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Monday, October 5, 1998 Published at 13:33 GMT 14:33 UK

Business: The Economy

Is the Brazilian economy going nuts?

Don't worry about Russia. The real financial crisis will come if Brazil's financial markets collapse, explains BBC News Online's Andrew Yates.

The Brazilian economy is beginning to crack.

BBC economics correspondent James Morgan: "Latin America and Brazil have become the latest victims."
The country is on the verge of a crisis which threatens to throw Latin America into turmoil and scupper any recovery in global economic growth.

Money is disappearing from Brazil faster than its rainforests, as international confidence in the country's economy and its currency, the real, has collapsed.

[ image: Brazilian investors are not dancing for joy]
Brazilian investors are not dancing for joy
Since the start of the year Brazil's stock market, has undergone more gyrations than a samba dancer, and share prices are now 40% lower than they were last Spring.

The spectre of currency devaluation, recession and bank defaults has extinguished the carnival atmosphere the economy has enjoyed over the past few years.

And political uncertainty, with new elections held on October 4, has only served to heighten the economic crisis.

What has gone wrong?

For the past few years Brazil has been the economic darling of the developing world.

[ image: President Cardoso holds the key to Brazil's economic reforms]
President Cardoso holds the key to Brazil's economic reforms
President Fernando Henrique Cardoso has been able to stabilise the economy, bringing inflation down from a peak of around 3,000% to around 4%, getting economic growth back on track and introducing vital social and educational reforms.

But his tenure has been tarnished by one major failure. The president has been unable to push through crucial budget cuts and pension and tax reforms.

Brazil's government is spending far more than it can afford to.

Its budget deficit is running at more than 7% of the country's total output. And its trade deficit is mounting as the economic crisis in the Asia hits its export sales.

In other words the government faces a huge debt burden, that threatens its economic prosperity.

Bankers Trust's John Williams:"The economic fundamentals down there are relatively solid."
While this is certainly a problem, it is not a disaster.

However dealers who have seen the international financial crisis cause havoc in Asia and decimate the Russian economy, are looking for its next victim.

Panic selling

Investors have not been so panic stricken for years, perhaps decades. And they have seized on the first sign of trouble in the Brazilian economy and magnified its effects.

[ image: The time for celebrations is over]
The time for celebrations is over
The flight of money out of Brazil has reached alarming proportions.

More than $25bn has left the country since August, at a rate which sometimes exceeded $2bn a day.

And the flight has exacerbated Brazil's problems.

Deutsche Bank's Stephen Bell:"I can guarantee volatility will continue."
It is a vicious circle. Brazil's economic problems have prompted fears that the real is overvalued, causing more investors to bail out.

That has drained the government's reserves as it attempted to defend the real.

Reserves have dropped from more than $70bn several months ago to $50bn - and falling.

Which in turn has raised concerns that Brazil will run out of money, exacerbating the capital flight.

Devaluation disaster

The Brazilian government responded by raising interest rates to nearly 50% to encourage investors to keep money in the country.

However this can only ever be a temporary solution, as it adds billions of dollars a month to the government's bill of interest payments.

Barclays Stockbroker's Justin Urquhart Stewart discusses whether the economic crisis will continue
And once Brazil is forced to devalue the real, it would have disastrous consequences.

A cheap real would in effect raise the prices of foreign goods, fuelling fears that inflation could once again get out of control.

Not only that, it would make it harder for Brazil's government, companies and banks to repay dollar debts. This in turn would increase the probability of default.

Why Brazil matters

Forget Russia! If the Brazilian economy collapses, the impact on the world's financial system will be far more devastating.

To put it in context, Brazil's economy is twice the size of Russia, accounts for almost half of Latin America's total economic output and is the ninth largest economy in the world.

And unlike Russia, American banks have a heavy involvement in Latin America.

If Brazil goes under, it could even signal the end of six years of uninterrupted growth in the US economy.

Stuck between a rock and a hard place

President Cardoso has been stuck between a rock and a hard place.

Decisive action is needed to salvage the situation, namely slashing government spending and raising taxes.

Without desperate measures, everything the president has worked for may crumble.

[ image: The Brazilian election is crucial]
The Brazilian election is crucial
However to announce such unpopular measures just before an election would have been political suicide.

But President Cardoso appears to have retained power.

And his election victory is likely to prove a vital one for Brazil's economy.

If, as now seems likely President Cardoso wins the election in the first round of voting it will increase his leverage to push through radical reforms.

If his main rival Lula de Silva of the Workers Party, had been elected, many economists believed that the Brazilian crisis could only have deteriorated, with controls on foreign currency flows introduced and the repatriation of profits by multinational companies.

A way out?

President Cardoso's victory gives the country a lifeline.

He has already indicated that he is willing to tackle the budget deficit after the election by raising taxes.

And now President Cardoso is likely to come to a deal with the International Monetary Fund (IMF) to set up a 'contingency fund', backed by leading industrial nations to help replenish the country's reserves and shore up confidence in its financial system.

While the IMF has welcomed the proposed reforms, it has stopped short of committing itself to extending a huge line of credit to Brazil.

One reason is the fact that the organisation is facing a cash crisis of its own, running dangerously short of funds.

But the Brazilian government now hopes that more money will be forthcoming.

The leading industrialised nations of the world have come to realise that the future of the global financial system could depend on it.

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