Brazil's Unwatched Borrowing

Op-ed from the Financial Times

August 27, 2002

The $30bn International Monetary Fund rescue package for Brazil raises a key question: how could a country recently characterised as a star performer again be on the edge of financial crisis after complying faithfully with its last IMF programme?

Does Brazil's crisis means there is something terribly wrong with the international financial system? Fernando Henrique Cardoso, Brazil's president, recently gave his own answer: "Rarely have markets behaved so openly against their own interests, ignoring fundamentals, creating false expectations."

There is something wrong. But it is not what Mr Cardoso has in mind.

Brazil has erupted into crisis because its policy-makers, private financial markets and the IMF have not paid enough attention to the country's steadily mounting debt problem. Contrary to what you often hear, some important fundamentals in Brazil have deteriorated over the past few years and the external environment facing it has also worsened.

The latest rescue package also shows that for all their rhetoric about withholding large-scale official financing when it is being used to prop up an unsustainable debt position, the IMF and the leading industrialised countries are not willing to do so when push comes to shove for larger emerging economies.

Sure, Brazil's competitive, floating exchange rate, its inflation-targeting framework for monetary policy, its primary budget surplus and its hedged banks put it in a better position than Argentina was before the latter's crisis. But Brazil's track record in some other important economic dimensions has been dismal.

In 1994, Brazil's net public debt as a share of gross domestic product was 30 per cent. Today it is almost double that-and this despite significant privatisation revenues and a tax ratio to GDP much above that of many emerging economies.

In not even one of the past eight years has Brazil's net public debt ratio declined.

Because a large share-more than 40 per cent-of Brazil's public debt is denominated in, or linked to, the dollar, it made itself hostage to the large depreciation of the real that has occurred in recent years. Is this the kind of fiscal policy and debt management behaviour that Paul O'Neill, US Treasury secretary, and the IMF want to hold up as the model for emerging economies?

Debt build-ups become more troubling when economic growth slows. This year, the Brazilian economy is expected to grow by about 1.5 per cent compared with almost 4.5 per cent in 2000.

The picture of external debt and financing requirements is no better.

Brazil's ratio of external debt-public and private-to exports stands at more than 400 per cent. Since 1980 only one emerging economy, Chile, has been able to bring down a debt ratio from high to more moderate levels without significant debt restructuring. Brazil's annual external debt service ratio is a sky-high 90 per cent. These ratios are so poor because its export sector, like Argentina's, is a mere 10 per cent of GDP-about one-fifth of those of average Asian emerging economies, and below half those of Mexico and Chile.

In 2000, Brazil recorded a current account deficit of 4 per cent of GDP, slightly higher than the deficit expected this year. But at that time Brazil was receiving $33bn in foreign direct investment; this year, it will be fortunate to get half that amount. With external financing requirements next year of $45bn-$50bn, there is an urgent question about where the money will come from. Brazilian companies are already facing an external credit crunch and their efforts to cover foreign currency debt payments have contributed to the steep decline in the real this year.

In addition, there is the uncertainty about who will be governing Brazil after the election. This makes it harder to lay out a credible, multi-year plan for key economic policies. Little should be expected from broad pledges to honour contracts and maintain a given primary budget surplus.

Given all the above, little wonder that since the start of the year markets have more than doubled the interest rate spread on Brazil's benchmark bonds.

No one wants an IMF that is so risk-averse that it forsakes lending to all but the Switzerlands of the world; or one that is so preoccupied with minor technical issues that it is willing to stand aside in the face of a widening and deepening financial crisis in Latin America. But the IMF has no future if it does not speak out forcefully about debt vulnerabilities when they are on the rise, and even more so if it cannot make debt sustainability a core condition for IMF financial assistance.

The IMF and industrialised nations failed to exercise that responsibility when they bailed out Argentina last August and Turkey before that. Unless they make future IMF disbursements to Brazil conditional on debt restructuring with appropriate macroeconomic and structural measures, I fear they will do so again.