Balance of Payment Crisis

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Balance of Payment Crisis

• Brazil 1998-1999

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What is Balance of P. C.

• When a country that has a large budget deficit,
  it has difficulty maintaining a fixed exchange
  rate, ultimately facing a balance of payments
  crisis.
• This means that foreign exchange reserves are
  falling rapidly, or are being maintained only by
  a level of foreign borrowing.

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Four Zones of Economic Discomfort
Brazil has been located in Zone 3 for many years,
with varying degrees of underemployment and
current account deficits.
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Brazil in the 1990s

• After a decade of inflation rates ranging from
  100 - 3,000 per year (1984-1994), Brazils
  central bank made an effort during the 1990s to
  control inflation and public spending.
• Inflation dropped from an annual rate of 2,669
  in 1994 to 10 in 1997
• 1994 Brazil government reissued the real and
  instituted a crawling peg
• The real was initially pegged to the US Dollar,
  which allowed Brazils currency to crawl upward
  against the at a moderate rate.

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Brazil in the 1990s (cont)

• The new currency, combined with high interest
  rates stabilized inflation for the first time in
  decades but
• ..there were bank failures and unemployment all
  over the country.
• Unemployment climbed from a low 6 in 1988 to 14
  a decade later.
• Due to high interest rates, investors dumped
  money into the Brazilian economy at extraordinary
  rates.
• The real now faced real appreciation.
• The rate of crawl of the exchange rate lt
  (Brazilian inflation Foreign inflation)

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Brazil in the 1990s (cont)

• 1997 - Foreign direct investment (FDI) grew by
  140 over the year before.
• The table below shows the rapid increase in FDI
  and international reserves.

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Brazil in the 1990s (cont)

• 1998 - Investors expected Brazils central bank
  to eventually devalue the real.
• Over the previous two years (98-99) the central
  bank was able to use its foreign exchange
  reserves to prevent the currency from drastically
  depreciating.
• In an effort to slow the outward flow of capital,
  the central bank raised interest rates.
• Between 1996 and 1998, Brazils international
  reserves dropped by 24 billion or 40.
• The IMF (International Monetary Fund) provided a
  41.5 billion loan in 1998 to help Brazil defend
  its currency.
• But markets remained hopeless and the plan failed.

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Current Account Reserves

• In addition, Brazil was running consistent
  current account deficits starting in 1995.
• As seen in the table below, Brazil started
  depleting its reserves in 1997 and 1998 to
  finance the current account deficit.

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Brazil in the 1990s (cont)

• 1999 - Brazil owed 244 billion (46 of GDP) to
  foreign creditors.
• Despite efforts to raise taxes and control
  government spending, Brazils yearly governmental
  budget deficits remained in the 6-7 range
  throughout the 1990s.
• The current account was in deficit, exchange rate
  reserves were declining, and unemployment reached
  its highest level in over a decade.
• January 1999 - The central bank decided to
  devalue the real by 8 and allowed it to float so
  it would no longer be pegged to the U.S. dollar.
  By the end of the month, the real depreciated 66
  against the U.S. dollar.

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Devaluation of the real

• Soon after the real depreciated its value,
  recession followed as Brazils government
  struggled to keep the real from losing its worth.
  
• Luckily, inflation did not rise.
• The recession diminished as Brazils export
  competitiveness was renewed and investors slowed
  their withdrawal from the real, resulting in
• Increase in the money supply
• Increase in reserves
• Interest rates lowered

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Waiting to happen

• Brazils actual economic data leading up to the
  devaluation is consistent with the balance of
  payments crisis model
• rapid expanding current account deficit
• constant government spending
• The Russian Financial Crisis in 1998
• Russias 1998 default on its debt had
  international investors in panic. Investors that
  previously had confidence in Brazils economy
  suddenly lost faith in the governments ability
  to maintain the reals crawling peg.
• The B.O.P. crisis model is the best way to
  analyze Brazils devaluation. In all, investors
  had good reason to believe that the central bank
  could no longer maintain the crawling peg.

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The DD-AA Model
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The DD-AA Model

• This model assumes an initial starting point at
  full employment (point 1) however, with an
  unemployment rate above 14 in 1997 and 1998, it
  is likely that Brazils output was well below
  full employment.
• With IMF support it is possible that Brazil could
  have avoided devaluation.
• In addition to building reserves, the central
  bank may have hoped that the devaluation would
  increase output to full employment levels.

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The Aftermath

• While currency devaluation might help a country
  improve its CA deficits and return the economy to
  full employment, there are some negative aspects
• Brazils large public debt held in U.S. dollars
  was instantly increased with the depreciation.
• Once the real was devalued, the central bank lost
  its credibility and had little choice but to form
  some sort of floating rate.
• Which makes it difficult to revert back to a
  fixed rate system that only functions if
  investors trust the central bank and become less
  risk averse.
• The devaluation also tensed relations with
  neighboring countries like Argentina who are
  deeply affected by Brazils economic policy.
• On the positive side, each year since the
  devaluation, the current account has improved and
  in 2003 it was positive for the first time since
  the early 1990s.

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Conclusion

• Looking at Latin Americas unstable economic
  history, its obvious that a fixed exchange rate
  was not the only cause of Brazils economic woes
  of the 1990s, nor is a floating exchange rate
  going to fix all of Brazils economic issues.
• Under this floating rate system, the government
  will now be tempted to print money freely in
  order to pay off debt. Inflation is the primary
  reason that Brazil adopted a crawling peg in the
  first place.
• Instead the Brazilian government must control its
  public debt and budget deficit spending.

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Conclusion

• Recently Brazils government has taken spending
  more seriously.
• In 2005 foreign debt was at its lowest point
  since 1997
• In addition, the 2004 budget deficit was at a low
  3 of GDP.
• Brazil has also managed to keep their exchange
  rate under control.
• Low inflation
• disciplined fiscal policy
• a floating exchange rate
• Although Brazil still has budget deficits and
  owes a sizeable amount to creditors, the country
  has taken steps toward more stable economic
  policy. Brazilians can only hope that these
  policies lead to economic growth for Latin
  Americas largest economy.