Brazil: When an IMF Bailout Is Not Enough

The loan guarantees help, but they won't rescue its economy

The news brought a surge of euphoria. On Aug. 7, the International Monetary Fund announced it was prepared to lend Brazil $30 billion--a record sum that was expected to calm the country's roiled markets. But the IMF package wasn't enough. After an initial boost, Brazil's stocks, bonds, and currency went right on falling. The real has lost a third of its value this year. The country's benchmark sovereign bond is trading at a 40% discount.

Analysts say that there are two main explanations for Brazil's continuing malaise: debt and politics. Following are some questions and answers for investors wondering whether Brazil, post- IMF agreement, is a buy or a sell.

Why hasn't the IMF loan helped?

It has--things would be much worse without it. But the loan is no cure-all. Only $6 billion will be available this year. The rest depends on commitments from Brazil's next President to stick to tight fiscal policies. But the irony of IMF credit lines is that while investors are glad the money is there if needed, they don't want to see governments actually dip into it. It's a seen as sign of desperation.

Is the IMF money enough to solve Brazil's debt crisis?

Unfortunately not. Brazil's net public debt, now at $255 billion, has risen from less than 30% of gross domestic product in 1994--when the present government took office--to 60% today. That's not high by international standards, but what really spooks the markets is the profile of the debt: Nearly one third of it is linked to the dollar, while another half is indexed to government interest rates. That means the amount of debt increases as the currency devalues, which is happening right now, or as interest rates rise, which will happen if the crisis worsens. What's more, the government is being forced to offer shorter and shorter term paper because investors won't accept long-term risk.

Altogether, more than $75 billion worth of domestic debt comes due in the next 12 months. Repayments for September total a relatively manageable $3.7 billion--but jump to $10.5 billion in November. "Brazil has almost no chance of making it," says Walter Molano, head of research at BCP Securities Inc. in Greenwich, Conn. "It is time [for investors] to get out." Others are more sanguine. "The Treasury has cash on hand to pay off several months of debt if it has to," says Marcelo Carvalho, chief economist at Bank of America (BAC ) in São Paulo. "Disaster isn't inevitable yet."

What role does politics play in the crisis?

President Fernando Henrique Cardoso has been widely praised for keeping Brazil's economy on an even keel for almost eight years. But Brazilians vote for a new President in October, and the leading candidates--labor leader Luiz Inácio Lula da Silva, and populist Ciro Gomes--make investors nervous. Their support for the IMF deal has been lukewarm at best. Only Cardoso's hand-picked candidate, former Health Minister José Serra, has come out strongly in favor of the IMF plan. And he is trailing badly in the polls.

If Brazil does default, what will be the impact on foreign investors?

A default would probably be triggered by a halt in payments on the domestic debt. Then all government bonds, including more than $55 billion in debt held by foreigners, would have to be renegotiated. Foreign banks are sitting on piles of domestic debt. Citibank's (C ) Brazilian operation has 16% of its assets in government paper, while the local unit of FleetBoston Financial Corp. (FBF ) has 17%. European investors, particularly Spanish banks, also stand to lose big. And a Brazilian default could set off a stampede out of other emerging markets.

What will calm the markets down?

What markets want more than anything is a sign that Serra's campaign is taking off. Free election television broadcasts started on Aug. 20, and the size of Serra's coalition in Congress assures him more airtime than his opponents. But even if Serra pulls off a miracle in October, investors will want to see clear signs that he is dealing more effectively than previous governments with Brazil's core problems: out-of-control pension and social security payments and a tax system that encourages evasion and hampers competitiveness. Only if these problems are tackled will the Brazilian economy get the growth needed to ease its debt woes.

By Jonathan Wheatley in São Paulo

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