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Friday, January 22, 1999 Published at 19:40 GMT

Business: The Economy

Brazil - a catastrophe in the making?

Will the economic crisis hit the poor?

How did Brazil get itself into a position where it was forced into a dramatic currency devaluation? Why was the strength of the currency, the real, considered so important? And are the consequences of a devaluation likely to be catastrophic? The BBC's Brazil correspondent Stephen Cviic explains.

There are many factors behind Brazil´s currency crisis, but to understand what has been going on in Latin America´s largest country, it´s important to look back to the events of the 1980s.

In 1985, the military government which had ruled Brazil for 21 years finally handed over power to civilians. In political terms, the transition was a great success. Brazil's military had allowed democratic politics of a kind to continue during much of their rule - elections for Congress and state governor for example - so it was not too difficult for the country to pick up its tradition of lively debate and hard political bargaining.

But in economic terms, the military inheritance was distinctly shaky. Brazil had undergone a huge transformation in the years since World War II. Most of its population lived in cities and the country had built up a powerful industrial base, making it one of the most important economies in the world.

[ image: Cardoso won a second term]
Cardoso won a second term
However, Brazil was plagued by a tradition of wasteful and irresponsible government spending, exacerbated by the country´s loose federal structure, which allowed state governors and town mayors to add their share to the growing budget deficit.

This led to inflation. Brazil was also an extremely closed economy, which meant that its industries were not in a good position to compete on world markets. Many of the rich managed to avoid paying tax.

The weak educational system - among other things - condemned millions of people to lives on the margins of society.

In the first flush of democracy, Brazil´s politicians made things worse. The new constitution of 1988 had widespread support at the time from most of the centre and the left, and many of its aims - such as providing job protection for civil servants - seemed laudable, since they were intended to reduce political manipulation of the bureaucracy.

Constitutional millstones

But it´s now clear that some aspects of the constitution have become a millstone around the country´s neck. The most obvious of these is the pension system, which makes few links between contributions and benefits, and which gives some civil servants pensions higher than their final salaries.

[ image: Devaluation could mean inflation]
Devaluation could mean inflation
In the late 1980s, inflation started to reach stratospheric heights. This was inevitable, since it was the only way Brazil´s politicians could finance their fiscal irresponsibility.

The people who paid the price were the poor, since the cash they received could become virtually worthless overnight. The middle classes were able to get round inflation by putting their money in indexed bank accounts.

Indeed, the indexation of the economy became part of the problem, since it created new inflationary expectations.

In 1989, Brazilians elected Fernando Collor de Mello as their president. This young, charismatic figure from the north-eastern state of Alagoas was to last fewer than three years in the job before his fall as a result of a corruption scandal.

His attempts to deal with inflation were a failure, but he did make one important change - slashing trade barriers and opening Brazil´s economy up to the rest of the world.

Under Mr Collor´s successor, Itamar Franco, inflation continued to rise. In 1993, it reached an annual rate of about 2,500%. No-one seemed to know what to do.

The Real Plan

Then Mr Franco appointed Fernando Henrique Cardoso as his finance minister. Mr Cardoso was a left-wing intellectual gradually moving towards the political centre. He was not an economist. But he assembled a team of advisers who put together the "Real Plan".

[ image: The central banker had to go]
The central banker had to go
The plan was a complex and ingenious attempt to defeat inflationary expectations by substituting the old currency for something known as a "Unit of Real Value".

In time, the URV was itself replaced by the new currency, the real. The idea was to use the real as one of the pillars of monetary stability, pegging it to the dollar and therefore restricting prices rises for imported and tradeable goods.

At the same time, the government was aware it would also have to deal with the basic, underlying problem - the budget deficit.

The Real Plan was a huge success, enabling Mr Cardoso to win the presidency in 1994 at the head of a centre-right coalition. The poor voted massively for FHC - as he was known, after his initials - since the Real Plan had suddenly given them a new burst of spending power.

Beating inflation

Between 1994 and 1997,consumption of chicken rose 40%, car purchase rose 30% and inflation sank to depths not seen for decades. In 1998, it was virtually zero.

Despite an early shock right at the beginning of Mr Cardoso´s first term, when the Mexican peso crisis shook the whole region, the omens from the international financial markets seemed favourable. Billions of dollars in both direct and indirect investment flooded into Brazil, which became one of the world´s most fashionable emerging markets.

But what of the budget deficit?

At the start of Mr Cardoso´s government in 1995, some generally favourable observers began to criticise him for his slowness in pushing through the constitutional reforms which would be necessary to get spending under control.

The president persuaded Congress to end state monopolies on sectors such as oil and telecommunications, opening the way for a series of massive privatisations. But reforms of the pension system, civil service and the tax system languished, partly because federal deputies and senators feared the consequences of unpopular measures.

Mr Cardoso and his advisers seemed more concerned with passing a constitutional amendment which would allow the president to stand for re-election. They succeeded.

The consequences

[ image: Markets went into panic]
Markets went into panic
In October 1997, some of the chickens came home to roost. At the end of that month, the Asian crisis hit Brazil, forcing the Central Bank to spend billions of dollars in foreign reserves to defend the currency. It was the beginning of a long drawn-out crisis.

The government reacted by doubling interest rates to almost 50%, announcing a fiscal austerity programme and pledging to push ahead with the constitutional reforms. Gradually, during 1998 the pressure began to ease.

The government and Congress relaxed. Parts of the austerity programme were never implemented; the pace of reform began to slow.

Politicians from the left - but not entirely from the left - were criticising the country´s entire economic model, saying it left Brazil too dependent on foreign capital and involved punitive interest rates, which were stifling growth.

But defending the real was the top priority for the government since it was the only way of ensuring that inflation remained low.

The Russian effect

When the Russian economy collapsed in August 1998, it caused immediate repercussions in Brazil. The budget deficit was heading for 7% of Gross National Product and foreign investors didn´t like what they saw.

Tens of billions of dollars flooded out. This time, the government knew it would have to take concerted action, or the real would perish.

In the middle of an election campaign, President Cardoso reaffirmed his commitment to the real, and said the fiscal adjustment would be speeded up. The authorities promised to save more than $20bn in 1999 through tax rises and spending cuts.

In exchange, the International Monetary Fund coordinated a $41bn loan which would gradually be disbursed if Brazil met its targets.

The problem, once again, was that many of the austerity measures needed to be approved by Congress. At first, all went well. But in early December, the lower house rejected a measure which would have increased civil servants´ pension contributions.

The markets began to smell blood. It was amidst this climate of extreme nervousness that Itamar Franco, the former president, once again arrived on the national scene. Mr Franco had become increasingly bitter over the past few years, because he felt Mr Cardoso was being given all the credit for the Real Plan when much of it should have gone to him.

He managed to get himself elected as governor of the state of Minas Gerais, the third most important in economic terms, and at the beginning of January announced his decision to declare a moratorium on debt payments to the federal authorities.

The final straw

Nervousness about Brazil turned into panic. By now, President Cardoso was himself convinced that the country would have to alter its economic course, since the high interest rates keeping the real in place were rapidly increasing government debt and stifling growth.

He would have preferred to have waited until a calmer moment. Instead, but with Brazil´s foreign reserves running dangerously low, he was forced to act.

On 13 January, the governor of the Central Bank, Gustavo Franco - one of the main defenders of a strong real - resigned, and his successor announced a widening and lowering of the real´s trading band against the dollar - in effect a devaluation of 8%. It was not enough. The markets wanted more, and on 15 January, the Central Bank - for the first time ever - allowed the real to float.

It was the most dramatic moment in Brazil´s recent history. On the positive side, the devaluation means that the country no longer runs the risk of running out of foreign reserves; exports will increase; and interest rates may eventually be allowed to fall.

But companies with debts in dollars will find them harder to service; and the government will now find it harder to meet its budget targets.

There is also the big question - what happens to inflation? It seems unlikely that price rises will reach the levels of the early 1990s, but among the poor, the prospect of renewed inflation will be greeted with gloom.

President Cardoso has also lost a good deal of his credibility, since he had linked himself so closely with the fate of the currency. It is possible that the devaluation will not lead to an economic catastrophe, but Brazil has now gone over the precipice, and it has no idea where it will land.

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