Courtesy Reuters

PANIC ATTACK

On October 27, 2002, Brazil elected as its president Luis Inacio Lula da Silva, known to all as Lula. Although Brazil emerged from military dictatorship less than two decades ago, and there is supposedly much disillusionment with democracy in Latin America, the election was a model of democratic propriety and participation, with a lot to teach to countries with a much longer democratic tradition. This was despite the fact that the campaign was marked by a panic in the financial markets as Lula, the candidate of the left-wing Workers' Party (PT), gained and sustained a strong lead over his opponents. Now that he has won by a landslide, the key questions facing Brazil are whether the panic will subside or deepen, and whether the Lula administration's policies will advance the modernization of Brazil and accelerate its growth rate and social progress or turn the clock back to old-fashioned socialism.

The timing of the financial panic leaves no doubt that its immediate cause was the prospect of a Lula government. But it was the high level of public-sector debt that had been built up during the government of Fernando Henrique Cardoso, his distinguished predecessor, that made the country vulnerable to a loss of confidence in the first place. This large public debt was the consequence of a fiscal splurge in the early years of the Cardoso government, when the financial markets were thrusting money on emerging markets. The splurge's effects were magnified by the severe depreciation of the real after times turned difficult in a context where much of the debt was indexed to the dollar. And even though fiscal policy was tightened in 1997-99, such that Brazil now has a large primary fiscal surplus (the budget surplus excluding interest payments), high interest rates plus the continued depreciation of the real have kept the debt growing.

The panic was extreme. The real had already depreciated substantially in 2001 as a result of contagion from the Argentinean financial crisis (the common assertion that this crisis produced no contagion is false), and it lost a further 40 percent of its value in the six months before the election. At the end of April 2002, the spread between Brazil's benchmark ten-year government bonds and their U.S. equivalents was less than 8 percentage points; at the height of the crisis it rose to more than 24 percentage points before dropping somewhat. Likewise, the main stock index in Sao Paulo fell by a third between the end of April and the election's first round of voting on October 6 (although it, too, recovered significantly before the second round of voting).

Economists had more or less convinced themselves that acute crises of this sort happen only when governments try to defend an exchange rate, but here was a major crisis that occurred when the government was doing everything by the book: it could boast a floating exchange rate, inflation targeting implemented by a respected central bank governor, and a large primary fiscal surplus. The explanation is that this time around the panic had a quite different cause: Lula's past support for debt repudiation. The markets doubted that he would impose the sacrifices required to sustain debt service, and fears that a default might be in the offing spurred a rush for the exit. Once started, the panic became self-reinforcing, especially because every depreciation of the real increased the debt burden.

THE DEBT TRAP

The fundamental question is whether Brazil's debt dynamics are sustainable or explosive. Explosive debt dynamics arise when the interest on the debt is so high that the debt gets progressively bigger relative to GDP, notwithstanding the primary fiscal surplus. If debt dynamics are explosive for all politically feasible levels of the primary fiscal surplus, then the game is up -- default is inevitable. Some economists have observed that the Brazilian debt-GDP ratio has continued to rise in the last couple of years even though Brazil had been achieving a very substantial primary fiscal surplus. From this they conclude that the debt dynamics are explosive.

In contrast, economists who have gone more carefully through the figures and controlled for unfavorable developments such as the real's depreciation have reached less dire conclusions. My own research, for example, has shown that if medium-term growth averaged 4 percent, if annual inflation were 3.5 percent, if the primary surplus were maintained at 3.75 percent of GDP, and if the real appreciated back toward a plausible figure for its equilibrium value, the debt dynamics look sustainable. But for all that to happen and for Brazil to avoid debt restructuring, it will need both prudent policies on the part of Lula's government and a return of reason in the financial markets. Without doubt, the former would make the latter more likely, but there is no guarantee that continued responsible Brazilian policies would be rewarded by a return of market confidence. The odds are in favor of Lula's government's being able to avoid a meltdown unless it makes an error that provokes a new crisis -- but the odds are not as overwhelming as one would like them to be.

Another question is whether Lula's government will indeed be anxious to avoid a debt restructuring. A voluntary restructuring of the debt that simply lengthened maturities would not solve Brazil's problem, which involves not liquidity but an excessive level of debt and extraordinarily high interest payments. A restructuring that reduced the value of the debt or the rate of interest would amount to a partial debt default, which is what the financial markets have feared.

About 80 percent of Brazil's public-sector debt is held internally, and a good chunk of its externally held debt is owed to international financial institutions (where its present value could not be reduced through restructuring). Even if Brazil halved the value of its restructurable external debt, it would reduce the value of its entire public-sector debt by only about $28 billion, or a little more than 10 percent. That saving would not be enough to resolve the debt problem, especially since a restructuring of external debt would harm the reputation of the Brazilian government and hamper its ability to roll over (that is, extend) maturing domestic debt at reasonable interest rates. Moreover, foreign investors would be unlikely to accept a restructuring that exempted their domestic counterparts. Hence any debt restructuring would need to include domestic debt as well.

The traditional argument against debt default is that proven bad debtors will find it more difficult to borrow in the future. The counterargument asserts that one of the biggest deterrents to market access can be an excessive debt burden, so a debt restructuring that reduces a country's level of debt may actually make it easier for that country to borrow more. This may be true at the international level, at least if a debt restructuring occurs after a shock has clearly undermined a country's debt-servicing capacity. But at the domestic level, lenders can respond to an unpromising situation by sending an increased proportion of their money abroad. To counter the incentive for such capital flight, therefore, a government lacking effective capital controls must offer a high domestic rate of interest. In this context, Brazil's past record of periodic debt defaults (the most recent of which was in 1990) helps explain the extraordinarily high domestic rates of interest that have prevailed there in recent years.

A second argument against domestic debt default is the impact that it would have on the country's financial system. Brazilian banks are in sound financial shape at present, but they hold about 30 percent of their assets in Brazilian government bonds and have capital of more than 10 percent (2 percentage points above the 8 percent recommended by the Basel Accord, the internationally agreed-upon capital standard). The banking system would therefore face insolvency if Brazil wrote down its government debt by half, even if banks were temporarily absolved from the responsibility of adhering to the Basel requirements. And if the government bailed out the banks, it would get virtually no debt relief on that part of the debt that the banks hold. A debt default would also threaten other parts of the Brazilian financial system, such as pension funds. And undoubtedly many other private-sector debt contracts would have to be renegotiated.

The third argument against debt default is the deleterious impact it would have on the institutional integrity of a market economy, the health of which depends on a legal obligation to fulfill contracts. A government that announces it will relieve itself of that obligation when it becomes onerous will find it difficult to nurture the emergence of a vigorous private sector.

Finally, debt defaults inevitably have a deflationary macroeconomic impact. If the government reduces its debts by 16 percent of GDP (a rough estimate of what would happen if Brazil wrote down by half its non-bank-held domestic debt), then it will also reduce the wealth held by the private sector by 16 percent of GDP. Just as a fall in U.S. stock prices has a deflationary impact on the U.S. economy, a domestic debt default would be bound to reduce demand. The government could step up its spending by the same amount that its interest payments are reduced, but that would not be enough to avoid net deflation if interest rates rise, as would naturally happen in the above scenario. This argument is consistent with the observation that debt defaults have not historically been a prelude to periods of prosperity. A debt default by the Lula government, even if less catastrophic than that in Argentina, would fatally undermine the PT's chance of establishing a reputation for competent economic management. It would likely make the party's presidential candidates unelectable for at least a decade.

IF CONFIDENCE RETURNS

If Lula's government succeeds in reestablishing confidence that the debt will be honored, however, then the outlook for eventually reducing Brazilian interest rates is good. The fear that the government will take the easy path of default when it faces a problem will disappear. The concern that an irresponsible leftist was waiting in the wings to expropriate wealth will have been disproved by events. Brazil's high inflation was conquered in 1994, so the period of high real interest rates that usually follows high inflation should now be over. A Lula government will want a competitive exchange rate to help get the economy growing again, rather than wanting high interest rates to hold the real up. In short, once the problem of accelerated inflation that has resulted from the depreciation of the real has been overcome, none of the drivers of the high interest rates of recent years would remain. Allied with the export boom that has already led to a dramatic turnaround in Brazil's current account, the resulting lower interest rates should prompt more rapid growth than Brazil has experienced in recent years. This is not to say that 2003 is likely to be a boom year for Brazil, but the payoff from deferring gratification could be substantial.

The Lula government thus has a strong incentive to avoid a debt default, even if that means raising the target for the primary fiscal surplus yet again and delaying hopes of five percent growth (a campaign promise) until the second half of Lula's term. This will mean resisting pressures from parts of his core constituency for large immediate increases in public expenditures, or else financing some expenditure increases by cuts elsewhere. Whether the PT will prove sufficiently disciplined to acquiesce in the short-run costs of such an investment in longer-run prosperity is unclear, but the signs so far are hopeful.

THE END OF THE WASHINGTON CONSENSUS?

During the election campaign Lula repeatedly promised to change the country's economic model, usually thought of in Brazil as having been something called the "Washington Consensus." Popular opinion often focuses on the specifically neoliberal bits of the Washington Consensus (a term I coined 13 years ago), such as capital-account convertibility and the minimal state that accepts no responsibility for income distribution, and these elements have indeed been problematic. But the basic notions that were embodied in the original concept of the Washington Consensus -- macroeconomic discipline, the market economy, and opening up the economy to foreign trade -- were precisely the things that Lula embraced in the course of moving to the center of the political spectrum to make himself electable.

That is not to claim that Lula's program will be cloned on my original list of policy points that Washington felt Latin America needed to reform. I deliberately excluded redistributive measures from that list because there was no unanimity about their desirability, but clearly Lula has no doubts that such measures are desirable. He has already announced a food-stamp program to combat hunger and an intention to step up sanitation measures and the construction of low-income housing. He also intends to double the minimum wage over four years and keep the marginal income tax rate at 27.5 percent (rather than cut it to 25 percent as had been previously planned). One can expect further expansion of the social agenda and more measures aimed at helping the poor and evening out Brazil's highly inegalitarian income distribution. Lula's embrace of the market economy is unlikely to go to the point of completing the privatization of the Banco do Brasil or going back on his commitment to create some form of industrial policy. One must hope that his supporters accept such changes as constituting a change of the model.

TRADE POLICY

Lula has often denounced U.S. proposals for a Free Trade Area of the Americas (FTAA) as amounting to a de facto U.S. annexation of Latin America. He prefers reinvigorating Mercosur, the trade block comprising Argentina, Brazil, Paraguay, and Uruguay. ThePTwas even one of the sponsors of an unofficial referendum held in Brazil in September that overwhelmingly rejected joining an FTAA. Yet in seeming contradiction, his transition team has indicated plans to continue negotiations for an FTAA. Where does that leave the prospects for reaching an agreement?

There is a lot at stake in these negotiations. Brazil is one of the few countries that traditionally imports more from the United States than it exports to it, one reason being that the United States has particularly ferocious protection on the goods that Brazil is well placed to sell (such as citrus, steel, and sugar). An FTAA that freed Brazilian exports of such restrictions could easily double or triple Brazilian sales to the United States. An effective FTAA could thus potentially offer major benefits to Brazil of exactly the sort that Lula envisaged when he spoke of his desire to make Brazil an export power. Moreover, some important U.S. sectors, such as producers of capital goods, would also expect to benefit from an FTAA. But the Lula government (like any Brazilian government) will sign on to an FTAA only if the deal offers a genuine prospect of realizing the potential benefits to Brazil -- and in this regard two subjects, agriculture and antidumping duties, are likely to be particularly vexing.

Brazil is a country of immense agricultural potential. It exported $9.2 billion worth of agricultural products in 2000 and could undoubtedly increase that amount substantially if the market opportunities existed. The Bush administration has already indicated a willingness to liberalize agricultural trade under the auspices of the World Trade Organization's forthcoming Doha Round. If implemented, that liberalization would boost American agricultural exports to Europe and Japan, thereby offsetting increased U.S. imports from Argentina and Brazil. There is an obvious common interest between those two South American agricultural powers and the United States in pursuing such an agenda. However, the recent Franco-German deal to freeze the substance of Europe's highly protectionist Common Agricultural Policy until at least 2006 has put hopes for a WTO agriculture deal on hold. Meanwhile, an FTAA deal to open agricultural markets would be all loss and no gain as far as American agribusiness is concerned. Thus it seems unlikely that either the Doha Round or the FTAA will be consummated until about 2007, assuming that Brazil does indeed insist on gaining access to the U.S. market for agricultural goods.

The second sensitive area involves antidumping duties and similar forms of process protection. The North American Free Trade Agreement allows the United States to limit imports from Canada and Mexico if their goods are considered cheap enough to be "dumped." It seems doubtful that Brazil will be equally accommodating, but the U.S. Congress will insist on similar provisions in any future deal. Optimists hope that protectionist opposition in the United States will be overcome if the negotiators wrap major concessions on these issues into a larger package that will prove attractive to Congress.

In addition, there is the question of financial services. Here the problem is not U.S. resistance to opening its markets, but potential Brazilian resistance to keeping its markets open for U.S. financial institutions. There were stories during the recent crisis about how Brazilian banks were continuing to roll over their maturing assets while foreign banks were converting everything they could into dollars. If these stories are confirmed, the Lula government might well seek a way for Brazil to protect itself against such behavior. Perhaps the United States will accept whatever the Brazilians come up with provided it is consistent with the principle of national treatment, but it might prove to be a contentious issue.

In short, there are several reasons for doubting that the FTAA negotiations will reach a speedy conclusion. But since both Brazil and the United States stand to reap large gains from an agreement, the hope is that they will eventually manage to find a package that is acceptable to them both, as well as to the other countries of the western hemisphere.

WHAT'S LEFT?

Lula's election has led to a wave of optimism in Brazil. His victory reflects pride that Brazil has risen above its elitist past and used its vibrant democracy to elect a president from a humble background. There is also hope that thePThas a new economic model that will somehow work without rejecting the essentials of a market economy or reverting to high inflation. And perhaps there is also an element of pride in defying international financial markets that gave the impression of thinking they could dictate the choice Brazil should make.

Lula's Brazil is not likely to be as easy a partner for the United States as was Cardoso's, but neither does it show signs of refusing partnership. Much will depend on whether Lula's administration succeeds in overcoming the financial crisis that blew up during the election. If it cannot, the outlook is bleak. If it can, its policies may not generate a new miracle, but they may at least lead the region into a less unstable future. The Bush administration surely appreciates the importance of Brazil's succeeding. But Washington also recognizes that -- barring such politically unthinkable steps as unilaterally disbanding agricultural protection or tripling the size of its contribution to the International Monetary Fund -- its power to ensure Lula's success is limited.

  • John Williamson is Senior Fellow at the Institute for International Economics. Copyright (c) 2002 Institute for International Economics.
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