Will This Weapon Wound Brazil's Inflation Dragon?

Can it really work this time? Brazil's policymakers are about to unveil yet another inflation terminator. With inflation now galloping at a 45% monthly rate and presidential elections set for yearend, the urgency to act is mounting. So on July 1, Brazil's central bank will ditch the shrinking cruzeiro and replace it with a new currency linked to the U.S. dollar called the real. The result, say economists, will be a sharp slowdown in the price spiral, to a manageable 3% to 5% monthly rate. That should give a big boost to the presidential aspirations of former Finance Minister Fernando Henrique Cardoso, architect of the plan.

To launch the new currency, Brazilian banks will swap cruzeiros for reals. That shouldn't be too difficult to pull off: Only $3 billion worth of cruzeiros are now in circulation. But as Brazilians become more confident about their currency, the amount of reals they are willing to hold is expected to grow.

HARD CUSHION. Although the real will be launched at 1-to-1 parity with the dollar to increase its appeal, it won't be freely dollar-convertible for domestic transactions the way Argentina's peso is. But the new currency will be backed by fistfuls of greenbacks. Brazil's central bank is expected to earmark up to $10 billion of its massive $38 billion reserve of hard currency for intervention in markets to steady the real's exchange rate, at least for several months. The hard-currency cushion is one reason why the current plan has a better chance of succeeding than previous Brazilian attempts to rein in inflation.

The plan has given a big boost to the stock market. In late May and June, a three-week rally lifted stock prices by 47% on the So Paulo exchange. "The market is rising primarily due to optimism regarding the issuing of the real," says Heitor Lima, head of brokerage operations at Rio de Janeiro investment bank Bozano, Simonsen.

But beyond that, the economy is in better shape, too. Cardoso has managed to push a reduction in Brazil's budget deficit through Congress. The deficit has been a prime engine of inflation. And a series of market-opening measures by former President Fernando Collor de Mello has forced Brazilian industry to become more competitive.

The economy could strengthen further if the currency plan succeeds. Consumer spending could be the first beneficiary as Brazilians discover that their paychecks actually hold up from payday to payday instead of evaporating into thin air. "We expect demand for consumer products to go up strongly, and we expect our sales to be pushed up indirectly," says Ronald J. Aldworth, director of auto-parts and farm-machinery maker Iochpe-Maxion.

One reason Brazilians won't be thrown into a tizzy about a new currency is that Cardoso gave them a dress rehearsal with an interim scheme. He devised the Unit of Real Value (URV), an index set daily to reflect roughly the dollar-cruzeiro exchange rate. Businesses and banks have been using URVs to establish prices. One worry is that Brazil's aggressive exporters could lose price-competitiveness in world markets as the currency stabilizes. But if the real becomes overvalued because of lingering inflationary pressures, as happened with the Argentine and Mexican pesos, Brazil will probably allow it to float within a narrow band.

The big uncertainty is the election, scheduled for Oct. 3, with a likely runoff on Nov. 15. In order for the anti-inflation plan to succeed, Brazil's next President and Congress will have to continue with much needed economic reforms, from budget-balancing to privatization of state-run companies. Cardoso, if he wins, could probably assemble broad backing in Congress for such measures. But Cardoso is trailing badly in public opinion polls behind charismatic former union leader Lus Incio Lula da Silva, the candidate of the leftist Workers Party. Even if Lula wins the election, he would probably have to moderate some of his tax-and-spend proposals. Still, business executives fear that a Lula victory could stall the reforms needed to buttress the new currency.

POLITICAL PLOY? Cardoso, lacking Lula's populist appeal, is pinning his hopes on a surge of popularity among voters by August if inflation plummets--provided that voters give him credit for curbing it. "The question for Henrique Cardoso is whether the drop in inflation will translate into enough votes to secure his victory," says political analyst Alexandre Barros. "Many may not vote for him due to suspicions that he timed the real just to boost his presidential bid."

No doubt, Cardoso's currency scheme is political as well as economic. But whatever the motive, achieving stable prices after decades of dizzying inflation could end up being more important than anyone's political fortunes.