The Anatomy of Brazil's Financial Meltdown
Brazil is experiencing a repeat of the kind of emerging-market financial dislocation that many hoped it had left behind in the 1980s and early 2000s. If unchecked by a circuit breaker, this self-sustaining cycle could gather further momentum, exposing the country to economic shocks that would hit the poor particularly hard and add to the political dysfunction.
In response to an outflow of investment funds and accelerating capital flight, Brazil's three main financial markets are stuck in a mutually reinforcing process of value destruction. The result is a horrid combination of sharp currency devaluation, rising external borrowing costs and increasing domestic interest rates.
These damaging trends exacerbate the threat of two additional vicious cycles, also of the self-feeding variety:
The first links the sovereign and the corporate sectors. The more government bonds and the currency come under pressure, the greater the threat of contagion to the corporate market.
The downgrade of Brazil's sovereign credit rating to junk status by Standard & Poor's this month already has pulled down the ratings of the country's corporates, increasing borrowing and refinancing costs across the board. Meanwhile, the scandal at Petrobras, the country's biggest company, has raised concerns the state may be forced to intervene with a bailout, adding to discomfort about the sovereign balance sheet.
The second links the financial sector and economic prospects. The more financial markets are disrupted, the greater the risk to the broader economy, which already is struggling with a recession and high inflation. This cycle could lead to skyrocketing production costs, declines in activity, increases in unemployment, falling real wages, curtailed consumption and accelerating capital flight.
If left to fester, these sorts of linkages feed upon themselves, exposing the country to what economists call a "multiple equilibrium": the risk that, rather than being on course to revert to the mean (finding its way back to stability), Brazil's economy deteriorates further, enhancing the risk of a slide toward an even worse outcome.
Brazil desperately needs a circuit breaker to eliminate the mounting threat of cascading negative outcomes. The best way to achieve this would be a series of official decisions, designed by the government and passed by the legislature, that restore the country's growth dynamic, contain its fiscal deterioration and reverse mounting inflationary pressures.
Such measures would cause financial markets to normalize rather quickly, resulting in a currency appreciation and notably lower borrowing costs both domestically and internationally.
With this in mind, the government has submitted a series of fiscal proposals to the National Congress. Unfortunately, the country's political dysfunction makes the prospects for full passage less than comforting.
History tells us that when a country delays putting in place a domestic circuit breaker, that potential role eventually will shift -- at least partially -- to external actors, including multilateral organizations spearheaded by the International Monetary Fund. And the longer it takes for this combination of foreign and domestic measures to coalesce, the harder the necessary reforms will be to accept for the country's political leaders and people.
Without the rapid implementation of circuit breakers, a stabilization of Brazil's financial conditions would depend on the large-scale re-engagement of foreign capital and the return of flight capital. This is unlikely to happen until the prices of Brazilian assets, and the value of its currency, collapse to levels that are even lower and that offer foreign and domestic investors compelling risk-adjusted returns. That was the situation in the fourth quarter of 2002, when such circumstances almost tipped the country into a costly default, a multi-year recession and soaring poverty.
For those who closely follow Brazil, and wish it to live up to its considerable economic potential, this moment evokes both hope and anxiety. The hope is based on the knowledge that, with improved governance, it wouldn't take much to turn this promising economy around. The anxiety is that the country's political class again may fall short in properly serving citizens, risking misery for the most vulnerable segments of the population.
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