When Brazil floats its currency, everybody listens

Brazil, like its currency, is floating in a sea of uncertainty.

Forced to devalue the real last Wednesday, the government - after years of setting the exchange rate - yesterday decided to let the currency find its own value on the markets.

And in days ahead, other decisions will likely be made that could worsen or prevent a recession in Brazil this year.

An economically sound Brazil means much for the US economy. Latin America's largest nation is now the world's eighth-largest economy, and the fastest-growing market for American goods and services, accounting for $53 billion in US exports in the first 11 months of 1998. Last year, Brazil received some $25 billion in direct foreign investment.

A cheaper real is expected to stimulate investment, fuel exports, spare precious currency reserves, and, most important, lower interest rates. Brazil's current annual rate of 30 percent is one of the world's highest.

A devalued currency should permit interest rates to go down to between 15 percent and 20 percent by the end of 1999, many analysts say. That in turn would bring badly needed relief to the nation's recession, growing trade deficit, and rising unemployment.

Previously, an unlikely alliance of businessmen and workers had blamed the overvalued currency and high interest rates, which helped keep the lid on inflation, for strangling economic growth and raising unemployment to record levels. In fact, high interest rates were said to be the main reason the spending deficit rose to $65 million, or about 8 percent of Brazil's $800 billion gross national product.

Radical but necessary

"We paid a dear price for defending the old exchange rate - $43 billion," says economist Amaury de Souza, head of the political-economic think tank Techne in Rio de Janeiro. "Allowing the real to float is a radical but necessary move."

President Fernando Henrique Cardoso has had trouble winning congressional support for several crucial financial reforms to bring the budget under control, including rejection last year of a plan to tax pensions of retired state workers that would have saved the nation an estimated $2.5 billion. Now he is expected to have an easier time with Brazil's fractious Congress, which has reportedly been jolted by last week's events.

This week, Congress, now in special session, is expected to approve some $13 billion in spending cuts by levying taxes on all bank transactions and the previously rejected pensions of retired state workers.

"Congress is in a panic now," says Mr. de Souza. "It's scrambling to vote for anything Cardoso wants."

Brazil's tourists in America

Another group in panic is Brazil's middle class, who analysts say will be the devaluation's biggest losers. Under the real plan, as it is known here, they traveled abroad in record numbers and created a boom for imported goods. Last year, more than 1 million Brazilian tourists visited the United States, causing Brazil to become the fourth market for American tourism behind Japan, Great Britain, and Germany.

"With the devaluation, the middle class's dream of being a first- world consumer has ended," says Fabio Silveira, a So Paulo economist.

But for most Brazilians, the major fear now is a return to chronic hyperinflation, long the scourge of the economy. Under Mr. Cardoso, inflation had been reduced from nearly 3,000 percent a year to less than 2 percent in 1998. In fact, the president won two elections on the strength of keeping inflation down.

According to the Foundation Institute of Economic Studies in So Paulo, the recession and high unemployment should keep inflation from getting out of hand, and the devaluation should cause the annual rate to rise to between 6 percent and 7 percent in 1999.

Many analysts here say that Brazil's economic woes began with the Asian crisis of 1997, and that the nation continued to be vulnerable as long as the real remained overvalued and Congress failed to pass necessary legislation to correct the federal government's unsustainable budget deficit.

Friday's dramatic announcement to allow the real to float against the dollar caused the Bovespa index of the So Paulo stock exchange, South America's largest, to shoot up by 33 percent, the second highest performance in the exchange's history. The Dow Jones Industrial Average, which had been sagging because of Brazil's financial woes, soared by 220 points.

On Monday the central bank announced that it would continue to allow the real to trade freely against the dollar but would implement a "dirty float" policy, in which the bank intervenes only when it deems the devaluation has reached an unreasonable level.

"The Brazilian government is well aware of the successes of South Korea and Mexico after those nations freed up their currencies," says Edmar Bacha, an economist who helped devise Cardoso's stabilization program and now heads the BBA investment bank in New York.

Mr. Cardoso's abrupt decision to end the cornerstone of his economic policy came at the end of a chaotic week in which foreign investors pulled out $4.4 billion, world stock markets tumbled, and the respected president of Brazil's central bank resigned. New York's Standard & Poor's even downgraded Brazil's international credit rating to a lower level than Bolivia and on a par with Kazakstan, the former Soviet republic.

The trade deficit has reached $6.3 billion, unemployment is expected to reach 12 percent in 1999, and economic growth has been forecast at a minus 1 percent or more.

Fearing a prolonged crisis and a further drain on currency reserves - some $43 billion had left Brazil since last year's market meltdown - the central bank acted last week. On Friday the real soared from 1.32 to the dollar to 1.60, before dropping to 1.42, for a 17 percent total devaluation.

The final blow to the real plan came Jan. 6 when Itamar Franco, the former president of Brazil and now governor of the state of Minas Gerais, announced he would stop payment for 90 days on his state's $15 billion debt owed to the federal government.

The declaration added to fears that the federal government didn't have the political support to pass severe budget-cutting reforms, a condition for release of a $41.5 billion aid package from the International Monetary Fund (IMF). Cardoso has promised the IMF to trim the deficit this year by $19.3 billion.

Over the weekend, Finance Minister Pedro Malan and new central bank president, Francisco Lopes, traveled to Washington to talk with US officials, explain Brazil's new economic policy to the IMF, and, perhaps, revise their agreement.

Investors worried by politics

Brazil's 26 states and the federal district of Braslia now owe the federal government some $78 billion. Many newly elected governors like Mr. Franco say they cannot maintain essential public services and also pay their debts.

To date, Cardoso has refused to renegotiate with Franco. The federal government has an arsenal at its disposal to guarantee payment, including blocking federal funds destined for Minas Gerais.

On Sunday, Franco announced he would ask the justice system to prevent the government from keeping such funds. That was on the eve of Franco's attempt to build a broader coalition by hosting a meeting with six other opposition governors Monday in the Minas Gerais state capital of Belo Horizonte. The prospect of a protracted political opposition has some investors worried.

"Investors will want to know how many Itamar Francos there are in Brazil," Eduardo Cabrera, chief economist for Merrill Lynch, recently told reporters.

"The president will have to renegotiate," says Claudio Goncalves Couto, a political science professor at So Paulo's Catholic University. "The series of events unleashed by Itamar Franco has given the states more room to maneuver."