Last Samba?

Last Samba?

The Brazilian Real was hit by speculators who were betting that
Brazil would be the next developing economy to go down the tubes victim of the Asian
malaise. Brazil is no Russia however. Being one of the ten biggest economies in the world,
a debt default in Brazil would bring down all South and Central American economies,
pulling into recession the U.S. economy.
By Basil M. Karatzas

Brazil has been the latest victim of the Asian flu, the turmoil in financial markets
that started in the summer of 1997 from the "tiger economies" of the Pacific Rim
and spread to Russia and the equity markets across Europe and the Americas. The tremors of
this Asian contagion were so severe that they have made international markets strategists
wonder whether this is only a bad case of flu.

Brazil was assumed suspect by association of possibly defaulting on its debt payments.
Its currency (Real) was hit by speculators who were betting that Brazil would be the next
developing economy to go down the tubes. The odds that Brazil would become the Russia of
the South America were so strong, that just in September and October of this year,
approximately $50 billion dollars in hard currencies flew out of Brazil. To put this into
perspective, it is equivalent to about one billion dollars per diem, or 70% of
Brazil’s foreign currency reserves.

However, Brazil is no Russia. Brazil is extremely rich in numerous natural resources,
including world class production of agricultural products such as coffee, citrus and
sugar. Partially based upon agriculture and partially based upon industry, Brazil’s Gross
Domestic Product (GDP) for 1997 was a staggering $820 billion, which increased by 3.2
percent units over the previous year. On the other hand, Russia presents a miniscule world
economy (Russia’s 1997 GDP was $230 billion), smaller than the state of Connecticut, and
it has an obsolete industry that produces no exportable products.

Not only has Brazil one among the ten biggest economies in the world, but it also is
geographically close and financially even closer to the United States. A debt default in
Brazil will bring down all South and Central American economies, which consequently will
pull into recession the U.S. economy per se. The Brazilian economy consists of 43%
of the GDP of all South American countries. Reportedly, U.S.-based banks have loaned
approximately $34 billion in commercial loans to Brazil and Brazilian interests, while
Brazil’s debt to the outside world is approximately $194 billion (about 23% of the GDP).

In addition, Brazil has done tremendous steps forwards in the last decade in terms of
modernizing its economy. Although still a lot is left to be desired in terms of open
market conditions, distribution of wealth and mainly current accounts deficits, Brazil has
managed to tame four-digit inflation rates to, a still high, but respectable 15%. In
contrast, Russia has no traces of democratic tradition (from czarism to communism and now
to "duma-ism"). Moreover, corruption levels in Russia not only dwarf Brazil’ own
corruption problems but they occasionally make Al Capone look like an angel. A tangible
example of modern distribution of wealth in Russia is the "privatization" method
whereby most of the state companies were simply bequeathed to former party Cossacks.

Brazil also happened to be lucky in the sense that its turmoil came after the
International Monetary Fund (IMF) and the world community had climbed a few steps on the
"Economy Salvation" learning curve. In the financial packages that were allotted
for the tiger economies and Russia, the installments of the loans were mainly back-loaded.
In other words, the loans were reactive: most of the installments of package aid were
mainly available at the end of the term of the arrangement. This obviously was more sort a
"last rites" approach than the drastic therapeutic medicine required, as proven
in the case of Indonesia and Russia. In the case of Brazil, the loan is front-loaded,
assuming certain conditions are consummated.

From the $42 billion package arranged with the IMF and the Inter-American Development
Bank, up to $37 billion can be available in the first twelve months of the arrangement
through the Supplemental Reserve Facility. This gives Brazil the luxury to sustain
extensive attacks on its Real and be proactive before major financial problems emerge. In
exchange for these special terms, Brazil has promised to a) expedite domestic financial
reforms, upon their fulfillment are based future installments of the loans, b) abbreviate
the payback period, and c) pay higher interest rates (approximately five percent higher
than the rate at which the U.S. Treasury finances its debt). However, unlike Mexico who
had to collateralize its loans from the U.S. in 1995 with its oil exports, Brazil did not
have to make such a commitment.

Cuts and Reforms

Is the Brazilian economy out of the woods? Has the storm calmed down and from now on
smooth sailing should be on the horizon? Current reality in the world equity markets
suggests that the worst has passed. For instance, the Dow Industrials jumped from a
negative year-to-date performance in October to new highs in November as if the Asian flu,
and Russian and Brazilian concerns have been resolved permanently. Equity markets,
nevertheless, are known for pendulous behavior and today’s assumed "happy-end"
scenario might seem too precarious in a few days.

The Brazilian economy is not out of the woods yet by any means. The country has to
finance an astronomical debt of $300 billion dollars. Despite progress that has been
achieved since current President Cardoso introduced the Plano Real in 1994 as a Finance
Minister, the debt is excessively high by any measure. As Brazil’s synonym
(hyperinflation) has calmed down, an excessive debt and the associated need to finance
such a high debt might bring the country to the brink of a financial calamity.

President Cardoso in order to secure financing from the IMF and mainly the U.S., had to
introduce plans of domestic spending cuts and social reforms. In the proposed three-year
austerity plan, approximately $84 billion in social and other benefits were trimmed. While
these will hurt across the board, it is the poorer strata of the population that will
especially feel the heat. In a country already notorious for uneven distribution of
wealth, further cuts for the poor might incite social unrest, increased crime rates and
further bounce back of foreign investment.

In a country that made enormous steps in the last decade in terms of developing the
economy, the recently "middle-classified" population who were able to find jobs
and get a taste of a westernized economy, going back to poverty conditions might push them
to be more vocal and un-cooperative for the required reforms. A little taste of capitalism
is a dangerous thing, and it is expected that 1999 will be a recession year in Brazil.

It is still early to annunciate whether Brazil will survive unscathed this turmoil.
There are tremendous fiscal (debt, etc) and social (poverty, illiteracy, etc.) issues to
be resolved before the road to financial happiness can be savored. Brazil, nevertheless,
is a richly dowered country with natural resources. Moreover, Brazilians have proven time
and again that they are capable of surviving perturbations and worth of attracting foreign
investments. After all, adjusting for political risk, Brazil offers a much higher
reward-to-risk ratio for foreign investors than other much touted countries, such as
Russia and China.

Basil M. Karatzas is graduating in May 1999 with an MBA degree in
international Business from Rice University, in Houston, TX. Basil also serves as
President for Platinum Holdings International, an international management and capital
consulting firm, and can be reached at

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