Pulling Brazil Back From The Brink

New Central Bank boss Fraga is wowing investors--for now

It was a whirlwind week for Arminio Fraga. On Apr. 21, Brazil's Central Bank president raced around New York, smooth-talking investment bankers about the improving financial condition of Latin America's largest economy. The next day, Fraga oversaw the government's triumphant return to the international capital markets after a year--a $2 billion offering of five-year bonds. Then it was off to Washington to brief Federal Reserve Board Chairman Alan Greenspan and U.S. Treasury Secretary Robert E. Rubin. "I'm a bit surprised by the speed [of the recovery], but not the outcome," Fraga told business executives in Washington.

Brazil is gaining in confidence again, and Fraga is leading the way. Since his appointment on Mar. 3, he has been the man in the hot seat, the person most responsible for pulling Brazil back from the brink after Russia's collapse last year shocked emerging markets around the world. A market-savvy economist with five years experience as a fund manager for billionaire financier George Soros, Fraga has moved decisively to prevent a rout of the real, a dangerous spike in inflation, and a default on Brazil's domestic debt.

GLOBAL GLOW. It's probably the best performance of a central banker this year--and in some ways, Fraga's feat has helped create the current euphoria over the end of the global crisis. But some skeptics believe that Fraga's success is more marketing genius than economics. His ability to convince investors that he has a solid plan is unparalleled. But, says Robin L. Rosenberg, a Latin America specialist at the University of Miami's North-South Center, "His efforts have been more directed toward investor psychology, and not necessarily fundamentals." Rosenberg and others worry that Fraga's smooth talk will lull the government into thinking it has won the war to stabilize the real. "That's a fragile strategy on which to base an economy," adds Rosenberg.

No doubt, Brazil still has a long way to go to turn itself around. Fraga's next challenge will be to lower interest rates from their current rate of 32% to around 25% by yearend. That's crucial if he is to prevent a prolonged recession in the country, where companies are already squeezed and gross domestic product is expected to plunge 2% to 3% this year. At the same time, he has to keep rates high enough to control inflation, maintain a stable real, and keep investors pouring money into Brazil's government bonds.

BLACK FRIDAY. Fraga's fans think he can pull off this balancing act. "Fraga is the right person at the right time," says Carlos Guimaraes, head of Latin American investment banking for Lehman Brothers Inc. in New York. Before President Fernando Henrique Cardoso named Fraga to the job in early February, the real had plunged 44% in 16 days. January was a disaster. Itamar Franco, Governor of Minais Gerais state, had sparked a panic when he stopped debt payments to the federal government. Market pressure had forced Cardoso on Jan. 15 to abandon the real's peg to the dollar. On Jan. 29, which Brazilians dubbed Black Friday, the real plunged to 48 cents (chart, page 50).

Suddenly, Brazilians were worried that the government would shut down the banks or declare a moratorium on the country's $200 billion in domestic debt. Investors didn't know if the Central Bank had the will to defend the real and keep inflation from taking off. The stock market swung wildly.

In the tense weekend that followed, Cardoso moved boldly. He fired Central Bank President Francisco Lopes, who had been appointed to the job less than three weeks earlier. In his place, Cardoso named Fraga, who was running Soros' Quantum Emerging Growth Fund. The bank needed "more energetic leadership," Cardoso said on Brazilian television. "That's why I chose a trader with experience in international markets." Fraga had credentials in spades: a Princeton University PhD in economics and real-world experience at Salomon Brothers and Brazil's Garantia investment bank, as well as Soros.

Fraga didn't disappoint. Although a month went by while Brazil shut down for Carnival and Congress debated his appointment, the bearded, 41-year-old financier immediately threw the market an unmistakable signal that he was ready to control inflation. On that first day, Fraga hiked Brazil's interest rates from 39% to 45%. It was a risky move, because Brazil was already deep in recession and every bump up in rates added to the government's ballooning debt. But Fraga bet that if he shocked the market by lifting rates six full points, he could lower rates slowly later on. The tiny rate hikes his predecessors had favored hadn't impressed investors.

Suddenly, investors, who only days before had bet against the real, began to give Brazil the benefit of the doubt. Since late March, Fraga has reduced rates four times and reaped positive reaction on each occasion. Inflation, which many analysts feared would soar to 40% this year, is now expected to level off at less than 15%.

CHEERING. But that was only the first part of Fraga's strategy. Jawboning the markets was phase two. Fraga scored with the investment community as he swept through New York, London, and Paris in mid-March. Almost immediately, he got a promise from bankers to stop cutting credit lines to Brazil. The markets cheered Brazil's revised inflation and budget targets with the International Monetary Fund, even though they amounted to an admission that the economy had seriously deteriorated since January. Even the bad news on Apr. 13 that the fiscal deficit had hit a dizzying 14% of GDP was largely ignored.

Improving the mood in the markets isn't enough, however. Brazil's 165 million people, a third of whom live in poverty, are still hurting from the crisis. Even moderate inflation of 10% to 15% will deal a body blow to workers, who can expect small or no raises this year. Unemployment, officially 8% but much higher if part-time or informal workers are counted, is a growing problem.

The wave of good feelings that Brazil is riding could crash down anytime. The government must continue to trim its budget and guard against overspending by states and municipalities. Reform of the tax code--on the government's wish list for four years--must be tackled. And the country remains vulnerable to scandal at home and unsettling news from abroad. On Apr. 26, Brazil's markets slumped after Lopes was arrested for refusing to testify about alleged insider trading at the Central Bank. He was later released and the charges dropped.

Rescue operations are never clean. Still, the lesson from Brazil's rebound is the same one Mexico and Argentina learned a few years ago: Boldness and openness pay off. Brazil's economy is still fragile. But thanks to the goodwill created by Fraga, the country has recovery in its sights.

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