Opinion Leaders' Digest 99-03
Date: Jan 22, 1999
Author : Sung No Choi, Director of Corporation Research Div. at CFE

Lessons from Brazilian Financial Crisis

From the beginning of this year, many people have forecast that domestic economic situations will improve. It is forecast that economy will grow above 3 percent in this year. Of course, the premise of such forecasts is that restructuring programs will be implemented without difficulties.

Though there are pleasant news domestically, the international circumstances seems to be on the brink of another financial crisis. Brazilian economy which occupies more than a half of South American economic activities fell into financial crisis.

Act III of International Financial Crisis; Is Act IV Coming?

In the summer of 1997, beginning with Thailand, Asian countries faced financial crisis and in the summer of 1998, Russia fell into the financial crisis. Now in January of 1999, Brazil is faced with the financial crisis. So, we can call the Brazilian financial crisis as the ACT III of the international financial crisis. Here, we are not counting currency crisis of Mexico in 1994.

As the financial crisis continues, many pundits make predictions on where the next financial crisis will occur. Since the policy to fix the exchange rate is not effective any longer and risky, as evidenced in the Brazilian case, many analysts say that Asian countries which stick to such policy will face the financial crisis. Analysts point to Hong Kong and China.

Hong Kong maintains a peg system where the local currency changes along with the changes of dollar. Yet, to maintain this system, Hong Kong pays dearly. Last year, growth rate was negative and the real estate price and stock price went down to a great extent. Furthermore, since financial deficit is expected this year, it is said that currency speculators will continue to attack the local currency. On the other hand, in China, after the bankruptcy of Gwangdung International Trust Investment Firm, foreign creditors began to collect their loans and the pressure to depreciate the Chinese currency is mounting. It is yet to be seen how long China is able to endure the difficulties. It will be good for the international economy if Hong Kong and China overcome the waves of pressures. Yet, if they open the ACT IV of the financial crisis, international repercussions will be substantial.

From this, we can see that international financial crisis is not a single event limited to particular countries. It can be likened to a mine which will explode anywhere and any time. However, it is least likely that as a result of Brazilian crisis, the booming U.S. economy will turn into recession, leading to world-wide recession or crisis. Yet, it should be remembered that international financial crisis does not come to a close with the Brazilian instance as the last one.

What are the lessons for us who are just beginning to get out of the financial crisis? It is important to learn what the Brazilian incident means for us.

The Nature of Brazilian Financial Crisis

In last summer, during two month period after the Russian financial crisis, Brazil underwent the reduction of foreign exchange reserve by 25 billion dollars. As a consequence, in November, Brazil agreed to receive 41.5 billion dollars from the IMF on the condition that it would take measures to correct the deficit financing. The reasons for prompt support of the IMF were, first, because there was a perception that the occurrence of financial crisis in Brazil will affect American economy adversely and, second, because the IMF believed that it could block the spread of financial crisis before the crisis got serious.

Nevertheless, due to two policy mistakes of the Brazilian government, the preparatory efforts of the IMF turned useless. The first mistake was to keep Brazilian currency, real, unreasonably overvalued. Brazil took a peg system to solve the chronic problem of hyper inflation. The peg system let the local currency to move along with the change of dollar. To make this system work, the amount of currency in circulation should be reduced through the stable monetary policy. But, the Brazilian government continued to keep financial deficit and failed to meet the condition for the proper working of the peg system.

Consequently, the pressures to depreciate real continued and, finally, on January 13, this year, the government depreciated real by 8 percent. On January 18, the government abolished the exchange rate band and adopted a floating exchange rate system. What is to be appraised in the process is that the Brazilian government did not use the foreign exchange reserve to defend the value of the appreciated real (how the Kim Young Sam government did regarding this issue is now being revealed in the recent hearing on the economic crisis.)

Second, the Brazilian political groups failed to reform the public sector. Initially, the Brazilian government adopted the peg system and pursued the stabilization policy measures n order to reduce the chronic financial deficit. In other words, the Brazilian government continued to take severe deficit financing budgets. Since the government spent a lot, the inflation ensued naturally. To compensate for the reduction of real income, the government deficit increased and the inflation aggravated. The vicious circle continued.

So, if the Brazilian government aimed to stabilize the local currency by taking real plan, it should have reformed the public sector. Among others, the deficit continued because the payment of pension for retired public employee was excessive. So, the reform of the pension system was seen as a touchstone of the government's will to reform. When the pension reduction bill did not pass the legislature several times, the government had a difficulty in meeting the conditionality of reforming the deficit finance structure and foreign investors doubted the Brazil's will to reform. The consequence was the outflow of capital from the country and the advent of the financial crisis.

To put it simple, the Brazilian political groups made decisions which brought about national crisis due to their political strife and they did not have the will to reform the deep-rooted wrong economic policy.

What Are the Lessons for Us?

We are getting out of the crisis taken place a year ago and set out to implement the restructuring programs in earnest. Looking at the Brazilian financial crisis, we are worried that we may have another crisis, depending on international economic situations, on the one hand, and we learn that we should not bring about the crisis by our mistakes, on the other. The Brazilian crisis gives us following lessons.

First, we should not take wrong economic policy to arbitrarily manipulate the exchange rate. To maintain the overvalued exchange rate, the Brazilian government kept a high interest rate policy. It wanted to keep the inflow of dollars through the high interest rate. Yet, such a high interest rate increased the debt burden to companies and the government and, consequently, domestic economy shrank. The Brazilian government can not maintain the high interest rate policy indefinitely and the outflow of capital was to take place.

Second, the government should reduce the financial deficit. The financial deficit due to the unproductive public sector can not be sustained for long. In Korea, we have recognized the enormous needs for expenditure in public sector, supplied from diverse pension funds and others and we also suspended the reform in the public sector. Because of this, it is inevitable that the deficit financing will continue for a substantial period of time. Restructuring in the private sector is important. Yet, restructuring in the public sector cannot be seen as exceptional and cannot be postponed.

As the Brazilian financial crisis shows, no field can be seen as exceptional in this era of internationalization. Poor performance in one field can be easily converted into the national crisis. We should not resort to the unreasonable policy to defend the exchange rate as before.

However, we need to remember that the floating exchange rate system is not a cure-all. We need to remove the basic causes of the capital flight. As everybody knows, poor performance of companies and financial sector is one of the basic causes. It is also well recognized that the poor performance of the public sector is one of the basic causes. The "government of people" should not consider the current reforms as completing the reform of the country. The most important and difficult reform is yet to be accomplished.

(The view expressed here is the author's personal view. It is not the official view of the CFE.)