Brazil’s Currency Crisis

2

Brazil: Recent Problems (2002) 40% devaluation of the Real against the dollar Large public debt (~60% of GDP), default risk

substantial….Debt tied to exchange rate Risk premium on Brazilian bonds (yield above US

Treasury bonds) : ~ 20% Investors demand higher interest for rolling over debt,

especially if currency continues to devalue To stabilize debt/GDP ratio, larger and larger primary

surpluses needed Contractionary monetary policy to halt creeping

inflation and devaluation high unemployment, contraction in GDP, low investment, low consumption

Flight of foreign capital, Large foreign debt

3

Brazilian currencies

REAL, Jun 1994 – present

MIL-RÉIS, Oct 1833 – Oct 1942

CRUZADO NOVO, Jan 1989 – Mar 1990CRUZADO, Feb 1986 – Jan 1989

CRUZEIRO, Oct 1942 – Feb 1967

CRUZEIRO, May 1970 – Feb 1986

CRUZEIRO, Mar 1990 – Aug 1993

CRUZEIRO NOVO, Feb 1967 – May 1970

CRUZEIRO REAL, Aug 1993 - Jun 1994

4

Brazilian Currency: Abandoning the Fixed Exchange Rate

January 13th Gustavo Franco, Brazil’s central-bank governor, resigned and his successor allowed the country’s currency, the real, to devalue by over 8% against the dollar, despite 41.5billion in IMF reserve help.

Introduction of emergency taxes to pay back public , dollar-linked debt 50% of GDP then

Public Debt : 62% of GDP 07/2002

5

6

Brazilian Banks vs. Argentinean Banks

Argentina:Bank Deposits and Loans dollarizedHuge problems when the Peso

devalued Brazil

Bank Deposits and Loans not dollarized

But, 30% of Banks’ assets (300% of their net worth) in government bonds

7

Reserve Requirements and Tight Monetary Policy in Brazil

10/11/2002 “The nation's currency, the Real, posted its

biggest one-day gain in 10 weeks after the central bank ordered commercial banks to set aside the equivalent of $1 in equity for each dollar they hold. It was the second time this week Brazil raised the reserve requirements to discourage banks from buying dollars. “

10/14/2002 Overnight interest rates: Increased 3 percentage points, to prop up the Real and to halt inflation. New rates: 21%.

8

Exchange RateExchange RateExchange RateExchange Rate

Evolution of the Nominal Exchange RateEvolution of the Nominal Exchange Rate

3.133.13

1.001.001.201.20

1.401.401.601.601.801.802.002.00

2.202.202.402.402.602.60

2.802.803.003.003.203.203.403.40

3.603.603.803.80

Jan

-98

Jan

-98

Jun

-98

Jun

-98

No

v-98

No

v-98

Ap

r-99

Ap

r-99

Sep

-99

Sep

-99

Feb

-00

Feb

-00

Jul-

00Ju

l-00

Dec

-00

Dec

-00

May

-01

May

-01

Oct

-01

Oct

-01

Mar

-02

Mar

-02

Au

g-0

2A

ug

-02

R$/

US

$R

$/U

S$

Change in the Change in the

Exchange RateExchange Rate

RegimeRegime

Inflation TargetingInflation Targeting

World Economic SlowdownWorld Economic Slowdown

Technology Stocks CrisisTechnology Stocks Crisis

September 11thSeptember 11th

Energy CrisisEnergy Crisis

ElectionElection

ConcernsConcerns

Daily figures updated up to September 4. 2002Daily figures updated up to September 4. 2002

9

Real and Risk Premium

10

Changes in International ReservesChanges in International ReservesChanges in International ReservesChanges in International Reserves

US$ millionUS$ million

20012001 20022002 20032003

DecDec Jan-JulJan-Jul Aug-DecAug-Dec YearYear YearYear

I - Reserve position (end of the previous periodI - Reserve position (end of the previous period)) 37 23437 234 35 86635 866 39 06039 060 35 86635 866 37 7437 74221. 1. Net Purchases (+)/sales (-) of Banco CentraNet Purchases (+)/sales (-) of Banco Centrall -950-950 -2 605-2 605 -5 134-5 134 -7 739-7 739 002. 2. Banco Central's foreign operationsBanco Central's foreign operations -417-417 5 7985 798 3 83 81616 9 69 61515 -13 984-13 984

DisbursementsDisbursements 00 14 76214 762 6 6006 600 21 36221 362 6 6506 650BondsBonds 00 3 9403 940 00 3 9403 940 4 0004 000IMFIMF 9 9729 972 6 0006 000 15 97215 972 00IBRD/IDBIBRD/IDB 850850 600600 1 4501 450 2 6502 650

AmortizationsAmortizations -156-156 -6 778-6 778 -1 0-1 09292 -7 -7 870870 -16 074-16 074Bonds, MYDFA and Paris ClubBonds, MYDFA and Paris Club -156-156 -2 393-2 393 -915-915 -3 309-3 309 -4 582-4 582IMFIMF -4 384-4 384 -17-1777 -4 5-4 56161 -11 492-11 492

InterestInterest 100100 -2 -2 211211 -1 691-1 691 -3 -3 902902 -4 560-4 560ExpenditureExpenditure -50-50 --3 0903 090 -2 358-2 358 -5 -5 448448 -5 960-5 960Reserve interest earningsReserve interest earnings 150150 879879 667667 1 5461 546 1 4001 400

OtherOther -361-361 2424 00 2424 00II - Total Banco Central operations (1+2)II - Total Banco Central operations (1+2) -1 367-1 367 3 1933 193 -1 3-1 31818 1 81 87575 -13 984-13 984III - Reserve position (end of the month)III - Reserve position (end of the month) 35 86635 866 39 06039 060 37 7437 7422 37 7437 7422 23 23 758758

(-) (-) Loans from IMFLoans from IMF 8 3138 313 14 45314 453 20 20 276276 20 20 276276 8 78 78484(-) (-) Sovereign Buy Back (exceeding value)Sovereign Buy Back (exceeding value) 00 1 4571 457 2 3852 385 2 3852 385 1 9571 957(-) (-) Difference of parityDifference of parity --284284 --404404 --404404 --404404 --269269

IV - Net reserves position (IMF concept)IV - Net reserves position (IMF concept) 27 83727 837 23 55323 553 15 48515 485 15 48515 485 13 28613 286

11

Warning Signs!

12

Over Selic Over Selic Deflator: 12 month - IPCADeflator: 12 month - IPCA

55

1010

1515

2020

2525

3030

3535

4040

4545

Sep

-95

Sep

-95

Mar

-96

Mar

-96

Sep

-96

Sep

-96

Mar

-97

Mar

-97

Sep

-97

Sep

-97

Mar

-98

Mar

-98

Sep

-98

Sep

-98

Jun

-99

Jun

-99

Dec

-99

Dec

-99

Jun

-00

Jun

-00

Dec

-00

Dec

-00

Jun

-01

Jun

-01

Dec

-01

Dec

-01

Jul-

02Ju

l-02

% p

. a.

% p

. a.

Average (Aug 95–Jun 99): 19.07Average (Aug 95–Jun 99): 19.07

Average (Jul 99–Jul 02): 10.22Average (Jul 99–Jul 02): 10.22

Real Interest Rate ex-postReal Interest Rate ex-post

13

Current Debt NumbersIndicator Jan/03 Dec/02 12 Mths 12

Mths(In billions of reais) Jan/03 Dec/02===========================================

===========

Nominal Budget Deficit 9.17 22.1 68.18 61.61Debt Payments 17.63 17.4 123.69 114.00Budget Surplus Exc. Debt 8.46 -4.7 55.41

52.39

======================================================

Indicator Jan/03 Dec/02 Nov/02 Jan/02(In billions of reais)

======================================================

Total Public Debt 1,163.2 1,132.9 1,138.2 905.7

(% of GDP) 73.2% 71.9% 73.8% n.a.Net Public Debt 888.9 881.1 869.5 685.3(% of GDP) 55.9% 55.9% 56.4% n.a.

14

Inflation 02/24/2003

Central Bank Target Rate: 8.5% Actual Inflation now : Six-year high of

14.5 %Expected to edge higherMonetary Contraction to slow down

inflationShort term rates raised to 26.5%

from 25.5% on Feb 22nd

15

Lessons From BrazilRoot of the Problem

Root of the problem: Fiscal deficit and contingent (dollar denominated) liabilities

Root of the problemMexico: Trade imblanancesThailand: Banking crises

Mexico’s fiscal problems posed policy dilemmas:Interest rates Exchange ratesCapital controls

16

Lessons From Brazil: Deficits and Debt

CA deficit finances by short term inflows Public deficit financed by debt: (High interest

rates on debt!) Ratio of net public debt /GDP doubled

between December 1995 and January 1999 Despite economic growth of about 3 % per

year.

17

Lessons From Brazil Speculative Attack

1. Overvalued currencyCapital flows in turn supported the overvalued

currency and large current account deficits.2. Growing trade imbalances

caused by overvaluation and rising debt service

(1)+(2) fueled speculative attacks against the real.January 1998- January 1999, financial investors

positioned themselves to take advantage of an expected devaluation:

Cost to CentralBank: $6 billion in January 1999