Brazil and the international financial community face an unpleasant challenge. Once the World Cup is over, the Brazilian electorate will discover that their presidential election campaign has increased uncertainty about Brazilian economic and financial policies and triggered a flight from Brazilian assets. How Brazil and the international financial community respond will have profound implications for the entire international financial system.
Four years ago, under similar domestic political circumstances and external financial uncertainty, the Brazilian authorities unsteadily manoeuvred through an external financial crisis. They abandoned their rigid exchange-rate regime, achieved a substantial shift in Brazil's consolidated primary fiscal surplus and stabilised the economy. Can they do it again?
The Brazilian economy remains vulnerable. The ratio of public-sector debt to gross domestic product rose from 34 per cent in 1997 to 49 per cent in 1999 but has now increased to 55 per cent when it was projected to be on a declining trend. Less than 20 per cent of public sector debt is held abroad but a similar proportion is linked to the dollar. Brazil's total external debt, which is less than 50 per cent of GDP, is primarily private-sector debt. However, the total is more than 310 per cent of exports of goods and services. These ratios put Brazil in the danger zone of debt sustainability.
The country's real growth rate, which was 4.4 per cent in 2000, declined to 1.5 per cent in 2001 as a consequence of the global slowdown; prospects are dim for a pick-up this year. Brazil's current account deficit has averaged 4.4 per cent of GDP for four years and the economy is still relatively closed: exports of goods and services are 13 per cent of GDP. Last, it is located in a bad neighbourhood. Foreign and domestic investors are concerned-not unreasonably-that Brazil will follow Argentina into external and internal default and economic and financial chaos. These facts are not reassuring.
The next Brazilian administration needs to act quickly. A successful programme requires a primary fiscal surplus at least one percentage point higher than the 3.75 per cent of GDP to which the current administration is now committed; this will involve additional reforms of the pension system and a comprehensive overhaul of the tax system. Tighter fiscal policy should contribute to lower real interest rates and an increase in investment. At the same time, the central bank must also be allowed to maintain a policy anchored in the current inflation-targeting framework.
Last, the Brazilian authorities will also have to deal with the lack of internal and external competitiveness of the Brazilian economy. A pick-up in its abysmally lowinvestment rate should help but that, in itself, is not enough. None of this will be put in place during Brazil's election and transition over the next six months. In the meantime, what should the official international financial community do?
Last September, the International Monetary Fund granted Brazil a $15.7bn (£10.7bn) stand-by arrangement in the context of the unfolding Argentine tragedy. Brazil has now drawn most of it. The IMF appropriately has relaxed its constraint on the use of Brazil's reserves to cushion the impact on the Real of attempts to hedge Real exposures.
In future, IMF management and the main creditor countries should not heed the calls of the moral-hazard fanatics or those who favour experimentation in the name of systemic improvement. Instead, they should stand ready, if necessary, to support substantial additional resources for Brazil and to relax further constraints on the use of Brazil's gross foreign exchange reserves.
In return for additional assistance, the IMF should seek a written commitment from the leading presidential candidates on the policies their administrations would follow, should they win. That commitment should avoid specifics but it must encompass four crucial elements. First, the next administration must increase the primary surplus by at least 1 percentage point of GDP until the ratio of public debt is reduced to, say, 45 per cent of GDP. Second, it must increase the domestic and international competitiveness of the Brazilian economy to reduce its external debt. Third, it has to maintain a realistic inflation-targeting monetary policy framework. Last, it should make prudent use of international reserves to cushion downward pressures on the Real but without targeting a particular exchange rate.
In the absence of such commitments by the leading presidential candidates and support from the official international financial community through the IMF, Brazil may be forced to default on its domestic and international obligations either before the end of 2002 or soon thereafter. That is a risk not worth taking.