Brazil's Neighbors Are Very Nervous

Its economic woes could spill over if they're not solved quickly

Before Hong Kong's stock market plunged in late October, Brazilian officials were insisting that the country's economy was sound. Brazil planned to finance its current-account and budget deficits--each close to 5% of gross domestic product--via foreign direct investment and a privatization plan expected to raise $90 billion by 2000. While its currency was considered overvalued by 15%, a war chest of $62 billion in foreign-currency reserves protected the real from speculative pressures.

Then reality struck. As an attack on the Hong Kong dollar's peg to the U.S. greenback touched off a rout on bourses worldwide, the Sao Paulo exchange dropped 22.3% in one week. Worse yet, a run on the real forced the central bank to spend some $8 billion in a battle to prevent devaluation. To discourage investors from selling the real, the bank on Oct. 30 doubled interest rates, to 43%, throwing an immediate chill into consumer spending. The economy, which had been expected to grow nearly 4% this year and next, is suddenly facing the possibility of recession.

Such is the price of defending an economy in a world where hot-money investors can call the shots and the best preparations can be for naught. But the crisis may give President Fernando Henrique Cardoso, who's up for reelection next October, much needed political leverage to push a recalcitrant Congress into passing sweeping reforms of the public-sector, tax, and pension systems.

The government is betting on privatizations to help restore investor confidence. Brazil expects to take in an estimated $17 billion from privatizations this year and at least $22 billion in 1998, says John H. Welch, chief Latin America economist for Paribas Corp. in New York. On Nov. 5, a consortium led by Brazilian conglomerates Votorantim, Bradesco, and Camargo Correa bought control of the state of Sao Paulo's electric utility, Companhia Paulista de Forca e Luz, for $2.75 billion. The price was 70% above the government's minimum and far more than analysts had expected. "It's a huge, endorsement for Brazil," says Corrado Varoli, head of Latin American mergers and acquisitions at Morgan Stanley, Dean Witter, Discover & Co. in New York.

It's not just for Brazil's sake that Cardoso needs to reassure investors. Much of Latin America is counting on him. Brazil's $780 billion GDP is more than twice as large as Mexico's, the region's second-biggest economy. A messy devaluation in Brazil could deter investment regionwide and snuff out economic expansion. The uncertainty has already hurt Latin debt markets. Yields on some five-year Brazilian bonds have shot up to 400 basis points above those on U.S. Treasuries--three times what the spread was before the turmoil. And analysts say sovereign and corporate issuance across the region will slow.

Even Mexico's stock market fell 11.4% during the last week of October, partly on concerns that the Mexicans would come under attack, too. True, in the wake of the 1994 peso devaluation, Mexico has reformed its economy, and its fundamentals now are strong. But Finance Secretary Guillermo Ortiz Martinez remains wary of a "samba effect" if Brazil's markets aren't stabilized soon. "If Brazil starts having serious problems, it would indeed affect us," Ortiz told BUSINESS WEEK. "It would affect the entire hemisphere."

LONG REACH. Most at risk are Brazil's next-door neighbors in Argentina. The Argentines send 30% of their exports to Brazil. So even though Argentina's economy is healthy and its currency stable, the Buenos Aires stock-market index dropped 16% when Sao Paulo nose-dived. Brazil's slowdown may shave a couple of points from previous forecasts that Argentina's GDP would rise 8% this year and 5.8% in 1998. "If Brazil catches a cold, Argentina will sneeze," says Argentine Vice-President Carlos Ruckauf.

Argentines fret that Brazil's temporary woes could turn into a full-scale crisis if they aren't solved quickly. Cardoso vows to cut interest rates as soon as he can. But the brief attack on the real already has cost Brazil two years of progress on lowering interest rates. Some authorities prefer to blame Asia for the crisis. But it has become increasingly clear that Brazil must take responsibility. Indeed, Latin America's long-term economic health depends on it.

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