BRAZIL'S ECONOMIC REFORM AND THE GLOBAL FINANCIAL CRISIS
CRS Report for Congress
Brazil’s Economic Reform and the
Global Financial Crisis
J. F. Hornbeck
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Despite backing from the International Monetary Fund (IMF), capital flight from
Brazil in 1998 prompted the government to jettison its pegged currency stabilization
program and float the real on January 15, 1999, becoming another casualty of the
volatile international capital markets. Brazil adjusted to its financial crisis faster than
expected, which is now considered over. This report provides a final summary of
Brazil’s financial crisis and related IMF assistance in support of congressional interest in
various aspects of the 1990s global financial turmoil. It will not be updated.
Facing increasing investor uncertainty and prolonged capital flight, Brazil devalued
its currency (the real) on January 15, 1999, following Mexico, Asia, and Russia as the next
casualty of the 1990s global financial turmoil. Although Brazil had ample foreign
exchange reserves and International Monetary Fund (IMF) support, nervous investors
withdrew a net $40 billion from Brazil over the four months following the August 1998
default in Russia. Yielding to market pressures, Brazil attempted an 8% “controlled”
devaluation on January 13, 1999, only to increase investor anxiety and capital outflows.
Rather than risk depleting its international reserves in the hope of outlasting the global run
on its currency, Brazil chose to float the real, causing a major devaluation that eventually
halted capital flight, but left the economy disrupted in other ways.
A combination of policy decisions and political events left Brazil exposed to the
vagaries of international capital markets. First, Brazil had an overvalued exchange rate
and huge fiscal deficits, which together could not be sustained indefinitely. Second, Brazil
became increasingly dependent on the very capital markets that tend to abandon countries
when they need them most. Finally, two political events in January triggered the final run
on the real: 1) failure to pass legislation that would have addressed the large budget deficit
that epitomized the country’s fiscal excess; and 2) announcement of a moratorium on
federal debt payments by a large state government. To grasp how these events made
Brazil vulnerable to capital flight, however, it is important to understand the role of
economic policies implemented earlier in the decade.
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Background: Economic Stabilization and Reform
In the 1980s and early 1990s, the Brazilian economy struggled with slow growth and
high inflation, aggravated by inefficient, wasteful, and at times questionable public
oversight. Policies to stabilize the economy repeatedly failed, but in July 1994, then-
Finance Minister (and now President) Fernando Henrique Cardoso launched the Real Plan
to beat Brazil’s high inflation. As an exchange rate stabilization strategy, it centered on
eliminating price indexation and creating a new currency (the real) that was pegged to the
dollar as a link to U.S. monetary stability. To maintain a credible peg, Brazil had to adopt
responsible (tight) fiscal and monetary policies to restrain those pressures that could cause
the currency to appreciate in real (inflation-adjusted) terms.
Table 1. Brazil: Selected Economic and Financial Indicators
GDP Growth (%)4.16.04.22.73.40.00.83.3
Inflation - CPI (%)2,7301,224184.108.40.206.78.95.6
Unemploy Rate (%)220.127.116.11.18.104.22.168.3
Nominal Fiscal Bal.-2.30.5-7.2-5.9-6.1-8.1-10.0-4.3
(% of GDP)
Primary Fiscal Bal.** 2.9 5.10.4-0.1-1.00.03.13.3
(% of GDP)
Current Account Bal.-0.2-0.2-2.6-3.0-4.2-4.3-4.4-3.5
(% of GDP)
Foreign Reserves ($b)30.637.151.822.214.171.1246.341.0
* = projected. Sources: IMF and Latin American Monitor: Brazil. May 2000.
** excludes interest payments.
Economic growth slowed under the Real Plan, but a recession was avoided and
inflation fell rapidly, declining from over 2000% in 1993 to less than 20% by 1995 (see
Table 1). The Plan also included a policy of real (inflation-adjusted) wage increases
(notably the minimum wage), which, combined with falling inflation, effectively
redistributed income to the poorest sectors of the economy and broadened the stabilization
program’s appeal.1 Beyond stabilization, Brazil’s longer term goals were promoting fast
growth and deeper economic reform. Deeper reform involved structural changes such as
continuing to open the economy to foreign trade and investment, overhauling financial
market regulation, privatizing government-controlled firms, allowing markets to function
more freely, and, most importantly in Brazil’s case, reducing large fiscal deficits.
Economic Challenges and Delayed Reform
The failure to complete reform and the volatility of global capital markets were two
factors that together eventually forced Brazil to abandon the Real Plan. Although Brazil
1 For details, see Dornbusch, Rudiger. Brazil’s Incomplete Stabilization and Reform. Brookings
Papers on Economic Activity. No. 1. 1997. pp. 374-78. Brazil, it should be noted, still suffers
from one of the most unequal income distributions in the world.
had succeeded in bringing inflation down to historical lows, the reform program did not
proceeded as swiftly as anticipated and was further impeded by inadequate economic
growth. Three interrelated economic problems developed.
Exchange Rate Valuation. A pegged currency stabilization plan was the foundation
of Brazil’s economic reform program, which meant that inflation had to be reduced
rapidly. High inflation with a pegged currency causes exports to become less competitive
and imports more so, leading to growing deficits in trade (goods) and on current account
(goods, services, and investment income). In effect, it causes the currency to appreciate
in real (inflation-adjusted) terms. If an appreciating currency is perceived to be seriously
“overvalued,” it raises the prospect of a future devaluation and such speculation is
frequently a critical factor causing investors to discontinue financing a country’s debt,
leading to capital flight and a financial crisis. Inflation and large capital inflows did cause
a real appreciation of the Brazilian currency. The real appreciated immediately when fixed
to the U.S. dollar in 1994 and continued to appreciate because of Brazil’s relatively high
inflation rate. In 1995, Brazil countered by tightening monetary policy to reduce inflation
and by instituting a crawling peg exchange rate that would reduce the nominal value of the
real. With a crawling peg, the real was traded within a narrow “band” that was
depreciated over time in small increments (a crawl of about 0.6% per month) to help offset
currency appreciation. The central bank bought and sold the real to maintain the exchange
rate within the band.
From 1995 to 1998, with inflation falling, renewed investor confidence and high real
interest rates led to large capital inflows, which then became the major threat to currency
stability. These inflows fueled the current account deficit, placing further upward pressure
on the value of the real. Over time, a consensus emerged that the real was in fact
“overvalued” by 15%-30%, increasing the risk of sudden investor withdrawal and a
currency crisis, and thereby placing additional pressure on Brazil to support the real with2
appropriate macroeconomic policies, particularly fiscal austerity.
Fiscal Deficit. Although monetary policy was tight, in part to defend the Real Plan,
lax fiscal management was a second critical economic challenge. The persistently large
budget deficit hit 8% of GDP in 1998 (roughly half federal, half state and local), raising
three problems. First, the need to attract capital meant domestic interest rates had to
exceed foreign rates, which increased the cost of financing government debt, hampering
correction of the fiscal deficit even if budget cutting had been taken seriously. Second,
Brazil’s dependence on foreign capital (debt service) grew more burdensome as the debt:
1) increased dramatically in size; 2) shortened in maturity; and 3) became increasingly
indexed to the dollar and short-term interest rates. Third, fiscal excess, by pulling in
foreign capital, put upward pressure on the currency value thereby impairing credibility of
the exchange rate peg. Fiscal discipline proved elusive because it required Brazil’s
congress to make sweeping changes to social security, pension, and tax laws, three large
structural components of the deficit with well-defined and politically active constituent
groups. On December 2, 1998, the Brazilian legislature failed to pass the major reform
bill, suggesting that the government would be unlikely to meet its fiscal targets. Although
other savings had been found, legislative gridlock raised a serious question about Brazil’s
commitment to fiscal austerity and broader economic reform.
2 DRI, Inc. World Markets Report: Brazil. October 1998.
Current Account Deficit. The third major economic issue was the current account
deficit, which exceeded 4% of GDP in 1998. Although below levels seen as unsustainable
(e.g. 8% in the case of Mexico in 1994), it was higher than generally considered desirable
(3%). The current account deficit may be viewed as a function of Brazil’s low domestic
saving rate. Brazil used foreign capital to supplement the shortfall of domestic savings to
finance private investment and the government deficit. To bring about higher saving rates,
Brazil would have had to encourage private sector saving over consumption, which is not
easily done through public policy, or directly increase saving on the public side by cutting
the federal budget deficit, which it had failed to do.
By January 1999, Brazil had to support a policy of high real interest rates to attract
foreign capital required to finance the fiscal and current account deficits, rather than
reduce interest rates to help stimulate the economy. Given this constraint on monetary
policy, shrinking the fiscal deficit was key to resolving Brazil’s economic problems. A
smaller fiscal deficit would have reduced the need for foreign capital and related high
interest costs, effectively lowering the current account deficit while increasing saving,
which would have exerted downward pressure on interest rates and the exchange rate.
Although this would have taken time, decisive movement toward fiscal austerity might
have allowed capital markets to retain confidence in Brazil’s financial future.
Capital Flight and the IMF Package3
Following Russia’s devaluation and default in August 1998, investors viewed Brazil’s
overvalued currency, weak fiscal position, and policy gridlock with great skepticism.
Capital flight ensued and Brazil approached the IMF for aid even before a full-scale
currency crisis had erupted. On December 2, 1998, the IMF approved a stand-by
arrangement comprising financial commitments from the IMF, World Bank, Inter-
American Development Bank (IDB), and 20 individual countries, including the United
States (see Table 2). The IMF's overriding goal was to provide private capital markets
with sufficient assurance of Brazil’s short-term liquidity to avoid a speculative attack on
the real. It was intended to buy time for Brazil to: 1) pass reform measures aimed at
addressing deeper economic problems, particularly fiscal reform; and 2) increase the
depreciation rate of its crawling peg to allay concerns over exchange rate valuation.4
Total financial assistance amounted to $41.5 billion. The IMF had the largest portion
at $18.0 billion, with $5.5 billion (30%) offered under the normal stand-by arrangements,
provided at slightly above U.S. Treasury rates and disbursed over three years subject to
IMF reviews of Brazil’s policy commitments. The remaining $12.6 billion (70%) was
made available through the IMF’s new Supplemental Reserve Facility (SRF) at a higher
rate and for only a one-year period. Both the World Bank and the IDB provided three-
year loans of $4.5 billion, available in 1999. Twenty countries also committed to
guarantees of loans made through the Bank of International Settlements (BIS), of which
the U.S. portion was a $5.0 billion commitment from the U.S. Treasury’s Exchange
Stabilization Fund (ESF).
3 For IMF details, see: CRS Report RL30575, The International Monetary Fund: An Overview
of Its Mission and Operations, by J. F. Hornbeck and the IMF web page: [http://www.IMF.org].
4 Ironically, this assistance was approved the same day Brazil failed to pass the fiscal reform bill.
Table 2. IMF Financial Arrangement for Brazil ($ billions)
(Approved December 2,1998)
IMF$18.070% under new SRF* at 3 percentage points over normal rates
(expired 12/1/99); 30% as normal stand-by arrangement.
World Bank$4.54 percentage point over normal lending rates.
IDB$4.54 percentage points over normal lending rates.
Bilateral$14.5Loans from BIS** guaranteed by 20 countries; 4 percentage
points above U.S. Treasury rates.
*Supplemental Reserve Facility (see paragraph below).
** Bank of International Settlements - Basle, Switzerland. U.S. portion ($5.0 billion) committed5
from Exchange Stabilization Fund (ESF), U.S. Department of the Treasury.
Source: IMF, IDB, and U.S. Treasury.
There were some ground breaking aspects to the Brazilian package. First, it used the
SRF, which was established by the IMF only one year earlier in December 1997 to meet
short-term liquidity problems in countries that have experienced a sudden loss of market
confidence, but that also have reform measures in place to suggest that market confidence
can again be obtained relatively quickly. Second, for the first time, the IMF activated the
New Arrangements to Borrow (NAB) to finance the Brazilian loan. The NAB is a new
agreement with certain countries to have them lend supplementary funds to the IMF to
assist with financial crises at times when the IMF’s liquidity is low. Third, it was originally
a preemptive loan arrangement in which Brazil requested support before it actually had a
financial crisis. Fourth, the IMF “front loaded” the package, allowing most funds to be
disbursed in 1999.
Brazil drew $9.4 billion in December 1998 divided between IMF and the bilateral
commitments. The draw was conditioned on following a number of policies including
reducing its fiscal deficit, following a strict monetary policy, enacting various structural
reforms, and maintaining its pegged exchange rate. The real’s stability at this point
depended on the credibility of Brazilian policies, which was lost when Brazil’s congress
failed to pass reform legislation. The resulting capital flight forced Brazil to float the real
within a month, its value dropping by 40% at its low point. Moving from a pegged to a
floating exchange rate meant that technically Brazil was no longer in compliance with
initial IMF conditions, requiring a renegotiation of terms. On March 30, 1999, with
reforms underway, the IMF in its second review agreed to new terms with Brazil; one
week later Brazil drew a second installment of $4.9 billion from the IMF, another $4.9
billion from the bilateral commitments, the full $4.5 billion from the IDB, and $1.0 billion
from the World Bank.
Subsequently, as a condition for making available the remaining IMF resources, the
Fund conducted three more reviews of the Brazilian economy on July 28, 1999, November
5 For details on the ESF, see: CRS Report RL30125, The Exchange Stabilization Fund of the U.S.
Treasury Department: Purpose, History, and Legislative Activity, by Arlene Wilson.
29, 1999, and May 31, 2000. The economy adjusted faster than many analysts had
predicted and Brazil did not need to access the full amount of the IMF package. From the
IMF alone, it drew a total of $11 billion, but repaid all the higher interest loans from the
SRF and bilateral agreements in April 2000, six months ahead of schedule. As of June 1,
2000, Brazil had an outstanding IMF credit balance of $1.9 billion from the three-year
Outlook and Implications
Economic indicators suggest Brazil has clearly beat all expectations regarding its
recovery from the January 1999 devaluation and effectively Brazil’s financial crisis is over.
Although at one time Brazil was expected to enter a deep recession, GDP actually grew
by nearly 1% in 1999, employment increased by 2.5%, and the annual inflation rate was
restrained to 9%, within the target range expected by the IMF. The current account deficit
was higher than anticipated due to weak export prices and the rising cost of oil, as well as
a slower than expected response of export prices to the devaluation. Foreign capital has
begun to return to Brazil, however, so the current account deficit has been fully financed
with foreign capital and Brazil’s reserve position has stabilized, even as it has repaid the
IMF. Improving trends in 2000 so far support Brazil’s optimistic assessment that its worst
economic problems are now past.
Economic policy and IMF assistance appear to have been two important variables
reducing the severity of Brazil’s financial crisis. Although implementing economic reform
earlier might have averted the crisis to begin with, clearly the economic fallout could have
been much worse. Structural reforms played an important role, particularly the fiscal
effects related to congressional action in 1999-2000 on redefining the public and private
pension systems, the fiscal responsibility law and broader tax reform, which affects federal,
state, and municipal budgets, and heightening regulatory oversight (and consolidation) of
the financial sector. Fiscal and monetary policy have held firm, keeping a check on
inflation while supporting solid economic growth in 2000. Fiscal excess, viewed by many
as a core problem, has improved as seen in the expected rise of the primary fiscal balance
(excludes interest expense) from 0% of GDP in 1998 to over 3% in 2000, although
reducing Brazil’s public debt remains a long-term challenge.
Many view the Brazilian IMF program as a success, providing liquidity and credit
enhancement as capital fled and conditionality working as a major catalyst for policy
reform, which Brazil clearly resisted right up to the January 1999 devaluation. The
devaluation rather than IMF assistance, however, was the major event halting capital flight,
a decision Brazil would have faced in the absence of IMF assistance. Brazil also would
have probably had to make policy adjustments in any case, but the fact that the IMF
worked closely with Brazil even prior to the actual crisis suggests that there may be some
merit in evaluating pre-emptive IMF assistance in cases of perceived potential crisis, versus
responding after the fact. Finally, the fact that Brazil’s recovery hinged on its ability to
pass long-delayed reform measures speaks to the importance of pushing for such change
before the onset of a financial crisis, a debate that is currently flourishing over the broader
issue of defining appropriate IMF assistance. Enacting such deep structural reform, while
also addressing severe social problems, remains one of the major political challenges facing
Brazil and the rest of the developing world.