Businessweek Archives

Commentary: Bid A Fond Adios To Fixed Exchange Rates (Int'l Edition)


International -- Latin America: COMMENTARY

COMMENTARY: BID A FOND ADIOS TO FIXED EXCHANGE RATES (int'l edition)

In the 1990s, Latin American countries, most notably Brazil and Argentina, clamped down on wild inflatiOn with an effective tool: overvalued currencies that they pegged to the U.S. dollar. The controlled exchange rates worked wonders, bringing economic stability to the lives of millions of people who had been caught for years in a spiral of rising prices and falling currencies. The strategy has paid political dividends, too. The biggest is the near-certain reelection of President Fernando Henrique Cardoso on Oct. 4.

Governments like to use currency to slay inflation rather than take unpopular measures such as budget cuts and tax increases. Consumers' purchasing power soars. Middle-class families fly to Disney World with their pockets stuffed with overvalued reals or pesos. The catch is that keeping the currencies high requires importing lots of money from abroad. That worked as long as international investors were willing to pour cash into emerging-market stocks, bonds, and direct investments.CAPITAL FLIGHT. But now, the strategy is coming undone. Investors, frightened by the crises in Asia and Russia, are pulling back from all emerging countries. Capital flight has lowered Brazil's hard-currency reserves to $46 billion, from $70 billion at the end of July. Investors worry that with its high debt and dwindling reserves Brazil will have to devalue and the real will plunge by 15% or more. Now, to avoid the chaos of such a forced devaluation, Brazil is discussing borrowing $30 billion or more in a bailout led by the International Monetary Fund. As part of any such deal, Cardoso will have to push ahead with long-delayed reforms, from slashing a huge budget deficit to overhauling the rickety social security system.

With the old game ending, Brazil, along with its close trading partner, Argentina, should start preparing for a shift to a floating exchange rate much like Mexico's. The Mexican peso, moving up or down in response to market demand, has served as a shock absorber, leaving Mexico's $30 billion currency reserve intact. Right now, of course, Brazil and Argentina can't abandon their rigid rates because such a move could trigger panic selling of their currencies. "Changing the currency system in a stressed scenario is the worst thing to do," says Dalton Gardimam, economist for Deutsche Bank Securities in Sao Paulo. But like a runner training for a marathon, these countries should make themselves economically fitter. When they're in better shape, moving to market-set currencies will be less traumatic.

Brazil is the key. If Cardoso is re-elected, he must use his mandate to speed a drastic fiscal overhaul, cutting spending and public payrolls. These actions, by easing investors' worries, will slow the capital flight and let interest rates, currently more than 40%, fall. This would permit the economy to start growing again. Then, if the global turmoil abates, Brazil could widen its exchange-rate band as a step toward letting the real float, possibly in mid-1999.OTHER SHOE. If the real moves lower, Argentina, with its close trade ties, will have a hard time keeping its peso fixed at one-for-one convertibility with the U.S. dollar. After seven years, Argentines would be shocked by losing this reassuring parity. In one scenario, says Walter T. Molano, head of economic and financial research for Warburg Dillon Read, Argentina would crimp its already low inflation, then introduce a thin band for exchange-rate movement.

Many countries have deployed exchange rates as economic policy tools. Chile nudged its peso upward in a narrow trading band in recent years to curb inflation by pulling in cheap imports. But the resulting current-account deficit has alarmed investors, and Chile recently widened the band to let the peso fall.

With capital skittish and global money managers calling the tune, Latin countries will need to rely on the markets more and more to decide their currencies' value. A fixed exchange rate is like a tall, rigid building "that can crumble under hurricane conditions," says Molano. "Flexible buildings sway back and forth." Latin America should get on with building structures that can weather the financial storms.By Ian Katz


Race, Class, and the Future of Ferguson
LIMITED-TIME OFFER SUBSCRIBE NOW

(enter your email)
(enter up to 5 email addresses, separated by commas)

Max 250 characters

 
blog comments powered by Disqus