The stock purchase, copying Hong Kong's example in August was a non-starter. Hong Kong had to use US$18 billion in 2 days to cushion the fall of its stock market in August 29, 1998. Brazil had only US$30 billion left and its market was bigger than HK's. So, the government decided that it was futile to even try, after some fake move to try to spook the market.
For many years, some economists have touted the myth of the indispensability of fixed exchange rates for small economies heavily dependent on external trade, like Hong Kong, or large free-trade economies facing high inflation, like Brazil. The inertia of the status quo and the lack of hard data on the uncertain effects of depegging have permitted this myth to assume the characteristics of indisputable truth.
Brazil pegged its currency to the dollar as a means of fighting chronic and severe inflation. When the Real Plan was introduced in 1994, inflation was 3,000%. Hong Kong pegged its currency to the dollar in 1983 to instill confidence in the uncertain political climate of its return to Chinese sovereignty.
As Hong Kong knows from first-hand experience, the penalties of an overvalued currency are injuriously high interest rates and runaway asset deflation, resulting in economic contraction that produces business failures and high unemployment, not to mention credit crunches and illiquidity that threaten potential systemic bank crises and recurring attacks on currency through manipulation of markets.
Brazil, burdened historically with costly social programs that have become politically untouchable, the overvalued currency peg inflicted much pain on the economy, particularly the export sector. Both industry and labor have wanted for a long time a lower real to relieve Brazil from high (70%) interest rate and to stimulate export, even if the current low inflation of 3% will rise as a result.
The latest crisis in Brazil was triggered by a moratorium on state debt payments imposed by the large and wealthy state of Minas Gerais on January 12, 1999. On January 13, Brazil devalued the real by 9%, having seen its foreign reserves dropped by more than half in the last 5 months to $31 billion. A drain of $1.8 billion from the Brazilian central bank was recorded the following day.
On the morning of January 15, to stop the financial hemorrhage, Brazil lifted exchange rate control entirely and allowed the real to float freely in the foreign exchange markets. Within minutes, the real fell to 1.60 to the dollar from its previous 1.32, but by day's end, settled around 1.43. By the end of the trading day on January 15, Brazil had managed to halt the flight of the dollar, with the real down 10.4% for the day and 18% from the pegged rate, even though the market had estimated the real to be overvalued by 30%.
With a free floating currency, Brazil's short term interest rate fell from 71.65% to 36.11% and the stock market jumped 34% on January 15 from its previous low, with lifting effects worldwide on other markets. The DJIA rose 219.62 points, or 2.4% to 9,340.55. US Treasuries dropped sharply, reversing the flight to quality, pushing yield on 30-year bonds to 5.12% from 5.05%. By 7 pm on January 15, only $173 million had left Brazil's foreign reserves coffer.
For recovery, Brazil still has to put its economic fundamentals in order, to cut government deficits and to reduce its $270 billion foreign debt. But its self imposed penalty of a overvalued peg has now been removed, gaining improved conditions for export and stimulative effects for domestic demand. With Brazil's currency free floating, it is highly unlikely that Argentina's currency board regime can hold. The is talk this morning that Argentina will try dolarization, but the penalty will be asset deflation, low exports, trade deficits and high unemployment.
Brazil's decision to abandon the peg is significant because it is the last large economy that follows free trade, market deregulation, fixed currency and privatization, the fundamental components of globalization promoted by neo-liberal economic theories. The decision represents a de facto declaration that market valuation of currencies is a more realistic option than placing faint hope of an international regulatory regime on capital movement or control down the road.
Hong Kong's situation is not congruent to Brazil's. Yet Hong Kong has incurred much unnecessary pain in holding onto the myth of an indispensable peg as Brazil did.
The events in Brazil last week has punctured the myth of the magic of the currency peg.
Tom Lehman wrote:
> Dear Paula,
>
> There have been reports that the Brazilian government has been buying
> Brazilian stocks. This maybe skewing some of the short term responses
> to devaluation---depending on the amounts and sectors involved.
>
> Your email pal,
>
> Tom L.