Reference no: EM131737611

Case Scenario: THE BRAZILIAN AND ARGENTINE DEVALUATIONS

In many ways the economic performance of Argentina, Brazil, and Chile have many elements in common. All three countries had relatively high standards of living in the early part of the twentieth century, but collapsed during the Great Depression. After World War II, they followed the hyperinflation route, creating full employment and the illusion of rapid growth. That illusion was soon shattered, leading to unrest in the streets. The government dared not institute layoffs among employees of the public sector for fear of exacerbating the political situation. The budget deficit ratio continued to rise, hyperinflation worsened, and productivity and the standard of living declined. Finally, the situation became so unfavorable that drastic steps were taken. The era of easy money ended, and an austerity campaign was started. Initially, all of these countries plunged into recession, but that was accompanied by a reduction in inflation to single-digit rates. Once political credibility had been reestablished, foreign capital returned, and real growth recovered. It is almost an economic parable. Bad economic policies lead to declining growth, economic misery, and political unrest. Good economic policies, after a period of adjustment, lead to rapid growth, economic prosperity, and political stability.

However, although the experiment worked well in Chile, the success has not yet been duplicated in Brazil and Argentina. Since the lessons to be learned are thus somewhat different, each country is now considered separately. For many years Brazil was the poster country for mismanaged economics and hyperinflation. As has often been remarked, ‘‘Brazil is a country with enormous promise ... and always will be.'' For the seven year period from 1987 through 1994, the inflation rate in Brazil, as measured by the CPI, averaged 1,280% per year. Not too surprisingly, the economy was in a recession during most of those years. Finally the government - and the voters - decided enough was enough. The Brazilian government revalued the real and set it equal to the dollar. Inflation slowed down to 6%, then 3%, and real growth rebounded to the 4-5% range. Because inflation was still slightly above the US, Brazil continued to devalue the real slightly, using a floating peg. Everything should have been fine - but it wasn't. Brazil was forced to devalue the real by another 40% in 1999, plunging the economy back into recession, and in early 2002 it was trading at approximately 2.30/$. By late 2002 that figure had fallen to 3.40/$. The proximate cause of the Brazilian devaluation occurred when Itamar Franco, the president of Minas Gerais - who was called by another Brazilian politician ‘‘the stupidest person in Brazil'' - declared that his state government would not repay its debts. Naturally that alarmed investors, causing them to rush their money out of the country.

Yet the alarm bells had rung much earlier. Indeed, for the previous several months, most investors were convinced that Brazil would have to devalue its currency again. The major problems were (a) its value was originally set too high when the new monetary regime was installed, (b) the trade deficit continued to increase, and (c) the government refused to take the necessary steps to reduce the growth in spending, particularly in the areas of pensions and benefits. In the months before the devaluation, Brazil tried to hold the value of the currency by raising interest rates and restricting growth in monetary and credit aggregates. The net result was that the five-year period of prosperity came to an end and the Brazilian economy plunged back into recession in 1998. Since then, growth has recovered but at a more subdued rate. The Brazilian story is subject to its past history of previous bursts of hyperinflation. As long as the government resolutely refused to put its fiscal house in order, and as long as the trade deficit continued to balloon, Brazil really had no choice other than to let its currency float. If the Brazilian political leaders want a stronger currency, they must balance the budget and reduce the trade deficit. So far, there is little eagerness to proceed on either of those projects. As a result, the real will probably continue to drift lower over the next several years. After the Brazilian real failed, foreign exchange traders focused their attention on the Argentine peso. In one sense that did not seem ‘‘fair,'' since Argentina had tried to do everything right: it reduced the inflation rate all the way to zero, tied the peso to the dollar, and backed it with gold. Yet in early 2002, Argentina was forced to devalue the peso, pushing its level down to approximately 3.40 pesos to the $, not so coincidentally the same rate as the Brazilian real.

The Argentine economy also plunged back into another severe recession, with the unemployment rate rising to 18%. One major problem was that when the Brazilian real devalued by more than 50%, Argentinean products were no longer competitive, and their trade deficit ballooned because Brazil was able to undersell them in virtually every market where they competed. Once the real plunged, the peso was bound to sink - in spite of their stated plan to keep it equal to the dollar. The fact that the Argentine authorities kept the peso from declining for three years while investors withdrew their money from the country simply made the eventual plunge that much more severe. By now it should be clear there are no shortcuts to economic prosperity; if there were, every tinhorn dictator in the world would have discovered them and put them to good use. Especially for smaller countries, the government budget must be balanced over the business cycle; foreign investors will not bail out the government, as they did for the US during the 1980s and much of the 1990s. Similarly, the current account must be balanced over the business cycle.

That in turn can be accomplished only if the value of the currency is set near its equilibrium value. Real growth will be enhanced if free trade is encouraged, which suggests working out a system with your neighbors and major trading partners to reduce trade barriers to a minimum. A common currency, such as the euro, may also help, but only if government policies switch toward those that are more free market oriented. A major devaluation by one country in a region is very likely to upset the trade balance for the entire region. Latin America would be better off if, like Europe, it had a common currency. In fact, many economists have suggested that these countries adopt the dollar, although political pressures apparently would not permit that. If nothing is done, various currencies will continue to come under downward pressure in the future, which will cause the values of other currencies to decline even if those countries are controlling their inflation rate and keeping government spending in line. For when one country can boost its exports at the expense of its neighbors, eventually those neighboring countries will be faced with large trade deficits and downward pressure on their currencies. Thus until the Latin American nations join together in a common currency, frequent devaluations - and recessions - are likely to occur in the future.