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RUDI DORNBUSCH, a renowned economist who died in 2002,

said there were two sorts of currency crisis. The pre-1990s kind is
slow. It starts with an overvalued exchange rate, which gives rise
to a trade deficit. Foreign-exchange reserves are gradually run
down to pay for it. When they are gone, the game is up. The
currency drops. The finance minister loses his job. But life goes
on much as before. The world does not collapse.

The second sort of crisis is the first sort on steroids. A country


that might once have blown some World Bank loans on bad
policies is able to tap global capital markets for billions of dollars
to misuse. Domestic banks join the party. The economy booms.
When the flow of capital suddenly reverses, the currency
collapses. Bankruptcy is widespread. The damage is big enough
to affect others

Brazil would seem to demand a third category. Elections this


month will decide its next president and the character of its
congress. They will thus shape the response to a slow-motion
financial crisis. The drama is likely to be played out in the
currency market. The impact might be far-reaching. But Brazil
shows no signs of an old-fashioned balance-of-payments crisis. It
at not the mercy of global capital. Its crisis is, in essence, a battle
with itself.

Compare Brazil with Argentina and Turkey, both in the eye of


market storms this year. They fit the template for a currency
crisis. Both had run large deficits on the current account, a broad
measure of the trade balance. These were financed by foreign
borrowing, much of it in dollars. Both suffer high inflation. Both
had skimpy foreign-exchange reserves. Brazil is different. Its
current account is broadly in balance. Inflation is close to a
record low. Its plentiful currency reserves dwarf its dollar debts.

Brazil’s problem is that its government finances are on a


dangerous path. Public debt has risen from 60% to 84% of GDP
in just four years. That owes a lot to a collapse in revenues after
2013. A brutal recession did not help. But the budget had been
flattered by windfall receipts from a mining boom and credit-
fuelled consumer spending. Those will not be repeated.

The third way


That means spending cuts are needed to fix the public finances.
The government wage bill has grown rapidly. But over-generous
pensions are a far bigger problem. They already account for 55%
of non-interest public spending. The cost will go on rising as
Brazil ages. Things would surely be worse were it not for a
constitutional amendment in 2016, which caps the rise in public
spending. An attempt to reform pensions was aborted when the
president, Michel Temer, was implicated in the corruption
scandals that have seen one of his predecessors impeached and
another sent to jail.
In a different Brazil, politics would seek to reconcile the claims of
bondholders (who are almost all Brazilian savers; see chart),
pensioners, well-paid government workers and the rest of the
country. Instead, to make the sums add up, the last of these
groups has suffered a squeeze on public services and living
standards. And the corruption crisis has engulfed the governing
class. The front-runners for president are polarising figures who
might struggle to steer pension reform through congress. The
crunch point might come next August, if not before, says Arthur
Carvalho of Morgan Stanley. A budget for 2020 must be
submitted then. If pension reform is not in place, a big squeeze
will be needed elsewhere for the country to stay below the
spending cap, he says. Or the cap itself will have to be lifted.

Bondholders would take fright. Though foreigners hold little of


Brazil’s debt, there would still be capital flight, a falling currency
and rising bond yields. As Brazilian savers anticipated the
inflation and chaos that would result from soaring public debt,
they would seek to escape it. Savers elsewhere in Latin America
have long used dollar accounts as a shield from inflation. This
would be novel for Brazilians, says Mr Carvalho. But because
short-term interest rates have been slashed to reflect subdued
inflation, the opportunity cost of pulling money from Brazil has
rarely been lower.

Nothing is ever entirely new. The symptoms of Brazil’s past crises


were high inflation and external deficits. But below the surface,
the underlying problem was lax fiscal policy, says Armínio Fraga
of Gávea Investimentos, a hedge fund, and a former governor of
Brazil’s central bank. In the slow-burning sort of crisis, said
Dornbusch, a mid-course correction can prevent the worst.
Brazil might yet manage that. If it cannot, its decline is likely to
speed up dramatically.

Economist.com/blogs/buttonwood
This article appeared in the Finance and economics section of the print edition under the
headline "Keeping it real"