Just as the US economic recovery is losing momentum with slower growth in 2Q and incoming economic data turning weaker, Brazil is battling another financial crisis. The event warrants global attention due to its sensitive timing.

The unique causes of the crisis

Because it happens with a six-month lag, many regard the crisis Brazil is facing as a lagging reaction and continuation of the Argentina crisis that resulted in depegging of its currency and default of its sovereign debts. If it explodes, Brazilian stocks, bonds and currency will plunge, and its economy will be devastated, just like Argentina. But in fact, before the situation reversed and worsened back in mid April, Brazil was clearly bouncing back from the initial shocks from Argentina. It was only when Brazil, which accounts for 40% of South America's economy, began to waver, did the emerging markets in the region begin to suffer (see Table 1). Simply put, the Argentina financial crisis was the product of a fixed exchange rate system and unsustainable fiscal imbalance. And the crisis Brazil is battling is the product of confidence crisis brought by political uncertainty and mismanagement of debt under a floating exchange rate regime.

Table 1, Changes in major Latin American currencies against the US dollar

The reigning Brazilian President Cardoso has already served two terms. Under the Constitution, he cannot run for a third term. Therefore in October, Brazil will elect a new president. Cardoso is market friendly with his free market economic policy. But his handpicked presidential candidate Serra has been trailing in the polls behind left wing candidate Silva and central-left candidate Gomes by a wide margin. In April, when Silva's support rate climbed above 40%, investors could not ignore the dire possibility that he might become the next president, and that default or debt restructuring might be forced upon them because Silva used to advocate a moratorium of sovereign debt. As a result, investors sold bonds and the currency en masse, pushing Brazil toward the edge of financial meltdown.

There are a few mishaps and mistakes in Brazil's debt structure and management, which in times of confidence crisis could trigger full-blown financial crisis. Up till today, Brazil's net public debt amounts to USD290bn, which fluctuates with the currency and reaches 59% of the GDP. This debt to GDP ratio is lower than that of most emerging market countries. Moreover, only one fifth of the debt is foreign and the rest is domestic, which in theory can shelter Brazil from a disastrous full retreat of foreign investors. But as a matter of fact, the lethal combination is that 80% of the domestic debt is indexed to the dollar or the interest rate. When investors dump Brazil's bonds and currency in a hurry, the cost of servicing the debt skyrockets and a debt crisis is born. For example, whenever the Brazilian Real devalues against the US dollar by 1%, the total debt burden will be increased by roughly USD1.4bn. And when interest rate climbs by 1%, the interest burden on those FRNs will increase by 1%. This unique structure of Brazil's debt triggers the crisis under special market circumstances.

Back in May, in order to calm the market, the Brazilian government offered to swap longer-term bonds for short-term bonds and government expenditures were mostly paid for with short-term bonds, resulting in extra issuance of USD20bn worth of short-term bonds that will mature shortly after the new government takes office in 2003. This further damped the market's confidence. The swap shortened the overall duration of the debt, increased the total amount of short-term debt, thus violating an important principle of debt management by emerging market countries. As a result, year to date the Real is down 24%, Brazil's sovereign spread over the US Treasuries is more than 20%, the interest payment alone reaches 9% of GDP, and Bovespa is down 44.34% in dollar terms.

It is not inevitable

Even so, a meltdown is still not inevitable as Argentina once experienced. Brazil is capable of holding out much longer than expected because its fundamentals have improved greatly when compared to the 1999 crisis and Argentina's crisis in 2001.

In 1999, Brazil's average debt maturity was six months, and monthly repayment was USD20bn. Today, the average maturity is 25 months and monthly repayment is only USD6.2bn. In 1999, Brazil ran a budget deficit amounting to 7% of GDP. But for 15 consecutive quarters ever since, Brazil has been running a primary budget surplus (on the rest of the budget ex interest payment). The government is sticking to the surplus target of 3.75% of GDP. The Real is freely floating, and its devaluation against the dollar raises the cost of capital flight. Compared to Argentina's situation, Brazil obviously enjoys a floating currency and more disciplined fiscal policy. More importantly, Brazil's banking system is relatively sound and cash rich. If the government chooses to enforce, the banks can absorb all the debt coming due. So far, Brazilian depositors have not lost confidence in the banks to embark on a bank run. All these enable Brazil to withstand more pressure.

Brazil is currently seeking for IMF's approval to lower its foreign reserve floor in order to have more ammo to intervene in the FX market. From now till yearend, about USD36bn domestic debt and USD3bn foreign debt will become due. And in the first six months of 2003, another USD32bn will mature. Brazil's Treasury has an account set up with the central bank for USD23bn, enough to pay off 2/3 of the debt maturing this year. As for the rest, the government has to convince investors to roll it over.

Defusing the crisis requires internal and external measures

If the Real continues its slide after the 25% drop against the US dollar so far this year, and the interest rate stays stubbornly above 20%, then a financial meltdown is just a matter of time for Brazil. In order to defuse the crisis, Brazil needs all the help it can get from the US and the IMF. Its next president will also have to pledge to abide by the market economy principles, take over the debt load, and maintain fiscal discipline.

The US has the veto power in the IMF aid program. They chose not to help Argentina because they were confident that the impact could be contained. The US Treasury Secretary O'Neil originally did not intend to help Brazil either. On July 28, his remarks that aid money would end up in Swiss bank accounts triggered a diplomatic outcry. Brazil's stocks, bonds and currency all plunged on the remark. He inadvertently set the crisis in motion. The White House had to clarify the following day. And two weeks later when O'neil was visiting South America, he had a change of heart. He voiced support to the IMF aid program and praised Brazil's economic efforts. In his first stop in Uruguay, he presented a emergency loan of USD1.5bn on behalf of the US. The fund he drew on was the Exchange Stabilization Fund set up by the former Treasury Secretary Rubin, who had used the fund to save Mexico in 1995. All these indicate that the US and the IMF will not remain on the sideline this time. Argentina defaulted on its USD95bn debt. If Brazil followed suit, the default would be three times larger. Eventually, Latin America could be dragged down and this external shock might push the US over the edge into double-dip recession. Therefore, saving Brazil equals to saving the US itself. Brazil has been an ardent follower of IMF's doctrines. If the IMF fails to provide a helping hand when Brazil is in trouble, then the market will call into question the justification of its existence. Moreover, President Bush just won the fast-track trade legislation battle to push for the signing of the FTAA before 2005. Under the circumstances, the US is unlikely to stay on the sideline either.

But the US and the IMF are in no hurry to rush the process. The uncertainties surrounding Brazil's presidential election make the offer of a blank check look like an endorsement of the left wing candidates, which the US and the IMF both want to avoid. But from the leading presidential candidates' point of view, it is close to political suicide if they inherit the debt crisis from the current government, have to abide by IMF's rules and give up their political agendas. The situation therefor becomes very delicate. The US and the IMF have to have some sort of pledges from the leading candidates to release the aid package. But the candidates themselves want to keep their own political agendas intact while receiving the aid. If either side strays from the game rules, both will get hurt. On the other hand, Brazil cannot wait too long. Therefore, internal and external measures will have to be taken and a consensus will have to be reached in to have for the aid package released to calm the market, to roll over the debt and eventually defuse the crisis.

Future development

As expected, Brazil reaches an agreement with the IMF on August 7 for a 15 month, USD30bn bridge loan, which even exceeds the market's USD15-20bn expectation. Brazil's bonds and currency surge on the news. The agreement also lowers Brazil's foreign reserve floor to USD5bn, providing more ammo for FX intervention. But primary budget surplus target of 3.75% of GDP will have to be maintained. Most importantly, USD6bn will be released later this year and USD24bn next year when the new government takes office. In other words, the new government will have to follow the free market economic policy and fiscal discipline in order to receive the bulk of the loan. As a result, Brazil stands a much better chance of fending off the financial crisis.

Nevertheless, there are still two trouble spots for Brazil in the next 15 months. The first lies in the very heart of the confidence crisis that the track records of the left wing candidates do not guarantee that they keep their words in following IMF's rules. The second lies in Brazil's economic growth that is out of anybody's control. If Brazil's growth slows down dramatically or even results in a recession, the government will have to rigorously control spending or even cut spending in order to achieve budget surplus, In times of economic slowdown, this is a very unpopular move. If a left wing president chooses to be a populist, then Brazil may be back to square one some time next year. The US and the IMF should be fully prepared to deal with this worst case scenario.

Lessons from the crisis

By studying the financial crises that took place since 1997 in Asia, Russia and South America, it can be found that in many cases, short-term debt crisis was aggravated through the unloading of stocks, bonds and currencies. Countries with the pegged exchange rate system were the first to be hard hit. But the crisis Brazil is facing shows that even with a floating exchange rate regime, short-term debt crisis can still turn into full-blown financial meltdown under unique market conditions. This raises the bar for debt management by developing countries. Firstly, the absolute amount of debt issuance has to be set at an appropriate level compatible with a country's financial and economic strength. Secondly, the ratios of foreign vs. domestic debt and long-term vs. short-term debt have to be appropriately set. Thirdly, rigorous scenario analysis has to be performed to ensure that debt repayment can still be carried out under the worst case scenario. There are no simple guidelines, only references. And a country has to consider its own unique situation.

For many years, China has been conservative in operating its capital account. This has successfully shielded it against many financial crises and maintained its growth. But ever since China joint the WTO and began to gradually open its financial and FX market according to market rules, the double effects of higher growth as well as greater risks/shocks have become more prominent. The above-mentioned crises suggest that special attention must be paid to two soft spots during the opening process. The first may occur around the time when the RMB's peg to the US dollar is changed. The second lies in maintaining sound fiscal and monetary policy to support a floating exchange rate system. One of the reasons Brazil can hold out longer than expected is its relatively healthy banking system. It can absorb all the maturing debt if being forced to. Depositors do not feel threatened to embark a bank run as in Argentina. The August 7 Wall Street Journal revisited problems in China's banking system on the backdrop of Brazil and Uruguay's crises. But this proves the point that China's banking system reform is forward looking. Its success will help prevent financial crisis from happening during China's opening of its financial markets.