Brazil: A Plunging Currency and a Trapped Economy

Brazil's economy is caught between a rock and a hard place.

Prior to September 11, an energy crisis and worries about Argentina's debt problems had sapped output, weakened asset prices and the currency, and discouraged foreign investment. Now, a global recession, investors' new aversion to risk, and even weaker capital inflows are making matters much worse.

Brazil's central bank on Sept. 28 lowered its forecast for 2001 economic growth to 2%, but most private forecasters now expect growth of less than 1% this year, implying a second-half recession.

The problem: The Brazilian real's 28% plunge vs. the dollar this year has frozen interest-rate policy. Rates, which are at 19% in order to support the currency, cannot be lowered for fear of further weakening the real and fueling already-rising inflation. Raising rates to shore up the real and attract investment would only further damage growth prospects.

Brazil's dilemma stems from the financing requirements of its massive external debt, some 7% of gross domestic product, set against the domestic financing needs of both the government and businesses. But sources of finance are drying up. Investors' flight to safety has hit both foreign direct investment (FDI) and short-term portfolio investment. FDI had been sufficient to cover Brazil's entire current-account deficit of about $24 billion this year. Now, FDI is expected to drop to about $20 billion this year and to just $12 billion in 2002, according to Standard & Poor's Corp. Plus, stock prices this year are down more than 30%--more than 50% in dollar terms. Fading exports are cutting into that source of finance, as well.

These problems are compounded by the government's lack of haste in addressing its fiscal imbalances. The government on Oct. 1 drew down $4.7 billion of its latest $15.6 billion loan from the International Monetary Fund. Ultimately, Brazil may be forced to tighten both fiscal and monetary policies in order to correct its imbalances, but that would come at a severe cost to the economy.

By James C. Cooper & Kathleen Madigan

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