Harvard economist Jeffrey Sachs explains how the International Monetary Fund's good intentions encouraged Brazil to "chase its own tail." Second of a two-part series excerpted from The Milken Institute Review. BY JEFFREY SACHS
In October 1997 Brazil first faced the intense speculation emanating from the Asian panic. It raised interest rates to more than 50% and announced plans to slash the budget deficit from around 4.5% of GDP to 2.5%. Growth was forecast 3% in 1998. But how that was to be achieved in the teeth of astronomical interest rates, sharp budget cuts, and an unchanged exchange rate policy was never explained.
Brazilian growth evaporated in 1998; in fact, output fell by 1.5% in per capita terms. The budget deficit went up to 8% of GDP-not down, as had been programmed-and for laughably predictable reasons: High interest rates designed to defend the exchange rate fed directly into the costs of servicing the government debt. And since government debt in Brazil is very short term (who would trust it, long term?), a change in interest rates becomes embedded in nearly the entire debt within months. By 1998 interest payments on internal debt approached 10% of GDP And unlike the case in 1994, these interest payments were not merely a reflection of inflation; they were "real."
The IMF's own policy recommendation of high interest rates was thus, ironically, responsible for much of the rise in the budget deficit. In 1998 Brazil was chasing its own tail-and all with enthusiastic support from Washington.
Austerity in 1997 pushed Brazil into recession. In 1998 it pushed the country over the cliff. When Russia defaulted on its debts on August 17 1998 (its IMF program collapsing within four weeks of signing), Brazil was hit again with a new wave of speculation.
Again the IMF pointed to the budget deficit as the culprit and again urged Brazil to defend its exchange rate through a policy of high interest rates. As of August 1998 Brazil's central bank still had about $70 billion of foreign exchange reserves. But after several months of speculative attack, during which foreign investors cashed in their credit lines and Brazilian investors moved their money to offshore accounts, the central bank had lost approximately $45 billion of its reserves.
In mid-January the Brazilian government threw in the towel, abandoning the defense of the currency and allowing it to float. By mid-March 1999 the real had lost approximately 36% of its value vis-- vis the dollar.
The low level of reserves ($25 billion) has left Brazil in a fragile position. Investors might still panic this year, especially in the face of the huge gap between short-term debts (perhaps $50-60 billion in foreign short-term debts and as much as $250 billion worth of internal shortterm debts) and meager liquid assets. Even if investors do not cut and run, they will certainly demand interest rate premiums for holding Brazilian securities. And that will lead to a deeper recession than would have been likely a few months ago, when reserves were still around $70 billion.
Washington argued for currency stability to the bitter end, even throwing Brazil a $41 billion lifeline in November 1998. The terms of the agreement were pure IMF boilerplate: Use IMF money to defend the currency; raise interest rates further; commit to huge fiscal cuts. This program lasted just eight weeks before it collapsed. Like the Russian plan the previous summer, it did nothing to restore market confidence, to ease the hemorrhaging of reserves, or to bolster the internal political equilibrium in favor of the chosen economic policies.
When the real collapsed in January 1999, the Brazilian team rushed back to Washington for "further instructions" from the IME They got the same package-high interest rates and budget cuts-but without a fixed exchange rate. This time, however, even the IMF acknowledged that the Brazilian economy was in collapse. Its dreary November forecast (growth of -1% in 1999) had further darkened, to a projected -4%, by March. In recent weeks the real has stabilized, and Brazil is tiptoeing back into the global financial markets. But the economy is hardly out of the woods, and the damage caused by the futile effort to hold the line on the exchange rate will endure.
What should have been done? The principal error was to defend the exchange rate at all costs, living with high interest rates for one and a half years, and running down foreign exchange reserves to dangerous levels.
John E Kennedy once observed that "success has a hundred fathers, while failure is an orphan." But even if nobody will accept the blame, the reasons for policy debacles are usually manifold. Before more patients are needlessly lost in the IMF's emergency room, it's worth trying to disentangle how the blunders were made.
One culprit, of course, was the Brazilian government. As in many other countries, the economics team fell in love with the pegged exchange rate. After all, the price for stabilizing the currency had been the presidency of Brazil. How could it be easily forsaken?
History has shown that stabilization based on exchange rates often leads to severe actual appreciation of the currency. Hence, the initial pegged rate should have been followed by either a devaluation or a flexible system (as was done, for example, in Israel in the 1980s and Poland in the early 1990s). For once inflation has been wrung out of the system, a devaluation under noncrisis conditions will not reignite inflation. Brazil willfully ignored this simple lesson.
Second, Brazil's love affair with the pegged rate became embroiled in politics. Even after the real was under attack, the government refused to budge. Part of the reason, no doubt, was technocratic analysis: The pegged exchange rate, some argued, was best for Brazil. Another large part, however, was presidential politics.
With President Fernando Henrique Cardoso's reelection looming in November 1998 and with the stability of the currency his most noted achievement, even a modest devaluation looked too chancy. As in Mexico in 1994, the painful choice of currency adjustment was put off until after the elections. And as in Mexico, the collapse came in the immediate wake of the returns.
Third, Washington fell in love with Cardoso's administration and was intent on keeping it in power. Without doubt, America gave Brazil remarkable latitude to follow a course of self-destruction. United States officials plead now that it was Brazil's choice, not theirs. But it was Washington's decision to create a package of $41 billion in emergency aid, and this allowed Brazil to dig its own financial grave. The IMF developed a similar crush on the Cardoso administration, with the close relationship between the deputy managing director, Stanley Fischer, and President Cardoso seemingly contributing to a loss of judgment at the fund.
One intriguing hint that personalities overruled substance can be found in the technical papers of the IME In April 1998 the organization issued a document titled "Brazil: Recent Economic Developments" (www.imf.org). It reaches the conclusion that the actual appreciation of the real cannot be attributed to improvements in underlying productivity. In other words, the technicians argued that the currency was unambiguously overvalued, even as the IMF senior management continued to back the exchange rate peg.
Brazil is a mess this year. The human costs are enormous, though they will hardly be felt or even commented upon in the United States as long as the Dow Jones industrial average continues its miraculous ascent. The one reliable prediction is that the IMF will remain in charge of the outside world's policy toward Brazil. No matter how many blunders that institution makes, it remains the lone doctor on call. The IMF will urge Brazil to keep interest rates high and to cut spending sharply. In short, it will contribute to the economic contraction.
Jeffrey Sachs 44
Background: Adviser to nations making the move to market economies
Noted for: Advice to Russia, 1991-1994; design of Bolivia's stabilization program, 1986-1990; advocacy of "shock therapy"…