The Tango Effect Trips Up Brazil

The pain from Argentina's slump is spreading fast

As the first quarter of 2001 drew to a close, things were looking pretty good for Brazil. Its economy was set to grow upwards of 4.5% this year, while inflation kept falling. The country was fast becoming the darling among emerging markets. But just as it seemed Brazilians could rest easy, Argentina sent them a nasty wake-up call.

First, the Brazilian real took a tumble. It fell to 2.17 to the dollar on Mar. 23, its lowest point since the currency was introduced in 1994. The main cause of the slide was fear that Argentina could be forced into a debt default or devaluation. A cataclysm of that sort would send shock waves across all emerging markets but as Argentina's neighbor and major trading partner, Brazil would be the first to be hit.

The real's tumble was a fresh reminder that Latin America's biggest economy remains extremely vulnerable to external shocks. "Contagion from Argentina to Brazil has been extreme and will continue to be so, should the Argentine crisis worsen," says Geoffrey Dennis, Latin American strategist at Salomon Smith Barney in New York. The so-called tango effect forced Brazil's Central Bank to do something it hasn't done in two years: raise interest rates. On Mar. 21, it ratcheted up the basic rate by half a point, to 15.75%. The move spooked investors and plunged the Sao Paulo stock exchange to its lowest level in a year.

Brazil's stocks and currency have clawed back some of their losses. But now it's Brazilian exporters who are feeling Argentina's pain. On Mar. 21, Argentina's newly appointed Economy Minister, Domingo Cavallo, announced unilateral changes to the common external tariffs agreed under Mercosur, the customs union made up of Brazil, Argentina, Paraguay, and Uruguay. Brazilian makers of machinery and equipment, who since 1995 have benefited from duty-free access to the Argentine market, are in an uproar over Cavallo's decision to slash duties on capital-goods imports from outside the trade bloc to zero.

Now, Brazilian manufacturers will have to fight hard for the Argentine market. Abimaq, the national association of machinery and equipment makers, claims that exports to Argentina, worth $800 million in 2000, will fall by as much as half this year. "First we had the mad cow, now it's the crazy horse," says Abimaq President Luiz Carlos Delben Leite, referring to a recent trade tiff with Canada over beef and to Cavallo, whose surname approximates the Portuguese word for horse.

FOOT-DRAGGING. Brazilian producers complain that they are already at a disadvantage vis-a-vis foreign rivals. Domestic taxes add almost 10% to the final cost of manufactured goods, says Delben Leite, not to mention the higher costs of capital local companies face. Cavallo's move may make things worse. "We could lose sales to more competitive manufacturing areas," says Suely Agostinho, manager of governmental and institutional affairs at Caterpillar Brasil.

The irony is that Brazil would be better able to withstand an Argentine crisis if Brasilia had not put off doing its own homework. Politicians have dragged their feet on tax reform and other structural changes that would make local industry more competitive. And manufacturers have relied too much on the captive markets bred by Mercosur's trade rules. Brazilians are now learning that the price of complacency can run high.

By Jonathan Wheatley in Sao Paulo

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