The Brazil Meltdown

September 25, 2007

Last year, as the Brazilian currency, the real, came under attack from currency speculators, the government of Fernando Henrique Cardoso spent over half its accumulated hard currency—some $40 million—to prop it up, prevent its wholesale devaluation and keep inflation under control. As the attacks continued, the central bank raised interest rates to 50% to keep the currency "attractive" to both foreign and Brazilian investors. Then, following IMF dictates—and in the face of fierce social and political opposition—Cardoso cut social spending to the bone, creating a (pre-debt payment) fiscal surplus. He then widened the band within which the real could float, hoping, like the Mexicans in 1994, that an inevitable devaluation could be gradual and painless. But the markets showed him no pity. On January 6, investors unloaded their real-denominated holdings and the currency crashed, quickly losing a third of its value.

"There is a common thread" connecting the Mexican, Asian, Russian and Brazilian financial crises of the past few years, economist Sidney Weintraub told a subcommittee of the House Committee on International Relations in February. "When national and foreign investors conclude that the financial and economic policies of a country are unsound, there is a cold-blooded flight from its currency." And there is no grace period. "The flight of capital is facilitated by the advances of technology and the ability to move vast sums at the click of a computer key."

And "cold-blooded flight" quickly becomes epidemic. When Russia defaulted on its foreign debt, private investment flows to most "emerging markets"—including Brazil—virtually dried up. Should the "vodka effect" become the "samba effect," other Latin American countries needing private foreign finance will suffer the same wrath and fear of the private investors.

Indeed, national and foreign investors—known to financial writers as "the markets"—now dictate "sound policy" to political leaders like President Cardoso. Cardoso played by all the rules established by "the markets." He privatized, deregulated, disciplined and cut, and in so doing he reduced four-digit inflation to under 5%, won international praise and got himself reelected. But as Brazil became "attractive to the markets," the usual contradictions kicked in. The wage discipline, public-sector layoffs and budget cuts that tamed inflation also increased poverty and unemployment, and decreased domestic purchasing power. The high interest rates paid to speculators who put their money into real-denominated investments crowded out domestic entrepreneurs who could no longer afford to finance their own activities. The domestic economy flagged and political turmoil grew.

It is remarkable how quickly the global financial media, wary of yet another financial meltdown, identified the villain in the piece, Brazil's former president and now governor of the industrial state of Minas Gerais, Itamar Franco. It was Franco's unilateral 90-day moratorium on repayment of his state's estimated $13.5 billion debt to the federal government that panicked foreign investors and sent the Brazilian currency—and economy—reeling on January 6. Minas Gerais was not unusual in its enormous debt. At the beginning of this year, the total internal debt owed by federal, state and municipal governments in Brazil stood at 41% of the country's GDP, or $320 billion. This internal debt is financed by a huge foreign debt which in 1996 stood at $180 billion, the highest among all developing countries. With this heavy reliance on foreign credit, it was important for Brazilian authorities to present the country to the outside world as a tranquil and industrious community.

Franco's action shattered that illusion. The mercurial ex-president struck a chord among long-suffering Brazilians who had been told by "the markets" that prosperity (or at least recovery) was at hand if only they kept quiet and played by the rules. Franco is villified precisely because his action was so out in the open, for all those creditors to see. With public spending cut to the bone—Franco told reporters he had to bring his own toilet paper to work—and the country mortgaged to the hilt, Franco's populist action may, in fact, have thrown a timely spotlight on Brazil's place in an international house of cards.

The events leading up to the currency crash, economist Weintraub told Congress, "sent a message of instability to Brazilian and foreign investors alike and these investors then behaved rationally. Those who could then acted to protect their assets." One cannot blame the investors who pulled their money out when the going got uncertain. They were simply behaving like the gamblers they are. The problem is in what financial writers like to call the "global architecture" of finance—an edifice that gives the gamblers control over the destiny of nations. As Lord Keynes once remarked, "When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done."

Watch for NACLA's July/August 1999 Report, which will examine the global financial system in depth.

Fred Rosen is the co-editor of NACLA Report on the Americas.


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