Latin Loot: Brazil Could Whip This Already Plunging Market By Peter Eavis Senior Writer 8/27/98 11:57 AM ET
Russia is metamorphosing back into a Soviet state. The question now is whether the panic gripping world markets is going to push Brazil back into the hyperinflationary chaos of the eighties. Signs suggest yes. The Dow may be down 300 points today, but a Brazil debacle will make that drop look benign.
Both Brazil's stock market and dollar bonds have plummeted over 30% over the past four weeks. The big fear is that the country will carry out a large devaluation by dismantling its dollar-pegged exchange rate regime, instituted just over four years ago as the cornerstone of the Real Plan.
Arguably, a full-blown currency crisis in Brazil would be much more serious for the global eco nomy than the debacle in Russia, whose economy is smaller than Holland's. Brazil has a massive influence on Latin America, as it makes up just under half of the region's GDP. Foreign companies have poured billions of dollars of investment into Brazil since the economic-stabilization Real Plan, including $10.4 billion in the seven months to the end of July.
Many U.S. companies depend on Latin America as a key source of revenue. BankBoston (BKB:NYSE) generates nearly 20% of its revenues in Brazil and Argentina. And only last month MCI (MCIC:Nasdaq) paid $2.3 billion for Telebras' long-distance business in privatization auctions.
In Defense of Brazil
Brazil has plenty of backers. This is what they say:
Yes, yes, Brazil has its fair share of economic problems, like its large -- and growing -- fiscal deficit, which could hit 8% of GDP this year. But, hey, the country has done a lot of good things under the presidency of Fernando Henrique Cardoso, up for re-election in October. Inflation's down to 3% from over 2000% in 1994.
And Brazil has nearly $70 billion of hard currency reserves, which constitute a sizable cushion against any concerted selling of the real. By contrast, Russia had $17.5 billion in reserves on the eve of its August meltdown.
In this much harsher environment, Brazil's shortcomings are becoming magnified. And there's plenty to get upset about.
The Huge Domestic Debt Mountain
Government bonds worth 95 billion reals ($82 billion) fall due in September and October. These bonds account for an enormous 43% of the entire domestic debt. By contrast, the Russians just defaulted on $40 billion of domestic debt that was to come due this year.
In the past, Brazilian banks and pension funds have been willing buyers of these instruments. Estimates put foreign ownership around 10% of the market (as opposed to 30%-40% in Russia). The domestic buyers may be reluctant to step in now.
In theory, the government can generate demand for its bonds by increasing interest rates. But because it's facing elections in October, Cardoso's administration is loath to hike rates.
If the government can't replace the old bonds with new ones, then it'll have to pay back the principal on the old bonds. This move will pump huge amounts of money into the economy, much of which will flow out of the country, thus depleting reserves.
The government clearly believes that it can bear some outflows because reserves total $70 billion. Pundits say it will let as much as $20 billion flow out. But reserve depletion is hard to control. It can quickly get out of hand, especially when there are so many other potential calls on reserves.
So far this month, dollar outflows add up to $3 billion (excluding one-off exceptional items), according to Paribas Capital Markets. In a full-blown crisis, Brazil could lose $1 billion a day. On top of that, Brazil faces net dollar outflows through its trade account and debt repayments of $14.4 billion, calculates Warburg Dillon Read ($11.6 billion for the expected current account deficit plus $9.8 billion in external debt amortization minus $7 billion in expected foreign direct investment).
Since reserves constitute no more than a Brazilian Maginot Line -- safe-looking but breachable in a crisis -- what could spark a rush for dollars?
Obviously, more bad news abroad. The trouble spots are well-known and well-covered: Russia, Japan, Hong-Kong/China.
Brazil Itself Offers Little Positive
Brazil itself is hardly healthy. Investors believe that it will not be able to solve its two largest problems -- the huge budget deficit and a terrible trade performance -- for many years. Why stick around when little suggests that Brazil can manage an economic recovery any time soon?
The budget deficit could hit a massive 8% of GDP in the third quarter of this year, according to J.P. Morgan. It may even stay at that unsustainable level if the government is forced to hike interest rates, as a large proportion of its expenditure is interest on its debt. And pre-election spending by both federal and state-level governments that has yet to find its way into fiscal accounts could be much higher than some assume.
Longer term, Brazil cannot grow without running up an unsustainable current account deficit (4% of GDP or above). As soon as economic growth picks up, the trade deficit grows, as imports get sucked in. At the same time, export performance over the past four years has not improved and shows few signs of doing so, a recent study from J.P. Morgan argues. Against this background, the outlook for Brazil is grim. If the Real Plan collapses, so would the rest of Latin America. Then, the emerging market crisis, once seemingly far away, will begin to bulldoze our own backyard.