III. From Exogenous Shocks to the Brazilian Crisis:
Towards the Recession

Faced with the continued presence of the international crisis, the countries of Latin America have had no alternative but to implement restrictive monetary and fiscal policies to limit imbalances in public finance and current balance of payments, and prevent, in many cases, the abrupt depreciation of interest rates and a return of inflationary tension. As a result, growth has slowed. With the breakout of the Brazilian crisis, the region as a whole is now exposed to bhe recession.

Latin American countries began implementing austere budget policies during the last quarter of 1997. Brazil was the first to put these policies into practice after being hit by speculative attacks set off by the Hong Kong crisis (the Hong Kong crisis being another episode of the international crisis). Brazil’s policy, namely the "pacote" of 10 November 1997 (essentially based on lowering expenses in an effort to bring about a drop of more than two points in the fiscal deficit), was unable to reach its objectives. (Table 9).

Table 9 - Budget Balance of the Latin American countries

In order to limit deficits, a second wave of fiscal adjustment measures were introduced by countries whose fiscal income was affected by the drop in raw material exports.¹ As a result of this Mexico, whose oil industry generates almost 40% of its fiscal income, decided to launch three austerity programmes in 1998. The effort made to reduce expenses focused on public investments, especially the transport and telecommunications sectors. On the other hand, fiscal demands on the national oil company (Pemex) reached 114% of its income.

Venezuela followed suit implementing three adjustment programmes in 1998. These programmes were based on a downward adjustment of the forecasted average prices for oil, changes in the dollar/bolivar parity bearing the budget law in mind, increased withholdings on the national oil industry income (PDVSA), and above all, cutbacks in public spending.

Ecuador suffered severely from the effects of El Niño (the infrastructure and agricultural sector were the hardest hit). Moreover, Ecuador’s public deficit increased as a result of dropping oil prices, even after having eliminated many government subsidies.

Only one country of the region, namely Chile, showed a fiscal surplus throughout the 90s. Nonetheless, the international crisis also bore an impact there. Income from the copper industry was dipping and income generated through taxes was also falling. It was then that the government decided to take measures to maintain public finance in a healthy state. By turning to the funds set aside in the copper stabilization fund set up in the mid-80s (264 million dollars were destined to this fund) and implementing budget cutbacks in the amount of 685 million dollars in 1998, Chile managed to achieve a fiscal surplus of 1% of GDP (1.9% in 1997).

At a later date, yet other countries of the region were forced to implement stricter fiscal measures. Peru cut back moderately on capital spending and current spending due to the drop in exports that accompanied the decline in Asian demand, the lower prices of metals and the decrease in its export supply of agricultural and fish products because of El Niño. In Colombia, the newly elected government (mid-1998) announced it intended, in 1999, to bring the fiscal deficit down to the equivalent of 2-3% of GDP by implementing fiscal reform. This would include broadening the tax basis of the VAT. Finally, the government of Argentina decided to strengthen austerity by implementing fiscal reforms extending VAT to more areas.

By August 1998, the worsening international financial crisis led to tighter monetary policies aimed at deterring a brutal depreciation in foreign exchange. Brazil had already of course significantly increased its domestic interest rates (4th quarter of 1997); Colombia did the same between February and July 1998. But when the Russian crisis exploded, monetary policy, in general, became more stringent. The marked increases that followed in real interest rates put the banking systems of Argentina, Chile, Mexico, and foremost, Venezuela and Brazil, to an arduous test (currently many of these countries are undergoing a process of reform which began after crisis of 94-95 crisis; Argentina, Brazil, Mexico, and Venezuela form part of this latter category, among others). (See tables 10 and 11 in this respect.)

Table 11- Monthly Inflation Rate

In Brazil, where investors place the least of their trust, the hike in domestic interest rates has been a reason for great tension between government authorities and the market itself.

In effect, from the time the Russian crisis broke out, the only way to repel the speculative attack launched on the real was for the central bank to significantly increase its base rate. This was done in two steps, hiking the rate from 19.75% to 49.75%, and taking a loss in international reserves of almost 30 billion dollars between the end of July (when reserves were about 70 billion) and the end of October 1998 (41 billion). The international scenario pivoted around Brazil’s situation at that point: the plummeting real took a deep downward plunge following the rubble’s hard fall. These conditions could lead to full contagion of the crisis by Latin America, along with a downturn in the positioning of international banks (particularly, North American banks) that acted as creditors to the region. This in turn could rebound, weakening the dollar just when doubts existed as to whether the North American economy was still on a growing streak. This clearly explains the reassuring declarations made by G7 and the IMF and the lowering of interest rates in the US. At the same time, the cornerstone of anti-inflationary economic policy adopted in 1994, represented the card that would win Cardoso another term as President.

Thus, Brazil’s currency managed to hold up until the presidential, legislative and governors’ elections of 4 and 25 October 1998. As a result, the strategy aimed at upholding the exchange regime aimed at gradually absorbing actual appreciation (the actual devaluation of the exchange rate was higher than the inflation rate) that was supposed to bear fruit by year end 1999 (Graph 10) needed the support of an ambitious austerity plan that would pave the way for an agreement with the IMF and solid international financial support. President Cardoso, reelected for a new mandate launched a three-year programme, which first needed congressional approval. This programme, aimed at cleaning up public finance, was based on the commitment assumed in two communiqués issued jointly with the IMF and made public in October.

The plan had to take on the feat of dealing with the Achilles heel of Brazil’s public finance: the deficit. Within a three-year span, the plan would cut back expenses by 84 billion dollars, lowering expenditures by 23 billion in 1999 alone, thus lowering the unbalanced budget from 8% to 4.5% of GDP. The objective was to achieve a primary surplus (prior payment of interest) in 1999, while assuming the cost this would have on growth (-1% in 1999). In comparison with the programme of 10 November 1997, the new plan was more realistic because it centered more on increased income than on decreased spending. The drop in expenditures through direct budget cuts accounted for less than a third of the adjustment efforts for the 1999-2001 period.

The plan’s announcement was followed by the agreement with the IMF. The terms of this "preventive" agreement, signed the 13th of November, would provide Brazil access to international financial support. This financing would total 41 billion dollars broken down as follows: IMF (18 billion), World Bank and Inter-American Development Bank (9 billion), and the large industrialized countries (14.5 billion). Most of the latter figure would be provided by the USA (5 billion) and the countries of the European Union (7 billion). Brazil received the first part of this money (9 billion) in December.

The new plan’s announcement and the IMF agreement’s signing did not reinstate an atmosphere of credibility nor did it dissipate the fear of a successful speculative attack. Negotiations between the Executive and Congress and new State Governors were drawn out more than would have been desired. In effect, Parliament’s opposition throughout the month of December to the implementation of a tax on Social Security retirement funds and pensions reinforced the feeling of mistrust among investors who only perceived the Brazilian authorities’ lack of competence in enforcing the austerity plan. This brought the process of lowering domestic interest rates to a halt.

The decision to lower interest rates was key for three reasons. In the first place, exorbitant real rates seriously impaired economic activity making productive investment’s reactivation practically impossible (investment turned modest from the 80s onward). Secondly, these low rates splintered the banking system; while private sector loans did not soften their downward plunge from 1997 on, doubtful and bad credit continued rising. Finally, and most important, these rates increased the burden on the financial expenditures budget of the domestic public debt. The lowering of the various domestic interest rates was one of the indispensable conditions to prevent increases in financial expenses that would altogether cancel out the savings achieved under the new austerity plan.

As a matter of fact, domestic public debt (estimated at 250 billion dollars at the end of 1998), did not seem excessive when compared to GDP (almost 35%, in other words approximately 45% of the total public debt if one includes the foreign public debt of nearly 85 billion dollars). Further, the holders of Brazilian domestic debt papers are for the most part residents of Brazil (Russia’s case differed in that non-residents held over 25% of that country’s public debt). Beyond the matter of debt accountability, the problem concerned rollover conditions, all the more because the debt was becoming increasingly variable, indexed on the basis of short-term interest rates (75% at the end of 1998, as opposed to 35% at the end of 1997). On the other hand, the maturity terms were becoming shorter, with important installments due the first quarter of 1999. (Graph 11)

Market instability peaked in early January 1999. It was then that several important Brazilian states (particularly Minas Gerais) announced their decision to not pay their debt service with the Central government. Faced with increasingly depressed market conditions and the pressure from industrial lobbyists pressing for new guidelines that would allow for a downward movement in interest rates, the government finally gave in. On 13 January, when authorities decided to broaden the real’s fluctuation band, the speculative attack took on an accentuated note. As a result, the real quickly surpassed the established margins forcing the government to announce the currency’s flotation.

The outbreak of the Brazilian crisis has emphasized a tendency toward a recession throughout Latin America. Although Latin America stood up well during all the financial turbulence originated by the Asian and Russian crises, the diminishing level of external financing along with its higher cost, the unhealthy repercussions on trade along with restrictive budget and monetary policy have translated into a sensitive slowdown in 1998’s economic activity (2.1% as opposed to 5.3% in 1997). In 1999, economic difficulties continued as a result of the recession in Brazil (affecting that country’s neighbors), mediocre growth in global trade, and the continued high cost of external financing (Table 12). Therefore, Latin American countries for the most part will have lower growth rates in 1999 than they did in 1998 (Graph 12) and the region will probably fall into a recession (-1 / -2%).

Table 12 - Latin America : spreads of sovereign euro-obligations

Despite congressional approval of measures previously rejected in December 1998 (such as the tax on financial transactions) and the calmer atmosphere resulting from the disbursement of a new tranche of the international aid plan, Brazil continues to be the country with the most difficult predicament, even after all the progress it has made. The plunging real is now under control (Brazil’s currency dropped to more than two reals per dollar in March 1999 when it had been worth 1.20 reals per dollar before 13 January), the new agreement with the IMF provides for strengthened austerity measures and the speeding up of privatization to generate a primary surplus of 3.1% of GDP, which is greater than established under the October 1998 plan. Likewise, an attempt to keep the tendency towards inflation at bay using an extremely restrictive monetary policy (Selic-type for the monetary market, which went from 39% to 45% on 4 March, ended up going back to 42.5%, and then to 29.5%). From the viewpoint of the new plan, economic activity in 1999 is expected to drop significantly (-3% / -4%), with inflation ranging from 10% to 20% and the real stabilizing around 1.70 per U.S. dollar.

The good results in controlling inflation (2.6% for the first quarter according to the IBGE government index), the easing up of domestic political tension, foreign investments starting to return, and the prospects stemming from the privatization programme requested by the IMF have led to a wave of market optimism. These factors have even made some authorities predict that the recession will not be as strong as expected. However, it might be too soon to determine the outcome. On the one hand, the new fiscal adjustment will meet its expectations if interest rates remain high (as these raise the cost of the domestic public debt, which continues to affect the State’s accounts). At the same time, during the third quarter significant commitments must be met as regards the maturity schedule. Further, private external debt maturities can accentuate pressure on the foreign exchange rate, causing new difficulties. Finally, the anti-inflation programme, aimed at keeping the possibility of having to use indexing out of the picture, is based on a strict salary policy that is under pressure from trade unions and sectors of the opposition.

Graph 12 - Generalized setbacks in growth in 1999

Argentina is the country most directly affected by the Brazilian crisis, which bears a particularly hard impact on industrial exports, feeds unfavourable expectations that have resulted in the drop in private investment and accentuates public finance problems. However, the preventive foreign debt policy, despite its cost, coupled with the strength that the financial system has shown until now and the recent renegotiations of the IMF Agreement makes one think that the currency board is not threatened.

Venezuela will continue suffering from the slowdown in activity which began in 1998. The effects of the drop in oil prices (despite the recent comeback), high interest rates and the need to decrease budget imbalances are at the center of its current recession. Ecuador, affected by a severe banking crisis that in turn has played a role in deteriorating the economic and political crisis, will go into a severe recession.

Of all the countries that could expect to see some moderate growth, only Peru is on the way to recovery. Peru, which succumbed to the full force of El Niño and the Asian crisis in 1998, is now on its way to a healthy recovery. Two countries, however, that will undergo new signs of slowdown are Colombia, currently following the tracks set for budget adjustments, and Chile which despite being the region’s strongest economy, is suffering the shocks of unfavourable trade: Asian crisis, dropping copper prices, and now Mercosur’s decreasing demand. In this context, Mexico, benefiting from the sustained dynamics of the United States, is a priori the least affected. It will nonetheless experience a slowdown in growth due to restrictive policies to keep fiscal and foreign deficits under control.

NOTES

¹ See table 11 for inflation rates.

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