Brazil Gets Real

Brazil Gets Real

Brazil Gets Real

Moneybox
Commentary about business and finance.
Jan. 19 1999 3:42 PM

Brazil Gets Real

So how weird was last Friday's reaction to the news that Brazil had given up its attempt to protect the value of its currency, the real, and was now going to allow it to float? The previous afternoon, after all, the new head of the country's central bank had vowed that Brazil would never allow the real to float, and all week we'd been deluged with predictions of the chaos that would engulf us if the Brazilian government failed in its efforts to keep the real strong. Then the Brazilian government admitted that it had failed in those efforts, and the Brazilian stock market rose 33 percent (the equivalent of a 3,000-point move in the Dow Jones Industrial Average), while U.S. markets leaped higher as well. Go figure.

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What happened Friday was described in many places as a "relief rally," but it's hard to see what the relief was, since no one--with the exception of economists like Jeffrey Sachs--had been hoping that Brazil would just give in. You might call it instead a "we were wrong rally," as the real proved stronger than people had anticipated--its value dropped only 10 percent against the dollar on Friday--and as the utter hopelessness of the government's attempt to prop the currency up became clear. On Monday, the central bank announced that the real would continue to float, and markets again applauded, albeit in a more muted fashion.

Brazil is not, needless to say, in the clear yet. Now that the value of its currency is completely subject to the verdict of the world's markets, it's more important than ever for it to pass a meaningful deficit-reduction plan. (Even though this is hardly the ideal time, given that the economy is in recession, to be taking money out of the economy.) But devaluation will have some immediately beneficial effects (as Sachs, for one, has been saying all along). Brazil's economy is heavily export-driven, and the falling real will make Brazilian goods more competitive in terms of price. At the same time, Brazil imports relatively little--something like 7 percent of the economy--so the inflationary impact of devaluation (when you devalue, foreign goods become more expensive) will be muted.

Most importantly, interest rates may fall now, since the government will not be as desperate to keep foreign money in the real. If rates do fall, that could give the economy a boost. And, in a broader sense, it was probably good for Brazil to accept the inevitable, not just because of the billions of dollars that the central bank was wasting buying Brazil's currency, but also because the value of the real is now closer to its "true" value (whatever that means).

The really interesting question about Brazil is what the provincial governors who are threatening to default on their obligations to the federal government are thinking. It was the defiance of the governor of Minas Gerais, after all, that set last week's crisis in motion. And what no one has yet explained convincingly is what these provincial governors think they're going to be able to accomplish. Perhaps what we're witnessing is an assertion that the power of the world markets can be defied, that a nation doesn't have to obey the dictates of currency traders and the IMF in order to survive. As it happens, that assertion is probably dead wrong, at least if by "survive" you mean something more than barely keeping your head above water. But it's still interesting to watch someone try to make the case.