Brazil’s Currency Crisis
By Team IV ( Chris Trick, Austin Weaver, Tim Moore, Pat Heffernan, Chris Barnes
Why Brazil Matters
- Biggest economy in Latin America
- One of the last big countries to attempt free trade and privatization; if this fails international investors discouraged.
- Unified global economy is threatened if Brazilian currency fails.
History
- Brazil had been through 6 currencies since the 1960’s
- In 1994 the Real Plan was adopted
- Before it were a series of failed plans (the Cruzado Plan of 1986, Bresser plan of 1987, and more)
- It worked well to tame inflation and maintain exchange rate stability for 5 years
History
- The Real was initially indexed one-for-one with the dollar
- It was quickly allowed to float though
- A policy of high interest rates to discourage speculation and over-borrowing quickly attracted a surge of capital inflows
- By the mid 1995 the Real Plan evolved into a crawling peg
History
- Said to be the worst currency crisis in the western hemisphere to date
- The Real Plan was one of the longest running exchange rate stabilization programs
Facts of Life Before Crisis
- 43% of Brazilians – over sixty million people – lack the essentials of a decent life
- One in three children drop out of school without completing primary
- Drug gangs rule the favelas and the middle class lives behind bolted doors
- Half a million North-eastern farmers watch crops wither in yet one more drought
- The urban environment, home to four out of five Brazilians, is deteriorating fast
- Blacks, over-represented amongst the poor, suffer social discrimination
- Indians face severe threats to their economic and cultural survival
- The income gap between men and women is the worst in Latin America
Why Peg to Dollar?
- Needed to convince domestic and international investors that chronic inflation would be stopped.
- Before Real Plan, inflation was 3000%.
- Fixing the exchange rate was easier then reducing government commitments.
The Fall
- It was in a financially fragile state
- It required large capital inflows to build up the central bank to defend currency
- This built investor confidence and led to exchange rate appreciation
- This fueled import-driven consumption and stifles export growth
- In order to attract the inflows the real interest rate had to rise
The Fall
- The high interest rates lead to a rising debt burden and a deteriorating fiscal balance
- A rising budget deficit and deteriorating trade balance inevitably lead to devaluation
- It just could not finance its current account deficit due to insufficient long-term instruments
The Fall
- Investors came to believe the capital inflows were insufficient to finance its current account deficit
- Productivity did grow from the imported capital goods
- The industrial restructuring it caused was not enough to fight off the deteriorating trade balance as unemployment rose
The Fall
- Speculative pressure built up and it became harder and harder for the central bank to maintain the rate
- Eventually the peg had to break; calling for a floating rate.
Other Reasons
- The political power of the elite prevented tax hikes and to encourage exports it could not impose higher taxes on manufacturers
- The public sector had won generous pensions and benefits that the government could not afford any longer
- Dismantling these programs would have led to further social instability
Other Reasons
- Given the political paralysis it is difficult to see how the prolonged overvaluation of the currency could have been avoided
How Much Was Lost
- During the first 6 months of speculative attack currency loss totaled $35 billion!!!
- After the first 3 months of 1999, US reserves went from $70 billion to about $32.9 billion.
The Fall
Foreign Influences
- The other currency crisis in Asia, Russia, and Mexico made the peg increasingly fragile
- Short-term capital flew faster into Brazil and the government had to sell off 10 billion dollars in reserves and hike interest rates from 21 to 44 percent
- This worked for a short time until the crisis hit January of 1999 unexpectedly
Decline of Reserves
Crisis Recovery
- Managed a quick recovery compared to other major currency crisis to date.
- Due to banking system being ready to handle both severe economic shocks and policies.
- Commercial banks able to take extreme measures to calm and stabilize markets.
A guy who came to International Finance for the first time, his @$$ was a wad of cookie dough. After a few weeks, he was carved out of wood.
-Johnny Stiver
