The Economist: Sachs to the IMF: Get Real
Sachs, Jeffrey, Global Finance
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. …