with the scenario of instability provoked by a succession of external jolts. The events of the crisis that led to changing its exchange system occurred during the week of January 11, 1999, the week of the real crisis. Primarily what occurred during this week was that the real was hovering around the bottom of its allowed trading band, billions of dollars in capital flowed out of the country, and the Brazilian equities fell in value. However, on Friday, January 15, the real was temporarily floated, allowing the real to decrease even further. As a result, the equity markets rebounded on the news of floatation, and rose by 28 percent (Eiteman, Stonehill, Moffett).
During the following week of the crisis, the temporary float was made permanent and the real continued to fall in value. In addition to this change, the Central Bank announced that it would increase the prime lending rate from 36 percent to 41 percent in order to limit the inflationary pressures from the devaluation of the real.
In the context of the new exchange system, several measures were adopted in the first quarter of 1999 to preserve the stabilization process, including the increase in interest rates as just mentioned, compulsory reserves on time deposits, offers of securities tied to the exchange rate, and exchange market deregulation. By the end of March 1999, it became evident that these policies started to dampen the inflation trend, recover foreign revenue inflows, and lessen the volatility of the exchange rates. All in all, these events helped to put to rest the negative expectations that had existed in relation to the macroeconomic performance of the Brazilian economy.
The government continued to adjust public sector accounts not only helped to rebuild expectations, but also is normalizing capital flows, as seen by the strong primary surpluses registered during the year. For example, the public sector borrowing requirements in the primary concept registered a surplus of R$31.1 billion, equivalent to 3.1 percent of GDP, a mark quite higher than the 1998 result of 0.01 percent of GDP (Annual Report 1999).
The 1999 balance of payments had a differentiated pattern of transactions with the rest of the world, when compared to previous years. When the exchange system was based on bands, the balance of payments had large surpluses and deficits, with strong upward and downward movements in Brazil’s international reserve position. Once the floating rate system had been adopted, Banco Central almost ceased intervening if the foreign currency market and fluctuations in reserve levels became much less tense. In other words, the balance of payments has tended to adjust itself through rates of exchange, with little need for using reserves as a financing instrument.
The change in interest levels altered the composition of Brazilian foreign accounts, principally in terms in goods and services not related to income. The current account deficit declined from US$33.6 billion in 1998 to US$24.4 billion in 1999.
Evolution of the balance of payments has also contributed to improving international investors’ perception of Brazil’s country risk. Brazil’s current account deficit declined by 27 percent in 1999 in comparison to the previous year. It closed at a level of US$24.4 billion. One should also take note of the reductions of US$3.5 billion in the service account deficit and US$5.4 billion in the trade result, despite the decline in the prices of Brazil’s major export products.
What actions were taken by the government?
In order to restore confidence in the currency after the initial devaluation, the government tightened monetary policy. The central bank raised nominal interest rates to 45%. This was possible without subjecting the economy to a banking crisis due to the relatively low capitalization ratios of the Brazilian commercial banks. The ratio of loans to capital in Brazilian commercial banks was only 2.5:1 in 1998 (Gruben and Welch p.87). This meant the banks were able to withstand the increases in nonperforming loans which were inevitable with such a high interest rate. This tight monetary policy was a good way to stop investor panics.
Economic indicators
Listed below are some measures of Brazilian Economic Performance Indicators for 1999:
(Bozano Simonsen, Brazil Research, 1999)
- Change in real gross domestic product for 1999 is -2.5 %
- The inflation rate (CPI) increased from –1.0% in 1998 to 10.5% in 1999
- The real interest rate decreased from 30.5% in 1998 to 21.6% in 1999
- The trade deficit as % of GDP decreased from 8.2% in 1998 to 7.0% in 1999
- International reserves (billion US$) decreased from 40.0 in 1998 to 36.0 in 1999
- The exchange rate R$/$ (end of period) depreciated from 1.207 in 1998 to 1.700 in 1999
Contagion
The currency crisis that Brazil experienced in 1999 was relatively mild and short-lived compared to other such crises experienced around the world at that time. The Brazilian crisis only had a very limited impact on an already troubled region of the world. The current account deficits and poor fiscal policies of countries in Latin America were the causes of current recessions and depressions in the area rather than simply the Brazilian crisis.
However, it is arguable that Brazil’s currency crisis spread to Argentina and was a major cause of the current Argentinean crisis and has impacted Paraguay and Uruguay in an adverse way. Brazil, Argentina, Paraguay, and Uruguay are all partners in the MERCOSUR trade agreement, so the devaluation of the real has made Brazilian products more competitive among these countries, especially in Argentina where prior to the crisis, 30 percent of its exports went to Brazil. With the drop in the value of the real, Argentinean exports became more expensive and were demanded less by Brazilians, and at the same time, more Argentineans began importing the now cheaper Brazilian goods. According to the IMF’s May 1999 World Economic Outlook, “Argentina has the closest trade links with Brazil among the major Latin American economies, and Brazil’s currency depreciation and recession have further worsened Argentina’s external economic environment. This follows a decline in economic activity in the latter part of 1998 as a result of the reduced supply of external financing, after three years of vigorous economic recovery from the Mexican crisis” (p.11). Only two years after the Brazilian crisis, Argentina ran into a crisis of its own.
As for some of the other major economies in the region, Mexico and Venezuela all suffered the least from the Brazilian crisis. In Mexico’s case, it was able to avoid any major repercussions due to its strong trade ties with the United States. Venezuela’s main export is oil, and until recently, exporting this commodity has kept it relatively insulated from any economic shocks coming from Brazil. Chile, another Latin American economy, has relatively low public debt, thus it is able to borrow money should it need to spend its way out of trouble and therefore has avoided any attacks on its currency by speculators. It should be noted however, that the emerging market crisis has led to general declines in commodity prices around the world and Chile has had to suffer the effects of a drop in copper prices which make up “40 percent of exports and 9 percent of GDP,” (IMF, Oct. 1999, p.45) of the Chilean economy.
The other negative effect that the Brazilian crisis has had would be on the flows of foreign investment money flowing into emerging markets. After the Asian crisis which led to a Russian crisis and the general collapse of emerging stock markets, the Latin American markets which had been avoiding current account deficits thanks to large amounts of foreign investments, suddenly began experiencing large capital outflows. Suddenly, the global appetite for risk seems to have vanished.
So, in conclusion, the current weakness in Latin America was not just caused by the Brazilian crisis, but on the general global economic slowdown since the exports and foreign investment these emerging markets depend on have been reduced by the slowdown.
Causes of the crisis
There were a number of key causes that led to the Brazilian currency crisis. Although there were many small factors that contributed to the problem, the main causes were inflation, poor fiscal policy, and poor currency exchange policies. All of these factors were the major contributors that led to the 1999 currency crisis in Brazil. Although the Brazilian government tried to fight all of these problems at different times before the 1999 currency crisis, they all contributed to the problem.
Inflation
From the beginning of the 1980’s to the early 1990’s Brazilian monetary policy officials did not fully understand the relationships between a poor tax system, continuous fiscal deficits, printing money to cover the costs the tax system could not and inflation (Gruben & Weltch, p. 12). The most notorious predisposition of Brazil’s economic history was their thoughts on inflation. (Gruben & Weltch p. 76). In 1972, Brazil experienced inflation levels of just under 20 percent, but by 1994, inflation reached an astounding 3000 percent (Saad Filho & Mollo, p. 109). Brazil has the highest inflation rates in Latin America. From 1986 through 1994, inflation rates in Brazil ranged any where from 100 percent to 2700 percent per annum. (Gruben & Weltch pg 76 - see Appendix 1).