Brazil: Into The Valley Of The Shadow Of Default?

Some life-or-death questions investors in Brazil should ask

Since Brazil devalued its currency by allowing it to float freely on Jan. 15, attention has turned to the other potential disaster--default. Until recently, investors had brushed off the government's roughly $177 billion in domestic debt and $90 billion in foreign debt as a pesky but manageable problem. Now they are watching with alarm. The 37% plunge in the real has jacked up the cost of Brazil's dollar-denominated debt. And as the government hikes interest rates to slow capital outflows, the debt mountain grows higher every day.

Indeed, three international agencies have slashed Brazil's debt rating. One, Duff & Phelps, says the country has a one-in-three chance of defaulting on its domestic debt. On Jan. 26, the government failed to raise the $833 million it had planned through an issue of mostly one-year bonds, even though it offered interest rates of 41%. That's a clear sign investors are skittish. And no wonder. By April, Brazil needs to roll over some $50 billion in domestic debt. That amounts to a hefty $500 million every day of the first quarter. President Fernando Henrique Cardoso faces tricky decisions over the next several weeks as he deals with Brazil's debt predicament. Here are some of the tough questions investors will be asking themselves as the crisis evolves--and some likely answers.

How likely is default?

The chances are increasing every week. Devaluation was supposed to reverse capital outflows from Brazil, but the exodus of money continues. In the first three weeks of January, $8 billion fled the country. Higher interest rates don't seem to be helping. In fact, rising rates are both strangling the economy and boosting the cost of repaying debt. Of course, the prospect of default is so frightening that the government will do all it can to prevent it. But economists figure that if Brazil cannot reduce real interest rates to around 15% from their current level of above 30%, default on the domestic debt is inevitable.

Can rates drop that low?

Brazil will be in a position to lower rates only if it can stabilize its currency and tame inflation, which is likely to take off in the wake of devaluation. Some analysts believe the government must keep the currency stronger than 2 reals to the dollar and inflation below 20% for the year if it is to have any hope of regaining credibility with investors. "The linchpin is confidence, and Brazil has squandered a lot of it," says Michael Gavin, director of Latin American economic research for Warburg Dillon Read. On Jan. 27, the real was trading at 1.91 to the dollar and the Central Bank raised interbank interest rates from 32.5% to 35.5%. That indicates its highest priority is fighting inflation.

Which debt is most at risk?

The domestic debt. Much of it is linked to high overnight interest rates, and $120 billion comes due this year. One factor working in Brazil's favor is that nearly all the domestic debt is held by local banks, pension funds, and insurance companies. These institutions are required to invest mainly within Brazil, so they have few alternatives to buying government bonds. Most foreign debt is longer term, with redemptions this year expected to total just $2 billion. But analysts believe that if Brazil were forced to default on its domestic debt, it would probably not be able to pay its foreign obligations. That's an issue for banks such as Citigroup and Spain's Banco Santander with big exposure in Brazil. Brazilian companies and banks could also be hard-pressed to repay the private-sector foreign debt of $140 billion--$26 billion of which falls due this year.

What would be the effect of a default?

It would have a profoundly negative impact on the economy. Many banks would be crushed. To prevent a collapse, Brazil could try a measure such as Argentina's 1989 Bonex Plan, in which depositors' short-term accounts were frozen and turned into long-term government bonds. That could keep the government solvent, but it would wipe out depositors. Companies would also be devastated because of the inaccessibility of capital. "It would be the worst recession ever," says Dalton Gardimam, economist for Deutsche Bank in Sao Paulo. Confidence in Brazil's economy would be shattered for years.