LATIN LOOT Brazil Races to Defuse the Debt Time Bomb By Peter Eavis Senior Writer 1/29/99 4:43 PM ET
With the Brazilian economic crisis deepening, pressure is building on the government of President Fernando Henrique Cardoso to default on its domestic debt as a last-ditch attempt to reduce its fiscal deficit.
But some Latin America experts are warning Cardoso's team that any forced restructuring of government debt could have disastrous economic consequences, including a potential external debt default, a grinding recession and even the return of hyperinflation.
"A domestic debt default would be a huge negative," says Ernesto Ramos, portfolio manager at Nicholas Applegate's Emerging Country fund.
Members of Cardoso's embattled economic team are strenuously denying that they are considering a forcible restructuring of the 320 billion reals ($150 billion) of debt.
But debt costs, which make up the lion's share of the budget shortfall, are climbing unsustainably. The cost of interest-rate-linked debt, which makes up nearly three fourths of the total, is snowballing as the government maintains high rates in the aftermath of the devaluation. On Wednesday, it raised one of the key lending rates to 35.5% from 29.8%.
Dollar-linked debt, 24% of the total, is also getting costlier as the real's value falls against the greenback. It has slid 42% since the Jan. 13 devaluation, to trade at 2.12 reals per dollar earlier today.
What's more, the government faces a daunting schedule of domestic debt maturities next month. In February, a massive 47 billion reals' worth of bonds come due, according to Lehman Brothers. Recent government bond auctions have failed due to lack of demand of the interest rates offered.
This week, Argentine President Carlos Menem advised Brazil to do what his country did in 1989: restructure its debt into cheaper, longer-dated dollar-denominated bonds, thus easing pressure on fiscal accounts.
And Duff & Phelps, the credit rating agency, said Monday that there's a one-in-three chance that Brazil will restructure.
Argentina's Unhelpful Advice
At first blush, arbitrarily cutting interest rates and lengthening maturities seems a simple way to reduce debt expenses. But it would be a confidence-destroying move that would greatly exacerbate the crisis, according to John Welch, Latin America economist at Paribas Capital Markets.
Brazilian banks hold large sums of government paper as assets. The problem is that these bonds have extremely short maturities, while the banks' liabilities tend to be longer. If the government arbitrarily lengthens its bonds by a number of years and ceases coupon payments for a period, the banks would be unable to repay their depositors, and loans would have to be cut sharply. This would stop nearly all lending to the corporate sector and depositors would be forced to accept long-term bonds in place of their original assets.
The many corporations holding government bonds would be hit directly. For example, Aracruz (ARA :NYSE ADR), the Brazilian paper and pulp firm whose ADRs have done relatively well in the crisis, holds some $700 million of dollar-linked domestic government debt, according to Fred Searby, analyst at SG Cowen Securities.
With businesses hit, the economy could shrink by over 6% of GDP, says Welch. Moreover, default may not even allow the government to cut interest costs and stop the real from diving. Welch asks: "Who would want to hold the real or government bonds after a default?"
And if the government does not have the will to pay its domestic debt, it may soon give up on honoring external repayments. Indeed, a culture of nonpayment could spread like wildfire through Brazil.
Lesser Evils
What alternative does Brazil have to a domestic default at this point in the crisis?
One is to monetize the deficit. This means that instead of issuing new bonds at high interest rates to pay off the old ones coming due, the government simply prints money to pay off the maturing paper. But if they do, interest rates would plunge, the currency would dive and money supply would rise. Of course, the drawback with this is that it would almost certainly cause high inflation -- something the Brazilians have spent five tough years getting rid of. "If they monetize, [annual] inflation could go to 80%," says Paulo Vieira da Cunha, Latin America economist at Lehman Brothers. What's more, the government would have to go back to high real interest rates some time in the future to get inflation back down.
Vieira is floating another plan that he feels could help Brazil out of its bind. All new debt issuance could be inflation-indexed. That way, if the government shows it has the mettle to keep prices down, it could quickly secure much lower interest rates. Investors, too, would be reassured by inflation-hedged returns. Such a scheme would have a good chance of working if it coincided with moves to make the central bank free of political interference, he says.
However, Vieira stresses the government must get to work on any indexed-bond scheme before inflation picks up, and before any debt monetization takes place. Any sign that inflation has slipped from government control would cause investors to shun indexed bonds at the sort of lower rates the government is after.
In reality, however, the odds of the government's adopting such a scheme are thought to be slim. Cardoso's team will probably rule out this proposal because of fears that it could lead to inflation-indexation elsewhere in the economy.
Cardoso Quivers
The escape route most people are praying for is still possible -- but looking less and less likely by the day. It's hoped that the current policy mix -- tight monetary policy, progress of fiscal reforms in Congress and maintenance of relations with the International Monetary Fund -- will restore enough confidence in the market to allow for a quick reduction in interest rates.
But the market wants to see more of a response. Ever since the devaluation on Jan. 13, the Cardoso administration's response has looked both ad hoc and lackluster. "It's not really clear who's in control of Brazil," says Tim Love, Latin American equity strategist at SG Cowen Securities.
It'll take a lot to reassure the market now. The real has to stop sliding, a credible anti-inflation package must be launched and more budget deficit reduction measures must make it through Congress. At the same time, Cardoso must see off the threat by state governors to default on their debts to the federal government, keep his cabinet intact and implement social measures as the recession deepens. Through all this, Brazil has to keep the IMF on its side.
Just over two weeks since the devaluation, Cardoso faces three unenviable options. Default. Monetization and inflation. Sticking to a Band-Aid policy mix that's currently making the debt problem even worse.
"Brazil got itself into this situation. Now it must pick its poison," concludes Walter Molano, economist at BCP Securities.
And as nearly everyone agrees, inflation would be debilitating, but default would be worse.