Brazil's looming economic crisis

Panic hit the Sao Paolo trading floors as the real fell

Analysis
By Jorn Madslien BBC News Online business staff

In times of war, military medics give priority to patients according to their chances of a quick recovery and their importance to the war effort.

Lula is considered scary by foreign investors

As such, US Treasury Secretary Paul O'Neill's decision to make Brazil his first port of call during his whirlwind tour of troubled Latin American economies, appears to have been the right one.

True, Brazil's economy has received a serious beating in recent weeks, with jittery traders hammering its currency, the real, to historic lows, and leading credit rating agencies raising questions about the country's ability to service its combined debts of more than $250bn.

Yet, it is widely agreed that rescuing Brazil's economy is not only possible: It is also crucial if the battle against Latin America's financial crisis is to be won.

External difficulties

Central to Brazil's economic woes are the economic crisis that has hit its regional comrades Argentina and Uruguay which were next on Mr O'Neill's list of countries to visit.

The real falls, then what?

The Brazilian currency, the real, lost 13% of its value during the week to 2 August 2002

On 31 July, the real closed at a historic low of 3.47 to the US dollar, down 35% since the beginning of the year

The weaker the real, the more expensive it becomes for Brazil to service its debts of more than $250bn

Investors tend to view Brazil as synonymous with Latin America, and as such its financial markets have been punished for mistakes made elsewhere.

But this does not mean that Brazil's problems are not real, nor does it mean that they are merely the result of trouble abroad.

Soaring unemployment at home, to a two-year high, has been widely blamed on the government.

This, along with other economic woes, has fuelled the popularity of the left winged Presidential candidate Luiz Inacio Lula da Silva ahead of elections in October.

The support for Lula, as he is known, is based on a growing resentment towards unregulated market forces which critics say has failed to deliver growth and prosperity, having instead caused the gap between rich and poor to widen.

Disgruntled investors

Investors, on the other hand, dislike Lula intensely.

Expensive bread in Brazil could be a sign of worse to come

They fear that if he was elected, he would ditch market friendly economic policies - such as privatisation, deregulation and liberal trade rules - thereby putting at risk the country's ability to raise fresh funds from the International Monetary Fund (IMF) and other international lenders.

"The market's mistrust is not in the current economic policy but in the possible future economic policy," explained WestLB economist, Horst Schoenebonn.

Such concerns have hit Brazil's stock and bond markets in recent weeks.

And on 31 July, the concerns sent the real into a tailspin which took it to a historic low of 3.47 against the US dollar, before bouncing back by the end of the week.

Local and global impact

For the Brazilian people, the real's plunge was brought home by higher bread prices.

O'Neill: A medic in the field?

Brazil imports 80% of its wheat, and given the currency's weakness its bakeries are having to pay more for their raw materials.

For the rest of the world, expensive bread in Brazil is merely an early symptom of what could become a major global headache.

Not only is Brazil's economy twice as large as its crisis-hit neighbour, Argentina.

It has also accounted for more than two thirds of all investment into Latin America.

Brazil is also a major customer for producers in the industrialised world, given that the US, Europe and Japan all export about three times as much to Brazil as to Argentina.

So whereas "global capital markets emerged relatively unscathed" when Argentina defaulted on its debts earlier this year, the "events unfolding in Brazil will have a much sharper impact on the global economy", the German bank, WestLB said in a research note.

Crucial rescue

The international community is therefore faced with a tricky dilemma.

On the one hand, bailing out Brazil may seem an obvious thing to do given the disastrous consequences of failing to do so.

But at the same time international lenders are loath to hand over more cash to already heavily indebted nations.

Such concerns were, rather crudely, expressed by Mr O'Neill last month when he said that Brazil must enact sound economic policies "so that [aid] does some good and doesn't just go out of the country to Swiss bank accounts".

But Mr O' Neill has since apologised and most observers have come to expect that the IMF will extend its current $16bn lending program to Brazil.

But some see further clouds on the horizon.

"We are sceptical of the chances of Brazil receiving any time soon a long-term agreement which would be sufficient to reduce the degree of uncertainty about the economic policies in the years to come," the UK-based bank HSBC said in a research note.