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Brazil's Nervous Neighbors (Int'l Edition)


International -- Finance: MARKETS

BRAZIL'S NERVOUS NEIGHBORS (int'l edition)

Its economic woes could spill over if they're not solved fast

Before Hong Kong's stock market plummeted in late October, Brazilian officials were insisting that the country's economy was sound. Sure, Brazil's current-account and budget deficits were each approaching 5% of gross domestic product. But President Fernando Henrique Cardoso was counting on financing them via massive foreign direct investment and a privatization program that was expected to raise $90 billion by 2000. And there was little chance that speculators would mess with the real in the way they had pummeled Asian currencies. Although it was considered overvalued, the real was protected by a war chest of $62 billion in foreign-currency reserves.

Then reality struck. As an attack on the Hong Kong dollar's peg to the U.S. greenback touched off a rout on bourses worldwide, the Sao Paulo exchange dropped 22.3% in one week. Worse yet, a run on the real forced the central bank to spend some $8 billion in a battle to prevent devaluation. To discourage investors from selling the real, the bank on Oct. 30 doubled interest rates to 43%, throwing an immediate chill into consumer spending. For now, the strategy appears to be working. Yet economists stress that without true reform, the economy, which had been expected to grow by nearly 4% this year and next, faces the possibility of recession.

Such is the price of defending an economy in a world where hot-money investors can call the shots and the best of preparations can be for naught. But the crisis may give Cardoso, who is up for reelection next October, much-needed political leverage to push a recalcitrant Congress into passing sweeping reforms of the public-sector, tax, and pension systems. On Nov. 12, Brazil's Chamber of Deputies will vote on reforms to make it easier to fire public-sector workers. The bill would then have to be approved by the Senate. "Brazil must become stronger to face the storms that come from abroad," Cardoso told congressional leaders on Nov. 4.

"HUGE ENDORSEMENT." For now, the government is betting on privatizations to help restore investor confidence. Brazil expects to take in an estimated $17 billion from privatizations this year and at least $22 billion in 1998, says John H. Welch, chief Latin America economist for Paribas Corp. in New York. The program got a big shot in the arm on Nov. 5, when a consortium led by Brazilian conglomerates Votorantim, Bradesco, and Camargo Correa bought control of the state of Sao Paulo's electric utility, Companhia Paulista de Forca e Luz, for $2.75 billion. The price was 70% above the government's minimum and far more than analysts had expected. "It's a huge, huge endorsement for Brazil," says Corrado Varoli, head of Latin American mergers and acquisitions at Morgan Stanley, Dean Witter, Discover & Co. in New York.

It's not just for Brazil's sake that Cardoso needs to reassure investors. Much of Latin America is counting on him. Brazil's $780 billion gross domestic product is more than twice as large as Mexico's, the region's second-biggest economy. A messy devaluation in Brazil could deter investment regionwide and snuff out economic expansion.

Already, uncertainty over Brazil has helped curb a growing appetite for Latin debt. Yields on some five-year Brazilian bonds have shot up to 400 basis points above those on U.S. Treasuries--three times what the spread was before the turmoil. Many Brazilian bonds lost as much as one-third of their face value after the market upset. Brazil's state-owned oil company, Petrobras, has postponed a $200 million Eurobond issue scheduled for November. Indeed, Latin American debt issuance had been strong all year. In the first three quarters of this year, Mexico and Brazil each issued $14.5 billion in debt, compared with $13.6 billion for Argentina. But analysts say that sovereign and corporate issues across the region will be delayed until confidence in Brazil is restored.

Even Mexico's stock market fell 11.4% during the last week of October, partly on concerns that the Mexicans would come under attack alongside Brazil. True, in the wake of the 1994 peso devaluation, Mexico has reformed its economy, and its fundamentals now are strong. Its 1998 current-account and budget deficits are expected to be only 2 1/2% and 1 1/4% of GDP, respectively.

Still, Mexican Finance Secretary Guillermo Ortiz Martinez remains wary of a "samba effect" if Brazil's markets aren't stabilized soon. "If Brazil starts having serious problems, it would indeed affect us," Ortiz told BUSINESS WEEK in an interview. "It would affect the entire hemisphere."

Even more worried are Brazil's next-door neighbors in Argentina. The Argentines send 30% of their exports to Brazil. So, even though Argentina's economy is healthy and its currency stable, the Buenos Aires stock market index dropped 16% when Sao Paulo nose-dived. Brazil's slowdown may shave a couple of points off of previous forecasts that Argentina's GDP would rise 8% this year and 5.8% in 1998. "If Brazil catches a cold, Argentina will sneeze," says Argentine Vice-President Carlos Ruckauf.

Argentines now fret that Brazil's temporary problems could turn into a full-scale crisis if they aren't solved quickly. Cardoso vows to reduce interest rates as soon as he can. Even when rates begin falling again, it will take time before they return to the pre-crash level of 20%. The brief attack on the real already has cost Brazil two years of progress on lowering interest rates. Consumers who had become accustomed to buying cars, stereos, and refrigerators over as many as 36 monthly payments will now have to make their purchases with cash--or pay exorbitant rates. At a Sao Paulo outlet of electronics chain G. Aronson, sales have fallen by half since interest rates were hiked. "They are completely static," says Assistant Manager Jose Matias. "No one is going to spend their [Christmas] bonuses now."

The anticipated credit crunch also will hurt the banking sector. ING Barings downgraded its rating of Brazilian bank stocks after the rate increase was announced. Some banks that trade heavily in financial markets suffered sizable losses during Sao Paulo's slide, but no major institution appears to be in trouble. One such investment bank, Garantia, experienced large losses, but analysts say it is financially healthy and should be able to recoup the money quickly. Consolidation of the sector, including acquisitions by foreign institutions such as Banco Santander and HSBC Holdings PLC, has given the seven largest banks 60% of deposits.

EYE ON REELECTION. Cardoso has another reason to get the crisis over in a hurry: He wants to keep his job. Since taking office nearly three years ago, the President's strategy has been to sacrifice growth in favor of stability. It has paid off. Thanks to a real that economists estimate is overvalued by at least 15%, inflation dropped from nearly 1,000% in 1994 to 5% this year. The economic strategy has won Cardoso high popularity ratings, while the opposition is divided. But his political fate depends on his ability to keep inflation at bay. If he can avoid a steep rise in inflation, Cardoso likely will win next year's election even if economic growth is dismal.

When emerging nations stumble, they are often tempted to fault external events. During Argentina's recession in 1995, officials pointed the finger at Mexico's 1994 peso devaluation. Now, some Brazilian authorities are blaming Asia for the country's problems. But in order to preserve the long-term economic health of all of Latin America, Brazil needs to strengthen the foundation of its own house first.By Ian Katz in Sao Paulo, with Geri Smith in Mexico City, and Andrea Mandel-Campbell in Buenos AiresReturn to top


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