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Brazil at a crossroads

Avoiding Argentinean contagion attests to how far Brazil has come. But will the victor in this fall's presidential election depart from the steady path to reform?

Avoiding Argentinean contagion attests to how far Brazil has come. But will the victor in this fall's presidential election depart from the steady path to reform?

By Deepak Gopinath
March 2002
Institutional Investor Magazine

On January 7, the day after Argentina announced that it was abandoning its decade-old dollar-peso peg and promptly plunged deeper into political and economic chaos, Brazil tapped the international capital markets for $1 billion. Demand from investors for the country's ten-year bonds was so great - $2.1 billion in bids - that Brazil upped the ante to $1.25 billion. The securities carried a stiff coupon of 12.6 percent, some 7.5 percentage points over that of U.S. Treasuries; but Argentina's risk premium had spiked to fully 40 percentage points over Treasuries.
The clear message: Brazil is no Argentina. The country is doing just fine, thank you, compared with its distressed southern neighbor (see related story, page 59) or, even more dramatically, the Brazil of a decade ago.

Despite the global downturn, in 2001 the country eked out economic growth of 1.6 percent, as it registered a $2.6 billion trade surplus, its first since 1994. Inflation was held to 7.7 percent - a far cry from the triple-digit rates of the 1980s - and foreign direct investment reached $23 billion. And last month, in a sign of confidence in the economy, the central bank cut interest rates by 25 basis points.

"I'm bullish on Brazil," declares the country's respected central bank president, Armínio Fraga, who helped steer the economy around the shoals of Argentina, an energy shortage, a post-September 11 liquidity squeeze and a global slowdown, all in the past year. "Once the international scene calms down and once we clear the political uncertainty in the elections at the end of the year, we should see further growth, assuming whoever comes next [as president] is reasonable."

Fraga's view is shared by seasoned observers. "Brazil's economic team has succeeded in implementing a series of economic reforms, a number of them substantial," says Citigroup senior vice chairman and veteran emerging-markets debt negotiator William Rhodes. "While a new government may change some economic policies, I don't think Brazil will turn back on reforms already on the books."

But will the winner in this October's national elections be "reasonable," as Fraga hopes? Will current President Fernando Henrique Cardoso be succeeded by a politician as committed as he is to the process of gradual but relentless reform that has brought Brazil to the point where it can shrug off Argentina's contagion and tap the international capital markets for its entire yearly foreign borrowing quota in one swoop?

Whoever wins will have to wrestle with a quandary common to emerging-markets countries but especially fraught with complications in Brazil's case: mustering the political will to carry out reforms that may be painful but are necessary to win the lasting confidence of international markets. "The dilemma is that Brazilians are now in an unstable equilibrium, and unless they push through reforms, they could find themselves in crisis," says Walter Molano, head of research at Greenwich, Connecticut-based BCP Securities. "They must either move forward or go back in the Argentina direction."

Brazil may have survived the fallout from Argentina, but country analysts and government and development bank officials caution that this is no time for policymakers - or investors - to take for granted the country's brighter prospects. In Brazil's past, recovery has too often turned out to be only remission. As Fraga himself tells Institutional Investor: "We need to keep pushing. We are not where we would like to be yet. Our borrowing spreads are still quite high, so we haven't relaxed."

Brazil faces plenty of economic pitfalls amid global recession, but politics may represent the most immediate threat to the country's well-being. The forthcoming elections amount in large part to a referendum on eight years of orthodox neoliberal economic policy, such as privatization and fiscal and social security reform. President Cardoso, however, cannot stand for reelection, and his designated successor - the notoriously uncharismatic former health minister Jose Serra - is lagging in the polls.

Meanwhile, candidates from the left - notably, Partido dos Trabalhadores leader Luiz Inácio (Lula) da Silva and Rio de Janeiro's populist governor and leader of the Partido Socialista Brasileiro, Anthony Garotinho - have registered strong support. Further blurring the electoral picture is the rise in the polls of Roseana Sarney, conservative governor of the impoverished northeastern Maranhão state and daughter of a former president.

Many investors believe that Serra will still prevail. Even if he doesn't, they doubt that Cardoso's successor will significantly alter current economic policy. "Brazil is actually a relatively mature democracy, and I don't see enormous risk rising from the elections. Even if Lula gets elected, I don't see a radical shift in fiscal policy," says Jerome Booth, who manages $1.25 billion in emerging-markets debt for Ashmore Group in London. "The point about Brazil that stands in stark contrast to Argentina is that policy is predictable."

Predictable, perhaps, but not without many of the same challenges that confront Argentina. Brazil is burdened with $280 billion of net public sector debt, making for a debt-to-GDP ratio of 53 percent, equivalent to that of Argentina. Moreover, one third of Brazil's debt is linked to the dollar and half is indexed to short-term interest rates; Brazil's ability to service the debt is thus highly vulnerable to currency fluctuations and the external environment. Brazil's 7.7 percent inflation last year was actually almost twice the 4 percent target. The country is running a $23 billion current-account deficit, making it overly dependent on foreign investors.

"If Brazil can't find financing for its current-account deficit, it could have another devaluation," warns BCP Securities' Molano. To bolster the weak real (which declined 15 percent in the first half of 2001), combat inflation and contend with the fiscal deficit, Fraga has had to push interest rates up to 19 percent, crimping economic growth. And indeed, many Brazilians are fed up with slow growth and high borrowing costs. They also want the government to do more to attack crime, which has become an emotional election issue.

The reform effort, conducted at a deliberate pace to avoid political upheaval, is incomplete. The government needs to do more to curtail federal and provincial spending. It hasn't dared to tackle public sector pension abuses. Brazil's tangled tax system, jury-rigged to meet short-term fiscal targets, discourages investment. Moreover, investors keeping a wary eye on Argentina are scrutinizing Brazil for similar fiscal slippage.

The chaos in Argentina could play out in curiously conflicting ways in Brazil's election, suggest analysts. On the one hand, it could strengthen the populist left because of sympathy for Argentinean "victims" of foreign banks and International Monetary Fund (read: U.S.) austerity measures. On the other hand, many voters may be grateful to the Cardoso government for having spared Brazil the fate of Argentina and thus be inclined to elect his chosen successor, Serra.

One thing seems certain: Preelection maneuvering and debate will increase market volatility as voters focus on the uncertainty surrounding the candidates' economic policies and their ability to field a credible economic team. "We can commemorate the fact that the worst never happened for Brazil, and in 2002 I am cautiously optimistic," says Paulo Rabello de Castro, a liberal economist and chairman of SR Rating, a São Paulo-based bond-rating and economic consulting firm. "But there are new risk factors facing us: namely, political discontinuity - the risk of policy changes affecting business confidence whenever polls show opposition politicians rising."

Indeed, many foreign investors and Brazilians would like to see Congress pass a law guaranteeing formal central bank independence. That, they believe, is the key to ensuring stability during the political transition. The immediate idea is to keep Fraga, who has run the central bank since 1999, in office for at least another year. "Armínio is seen as a demigod," says Rabello de Castro, an adviser to Sarney's center-right Partido da Frente Liberal. "He's powerful, glorious but mortal. We need to give him a mandate and a constitution." Many analysts doubt, however, that such a sweeping law will pass in this election year.

Fraga, even more than Alan Greenspan at the U.S. Federal Reserve Board, is a linchpin of his country's economy. Cardoso's 1994 Real Plan instituted a crawling-peg exchange rate that helped to bring inflation down from 1,100 percent to single digits by 1997. But government overspending and the fallout from the Asia financial crisis combined to cause a failure of confidence in Brazil. By January 1999 the central bank was unable to defend Brazil's currency and was forced to abandon the peg, sending the real plunging by 50 percent against the dollar. The following month Cardoso hastily wooed Fraga away from his job as a portfolio manager at Soros Fund Management in New York to keep the economy from spiraling back into hyperinflation and recession. Fraga moved quickly to increase interest rates and implement an inflation-targeting system, and his success cemented his reputation as a credible policymaker.

The government has made significant progress on the fiscal and monetary fronts during the past few years. Brazil boasts a primary fiscal surplus (that is, the budget balance excluding interest payments) of 3.7 percent; in 1997 it had a deficit of 1 percent. Congress has set limits on borrowing by federal and local governments. And Fraga's inflation-targeting program has been largely successful. The central bank did miss last year's 4 percent (plus or minus 2 percent) target but is expected to achieve this year's 3.5 percent (plus or minus 2 percent) goal.

Bolstered by a sound monetary policy, Brazil's economy appeared to have rebounded in 2000, with growth a respectable 4.5 percent and inflation hovering around 6 percent. The country attracted $30 billion of foreign direct investment that year. The mood was buoyant.

Then came the horrors of 2001: energy shortages, a global slowdown, September 11 and Argentina's economic collapse. By midyear the real was being buffeted by investor concerns about whether Argentina could maintain its dollar peg and service its debt. Brazil's currency began to slide against the dollar, meaning that the country was going to have a difficult time servicing its domestic debt. A weaker real also threatened higher inflation, which in turn would force up interest rates and put a damper on already anemic economic growth.

Early in the year, when the outlook for the economy was still rosy, investors fretted that Brazil would face a $6 billion gap in financing its current-account deficit, which was expected to grow because of rising imports. Fraga sought to allay the market's qualms by announcing that the central bank would provide the $6 billion, in daily increments of $50 million. Still, by August investors and corporations, increasingly nervous about neighboring Argentina, were loading up on dollar hedges. Fraga had to find a way to stem the real's decline, lest the central bank lose control of inflation. He made shorting the real less attractive by increasing bank reserve and capitalization requirements - but met with little success.

After September 11 Fraga reversed course. The real had dropped 16 percent in three months, to 2.84 to the dollar by mid-September. Brazil's risk premium had begun to move up in lockstep with Argentina's. "There was a moment, after September 11 in particular and after Argentina's economy deteriorated, where we went through what we should call a bit of a panic here," confides Fraga.

He began flooding the markets with dollar-linked real bonds, satisfying the market's demand for dollar hedges; the central bank issued some $9 billion worth of bonds in September and October. Fraga was in effect betting that a global flood of liquidity, as central banks everywhere opened the spigots, and global investors' preoccupation with the war on terrorism would divert attention from Argentina and take pressure off the real.

That's essentially what happened. By October market sentiment had shifted, and the real had begun to recover. It helped, too, that Brazil had earlier negotiated a $15 billion emergency IMF package that helped tide it over the post-September 11 liquidity crunch. Moreover, encouraging balance-of-trade and foreign direct investment figures assuaged investor concerns about Brazil's debt dynamics. Firms that had snapped up the dollar-linked bonds had to unwind their long-dollar positions in a hurry, helping to accelerate the real's rebound. By mid-December the currency was up 21 percent from its September low, and Brazil's country risk had fallen 360 basis points; Argentina's, meanwhile, had soared 2,700 basis points. "Fraga made a bet that there would be positive news," says Paulo Leme, head of emerging-markets research at Goldman, Sachs & Co. "It ended up being a very skillful strategy and explains why the real appreciated so quickly."

Nevertheless, Fraga's moves were controversial. Earlier in the year he had indicated that interest rates would be coming down, and here he was, raising rates. That cost him a measure of trust among investors as well as ordinary Brazilians. Some who held long-dollar positions felt burned when Fraga shifted tactics. "Many people lost money," notes Edmar Bacha, head of Brazil's Associação Nacional de Bancos de Investimentos.

Other market participants felt Fraga had actually increased the real's volatility. "The central bank allowed the real to devalue too much," says Gustavo Loyola, a former central bank president and now an economist at São Paulo-based Tendências Consultoria Integrada. "The foreign exchange market in Brazil is not deep, so when the central bank upsets these markets, they tend to become overvolatile."

Quibbles aside, it looked as though Fraga had steered Brazil back into the clear. And after the January bond issue, Brazilian risk appeared to have "decoupled" from Argentina's. Although Brazil's risk premium remained higher than those of many other emerging markets, it was no longer tracking Argentina's: Financial contagion appeared to be a dead issue.

Having survived 2001, Fraga and other officials are optimistic that Brazil can pick up where it left off. Fraga ticks off the reasons for his optimism: progress in controlling inflation, sounder fiscal policy, reform of the banking sector, the move to a floating exchange rate and a start on reforming the state apparatus.

But it is a long way from here to there. For one thing, there's still a fair bit of contagion out there. "Argentina still affects Brazil," says Loyola. Octavio de Barros, chief economist at Banco Bilbao Vizcaya Brasil, adds, "The difference between Brazil's country risk and [that of] other emerging-market countries is still very high."

Brazilian banks don't have significant exposure to Argentina but may be affected indirectly, through corporate customers whose business with Argentina has dried up. According to the influential Federação das Indústrias do Etado de São Paulo, its members lost $1.2 billion to $2 billion in outstanding receivables due from Argentinean firms in 2001. "Companies with receivables are in bad shape," says Maurice Costin, Fiesp's director of international relations and foreign trade. "The second big problem is that Argentina was a very big importer of finished products. For the time being, everything has stopped. This will mean another $2 billion in lost sales this year."

The contagion will be aggravated by the uncertainty surrounding the forthcoming elections. "We see a lot of volatility in economic variables caused by uncertainty about the candidates," says Alkimar Moura, chief financial officer of state-owned Banco do Brasil. Analysts don't expect any candidate to win the 50 percent of the vote needed to prevail in the first round, forcing the top two candidates into a runoff.

Either Sarney - whose PFL is part of Cardoso's coalition - or Cardoso candidate Serra is expected to be pitted in the second round against the PT's Lula, a four-time presidential candidate. As of late January polls showed Lula favored by 26 percent of voters, Sarney by 23 percent and Serra by 7 percent. Garotinho, Rio de Janeiro's populist governor, has 15 percent. The remainder of the electorate is divided among marginal candidates.

Many analysts and economists are operating on the assumption that a candidate from the current coalition - that is, Serra or Sarney - will wind up beating Lula, who has shown himself to be unable to expand his appeal beyond his core base in previous elections. "Neither Serra nor Roseana are candidates of deep change," says economist Loyola. "In a sense, it will be a continuation of Fernando Henrique Cardoso. But if another candidate wins, like Lula or Garotinho, the market will reflect a high degree of risk, and interest rates could go up."

How likely is this? "There is a risk," says banker Bacha, a friend of Serra's, "that Serra doesn't climb much in the polls but succeeds in taking votes away from Sarney. That would leave Lula and Garotinho in the second round."

The elections are further complicated by Argentina's collapse. "Argentina vindicated the credibility of Brazil's economic team, which was in doubt in September," argues Goldman's Leme. Adds Walder de Goes, head of Goes e Consultores Associados, a political consulting firm in Brasília, "People will understand that Lula is dangerous and could create a crisis like Argentina."

But that may be wishful thinking. Argentina's troubles "could help the government but could also work to strengthen the antiglobalization position," says Banco do Brasil's Moura. Christian Deseglise, head of emerging markets at HSBC Securities in New York, warns that "the market has been concentrating on financial contagion but not political contagion - which could be more damaging." Lula's economic adviser, Guido Mantega, contends that "what happened to Argentina is a weapon for us in the opposition: Argentina made many mistakes on its own, but it also followed IMF policies. Fear may favor the government, but reason is in our favor."

Observers are concerned about the view of some of the presidential candidates, particularly Lula and Serra (Sarney's economic program is unknown), that the root cause of Brazil's external vulnerability lies not, as the Cardoso team believes, in fiscal deficits but in current-account deficits. Both Serra and Lula favor government industrial policy to boost exports and promote import substitution. But such interventionism, say skeptics, risks undermining Brazil's economic stability. "The danger is that privileging this type of policy could increase protectionism - direct and indirect subsidies for exports - and could be inflationary," says Loyola.

Business guardedly supports the emphasis on exports and industrial policy. "The government has to gear itself more to industry and less to finance," says Fiesp's Costin. "It is not that we want inflation or protection, but we want incentives to increase production domestically." Executives have long criticized Brazil's high interest rates and inefficient tax regime. "Cardoso's biggest accomplishment was bringing stability into the economy," says Alberto Weisser, CEO of Bunge, a White Plains, New York-based agribusiness firm that has invested more than $1.5 billion in Brazil. "But we need tax reform."

A former metalworker and union leader, Lula has in the past rejected Cardoso's market-oriented policies and, more recently, had flattering things to say about Hugo Chávez, Venezuela's radical president. At January's World Social Forum in Pôrto Alegre, Brazil, Lula suggested that repayment of Brazil's foreign debt be made contingent on a reduction in poverty levels. "The whole world would be sensitive enough not to allow children to die of hunger because debt has to be paid," he declared.

For the markets, Lula's election would be the worst-case scenario. Yet aside from the occasional rhetorical flourish, he has been trying to recast himself as an economic moderate. "The PT is a fiscally responsible party," says Mantega, an economics professor at Fundação Getulio Vargas in São Paulo. "Our program is not too different from the government's. We will see similar programs from all the candidates. The people know the government has made many mistakes - low growth, big social problems, crime - they know that the PT is more capable of resolving social problems."

The PT has demonstrated fiscal conservatism in running local governments, but its policies emphasize growth rather than stability. Mantega believes that Brazil's inflation target for 2002, for instance, is too rigid. "Inflation targeting is useful for the market, but the targets must be realistic," he says. "To meet its low target, the government maintains high interest rates, and this doesn't permit growth." Mantega also argues that boosting exports, implementing industrial policy and reforming the tax system won't erode fiscal stability. "This is not a question of increasing deficits," he says, "but of reorienting money already in government institutions."

Many observers are sanguine about the ongoing economic debate. "The opposition is not socialist, it is interventionist," says Banco Bilbao Vizcaya's Barros. "They are honest but have a naive belief in government intervention. A good economic debate between now and the election will help define country risk. It will be a learning process for the opposition."

Central bank chief Fraga believes a political consensus exists on the need for conservative macroeconomic management and isn't too concerned about proposals to boost exports, provided fiscal responsibility is maintained. "I can't imagine anyone running on a platform of fiscal irresponsibility or higher inflation or things like that," says Fraga. "There is no longer the illusion here that you can get something for nothing; and that realization is very healthy and, in my mind, will prevent a slippage from happening."

Yet fear of slippage is strong enough that investors have clamored for Fraga to remain on as central bank chief for at least a transitional period. Both Serra and Sarney would most likely invite him to stay on. Lula would not. "Fraga is a good technician, better than his predecessors, but he is very much identified with the policies of Fernando Henrique Cardoso," says Mantega.

The government is trying to push central bank independence through Congress to institutionalize the current arrangement whereby the government sets the inflation target and the central bank acts autonomously to meet it. Fraga himself has long been an advocate of central bank independence. "The law is just one more element in the process of reaching a certain social maturity as far as things macroeconomic are concerned," he says. "We've learned the hard way in Brazil: We have done some silly things with our monetary institutions over the years. We've had hyperinflation, debt defaults, asset freezes - and it didn't do us any good. Now we are looking at something that allowed us to sail through the terribly uncertain waters of 2001 reasonably well, and maybe in 2002 Congress will decide the time has come to revisit our central bank law."

Serra and the PT are uneasy, however, with complete central bank independence, and the bank bill's chances of passing this year are uncertain, despite the support of Fraga as well as bankers and investors. But would Fraga stay on if he were asked by Serra or Sarney? "I feel quite flattered that the question is even asked," he says. "If a new law comes and President Cardoso asks me to stay a little longer as part of the transition period, I would do so. Anything beyond this I would rather not discuss."

Apart from the election, the biggest uncertainty for Brazil is global growth. "If the international economy doesn't show a recovery, it will hurt Brazil's trade and financial flows," points out Banco do Brasil's Moura. "Brazil's growth depends on external conditions." Without sufficient foreign investment, Brazil could face a debt crunch, if not this year, then next. In January the IMF blessed the government's economic management but said Brazil needs to reduce its dollar-linked debt.

That task will be left up to the new government. And it may have to do more than just pursue the "reasonable" policies of a Fraga. "Brazil doesn't need the status quo: This is a country with an explosive debt-to-GDP ratio," warns Christian Stracke, chief Latin American debt strategist for Commerzbank Securities in New York. "Markets will expect the new president to have to do fiscal tightening, but the new president may not have the mandate to do that."

Brazil, so accustomed to crises, isn't out of this one yet.