Brazil’s 1998-1999 Currency Crisis, Essay Example

Introduction

Brazil is currently coming out of an economic crisis which was initially suspected in 2013 but revealed its true presence in 2014. This economic crisis that arose from the decline of real value and inflationary support by the Brazilian government is very similar to other financial crises of previous years, especially a similar crisis that occurred in Brazil in 1998-1999. The following will assess the current 2013 financial crisis and compare it with historical data. Recommendations are also offered to on the best way to avoid crises in the future.

Contemporary Episode

The most recent economic crisis in Brazil happened in 2013 and the region may still be seeing the effects of this crisis. Philip Inman notes that Brazil’s real economic crisis can be seen in the fact that it overvalues its currency (Inman, 2013). The author notes that “they can only disguise a problem that has loomed for some time: that a high currency kills the trade in price-sensitive goods. The soaring value of Brazil’s currency, the real, has badly hurt exports” (Inman, 2013). Inman bases his conclusion on the fact that in 2012, while the UK accounted for a 3.8% in Brazil’s imports with a $3.5 billion values. Brazil’s exports to the UK were down 13% over the course of 12 months. Inman attributes the Brazil’s economic crisis to year of years of protectionist policies which resulted in the overpricing of manufacturing. This impacted Brazil specifically in regards to the export of their resources like soy beans, gold, sugars, and metals. Through overpricing their commodities, they were less appealing to other countries within the global market and the Brazilian economy as a whole started to decline. Inman notes that the decline in China’s purchasing of their products was the most significant blow to the country’s economy as China represents their largest exporter. Brazil’s unemployment rate also hit 6% in 2013, which represented a substantial increase in unemployment for the country’s labor market (Inman, 2013). The author goes onto note that this decline had nothing to do with the economic recession caused by the global financial crisis of 2008 as in 2010, “the country appeared to shrug off a brief recession. GDP growth reached 7.5% – the highest rate for 25 years. But rising inflation forced the government to cool the economy just as the eurozone crisis unsettled international markets. The economy slowed, growing just 2.7% in 2011, and 1.3% in 2012” (Inman, 2013). The cooling off of the economy meant that Brazil felt obligated to increase interest rates interest rates, which in turn made the country more attractive to foreign investments from regions like Italy, but in order to buy Brazilian assets, investors had to buy Brazilian currency, and increased demand for the real resulted in inflation of the exchange rate. Inman notes that, “with inflation still at 6.7%, the government has little room to stimulate the economy. It is a common problem among emerging economies as China slows to a crawl. Turkey is struggling. So is South Africa. All of them are trying to avoid the vortex of pain when social problems triggered by their stuttering economies only goes to make the situation worse” (Inman, 2013). Here the Brazilian financial crisis of 2013 can be likened to the Asian Contagion of 1997 in how the impact is not just in one country but trickling over to impact a wide range of developing countries like China, Turkey, and South Africa as well. The authors point out this is largely due to the fact that these regions, like Brazil, keep their currency inflated because they are in desperate need of foreign investment, but the process hampers exportations which ultimately leads to a decline in domestic productivity and manufacturing.The problem is the effort has not worked, and foreign investment has slowed down in Brazil and the currency value has further declined. This has caused all countries involved in the crisis to juggle in an attempt to dodge further pitfalls in the hopes that China’s recovery will show ample routes to financial adjustment for Brazil as well.

When all is assessed, the main cause of Brazil’s financial crisis can be attributed to manipulation of the real in the hopes of sustaining high interest rates for foreign investment. The initial act that fueled the crisis was a disproportionate faith in the value of the real compared to a strengthening U.S. dollar. This miscalculation by the Brazilian government resulted in them overvaluing their currency. Maintain high interest rates while the real was in decline made it more difficult for domestic labor and manufacturing to continued and reduced the amount of exports leaving the country. In turn, the foreign investment Brazil expected would continue during its years from 1980 to 1997 when hot money was on the rise through foreign investing, did not continue to flow through the country. In the end the country had an economic crisis similar to that of 1998-1999 where similar events resulted in the decline of the real and rioting in the streets. This incident can also be compared to the Asian Contagion crisis of 1997-1998.

Brazilian Financial Crisis 2013-present Vs. Asian Contagion 1997-1998

The Asian contagion of 1997-1998 was an economic crisis that started originally in Southeast Asia but would later spread to Colombia, Russia, the Ukraine, and Brazil. Pempel (1999), notes that the impact of the Asian economic meltdown reached the the majority of East Asia. The author identifies the crisis as being one that initially originated out of Thailand, when he notes that, “In July 1997, there was a massive run on the Thai baht. Despite a $26 billion dollar effort by the Thai government, the currency lost 48.7% of its value, triggering a sharp down turn over the next 6 months in Thai assets and growth” (Pempel, 2013). Similar to the current 2013- present Brazilian financial crisis, caused from the Brazilian government overvaluing the real, the Asian Contagion also formed from issues with the country’s exchange rate, manipulating the value of currency. Pempel (1999) notes that following the financial collapse of the Thai baht, the Thai government was in need of foreign currency and had no choice but to “float the baht” to maintain the integrity of its fixed exchange rate (Pempel, 1999). This action cut trade to the U.S. through removing the currency’s tie to the U.S. dollar. This placed Thailand in a critical financial position where the government exhaustively provided support for the baht while overextending itself economically through domestic real estate markets and its ultimately decline. In addition to this, the country had accumulated significant international debt. This was a debt that had already been established prior to the collapse of Thailand’s currency but it made country bankrupt. The impact on Thailand’s economy was so significant that it had adverses effects which spread to other regions of the world. Japan as well as Southeast Asia saw declines in the value of their currency as well as the stock market, and substantial rise in private debt due to the decline in currency value.

There was a rise in the Foreign debt-to-GDP ratios in the majority of Southeast Asian nations (ASEAN). Overall across the Philippines, Hong Kong, China, Taiwan, Singapore, Vietnam, Laos, Thailand, Malaysia and Brunei, Foreign debt to GDP saw and increase from 100% to 167%, reaching as high as 180% during the height of the crisis. In fact, South Korea saw a rise in their service to exports ratio to 21% and it eventually reached 40%, revealing the country significantly did more importing than exporting due to overvaluing their currency and creating false support. The same trend can be seen in Brazil’s 2013 financial crisis as the debt to service ratio rose from 15% in 2012 to 28% in 2013 (World Bank, 2014). This trend is a financially natural response to the over valuation of currency in respect to exchange rates, as the currency value declines, the country is forced to use more of the currency to purchase foreign goods or cut production specifically in areas that rely on the supply of foreign commodities. This is largely why decline in currency value impacts Total Factor Productivity (TFP). On the other hand, due to the same fact that the currency value has significantly declined, one would suspect that it would have no impact on trade and in fact foreign countries would be more ampt to trade with a region that can provide goods and services at a reduced price, but the governments choose to maintain a fixed exchange rate and take on the burden of supporting the failing currency. This leads to reduced buying and investing on the behalf of other regions.

Another comparison can be made between the Brazilian fiscal crisis of 2013 and the Asian contagion of 1997 and it can be seen in the socio political impact the decline in currency value had on the region. Specifically in Brazil, the decline in the value of the real resulted in massive riots across the country, as Inman notes, “Bert Colijn, a labor market economist at the Conference Board, said signs unemployment was rising were cause for concern – especially after the riots, which started earlier this month and were still going as the pope began his week-long visit” (Inman, 2013). The same occurred during the Asian Contagion of 1997. Even though the majority of Asian governments had sound fiscal policies,  the International Monetary Fund (IMF) still took it upon themselves to install a program that would invests $40 billion in stabilizing the currencies of Indonesia, South Korea, and Thailand, as these were the regions most impacted by the economic crisis.Despite these efforts, little could be done to stabilize Indnonesian currency and widespread riots across the region resulted in President Suharto stepping down after 30 years in power. By 1999, however Asian markets began to show signs of recovery. Leading up to 1999, the total capital inflow of Asian markets were cut in half.

The cause of the Asian Contagion can also be attributed to a range of external factors that began to change the global economic climate. During the mid-1990s, the devaluation of the Chinese renminbi, and the Japanese yen occurred in response to the Plaza Accord of 1985, which resulted in an increase in U.S. interest rates. While this created a strong U.S. dollar, it resulted in a dramatic decline in semiconductor value prices. It ultimately had an adverse effect on the growth of Japan and China’s economy.          When Allen Greenspan decided to raise the U.S. interest rate to head off inflation, it made the United States a much more appealing investment option than Southeast Asia, which up until that point had been attracting a a lot of short term investment funds of foreign investors seeking a quick profit. This decline in investing ultimately resulted in a decline in the value of Asian currencies and attempts to maintain the fixed exchange rate by Asian governments in hopes of keeping up with the United States. There are some economists who attribute the Asian Contagion of 1997 to the growth in Chinese exports as they began to compete directly with other Asian exporters. The excessive real estate speculation associated with the rise interest rates compared to the fixed exchange rate was also something that resulted in overconfidence in the Asian market.

The parallels between the current financial crisis in Brazil and the Asian Contagion, largely stem from the value the regions place on their currency during times of devaluation. Even in their differences, for example the fact that the real estate market played a significant role in the economic crisis of the Asian markets where it had no real impact on the current crisis of late, the cause of such an impact can still be attributed to the decline in currency value and the discrepancy that occurs from governments seeking to maintain a fix exchange rate policy.

Reinhart and Rogoff

Reinhart and Rogoff (2009) point out that the policy makers and central bankers who benefit from the economic rise associated with financial bubbles tend to believe “this time is different” (Reinhart and Rogoff, 2009). They argue that this is a delusional belief that tends to result in investors being over enthusiastic about markets and placing too much confidence in market value. As their overconfidence catches up with them, markets naturally become overvalued and decline as panic sets in. The reason this happens as the authors note is due to the fact that “otherwise-savvy people ignore the telltale signs of a bubble when they are in the grasp of “this-time-is-different syndrome” (Reinhart and Rogoff, 2009). They argue that investing too much confidence in the stability of rising markets is such a common occurrence that brilliant minds like previous Federal Reserve Chairman Alan Greenspan is also subject to its lure. The prime example the authors use is that in the 1920’s, U.S. economists and bankers estimated that there would not be recurring wars and the world would see a stable economic future. This turned out to be a false overly optimistic view of the future and economy. In addition, from 2003 to 2007, bankers believed the innovation of new financial instruments created a justifiable economic environment where soaring home prices and rising household debt. This is a common misconception that historically has resulted in bubbles and ultimately followed by financial crisis. Reinhart and Rogoff note that, “In fact, rising home prices and financial innovation are strong indicators of a bubble. Currency debasement was common for centuries. In the past 100 years, inflation has replaced debasement. Sovereign defaults are a normal part of global capitalism, although they ebb and flow” (Reinhart & Rogoff, 2009). The authors recommend the use of a early warning system that is conscious of the fact that financial crises have been a common occurrence for the past two centuries. These arguments Reinhart and Rogoff present about the impact of overconfidence to believe a specific economic upturn is impervious to the outcomes of the past, can be seen in Brazil’s handling of its currency in 1998-1999 and then repeating the same trend in 2013.

The 1998-1999 Brazilian Economic Crisis

In Evangelist and Sathe’s (2006) “Brazil’s 1998-1999 Currency Crisis” the authors note that following “a decade of inflation rates ranging from 100% to nearly 3,000% per year, Brazil’s central bank made an effort during the 1990s to reign in inflation and public spending. In 1994, the government reissued the real and instituted a crawling peg” (Evangelist and Sathe, 2006). The impact of a new currency combined with extremely high interest rates, as high as 30% resulted in stabilizing inflation. This marked the first time Brazil had stable inflation in decades but the influx of foreign investment created a sense of confidence in the Brazilian market that was unrealistic. This was attributed to the fact that banks had less reason to hold currency due to the fact they could makes profit much faster. The authors further note that “investors, attracted by high interest rates, poured money into the Brazilian economy at unprecedented rates. In 1997 foreign direct investment grew by 140% over the year before” (Evangelist and Sathe, 2006). The problem that occurred happened when Brazil overvalued the real based on this upward trend and ultimately had their interest rate far exceed the value of their most precious commodity, gold. The following table shows this discrepancy and how it resulted in a plummeting the Brazilian economy in 1998 and 1999.

Evangelist and Sathe attribute the above volatility to a fundamental weakness that has always existed within the Brazilian economy, the fact that despite being successful with lowering inflation, Brazil has been plagued with underemployment and current account deficits.

Comparison and Persistence (40%)

Discuss the similarities and differences of the two crises (contemporary with historical).

The economies of Southeast Asia during the 1980s and early 90’s were able to maintain significantly high interest rates which made them attractive to foreign investors interested in receiving a high rate of return. But when external factors, such as the strengthening of the U.S. dollar compared to that of the Southeast Asian markets began to impact the actual value of Asian market currencies, governments found themselves overvaluing the currency and keeping interest rate high despite not seeing ample returns on GDP or TFP. The same can be said of the 2013 Brazil’s current and past economic history in respect to how it values its currency.

The main similarity between the current financial crisis which Brazil is enduring and the financial crisis of 1998-99 has to do with the country’s lapse in judgment regarding the overruling of their currency and the ultimate decline this created in their economy.

Discuss some mechanisms/channels that may (or may not) explain persistence.

The above chart demonstrates the Total Factor Productity of Brazil between 1950-2008. It reveals that between 1951 and 1967, the country saw TFP growth, attributed primarily to rating of the real. The chart further shows that the country saw a substantial rise in TFP growth. As the second regime took power in Brazil in 1968, the country saw a rise in interest rates as a direct respone to their rise in TFP growth during the first regime. by the third regime the inntial rise in interest rates caused by the rise in TFP growth caused Brazil’s financial market to enter an economic crisis that lasted from 1981 until 2008 where there was a decline in both productivity growth as well as a decline in capital earned by worker. The fact that Brazilian officials could not foresee this occurrence and predict the impact raising interest rates, and ultimately the value of the real, would have on their economy in 2013 based on past experiences is a prime example of Reinhart and Rogoff’s argument.

In recommending ways to avoid another financial crisis and not falling into the syndrome of “this time is different” Reinhart and Rogoff note that “this-time-is-different thinking is so infectious that it saps the will of those who might dampen the party” (Reinhart and Rogoff, 2009). The authors argue that it is incredibly difficult for economists and investors to innitiate the necessary changes to avoid a financial crisis or to even alert the public to the reality of a bubble about to burst, due primarily to the fact that “this time is different” becomes a contagious phenomenon immune to reason. Despite this the authors note there are some ways through which Brazil or countries like it can avoid the same trends. They state there are two main steps a country can follow to avoid falling into this sort of trap, specifically, adopting “1. An early-warning system – Because financial crises follow established patterns, the world’s policy makers and investors need a warning system that alerts them to danger signs. For instance, an unusual rise in housing prices reliably predicts a banking crisis” (Reinhart and Rogoff, 2009). The authors acknowledge the fact that practicing early warning signs has little impact on allowing economists to identify the exact moment when an economic crisis is at its peak, but the method could serves as a valued indicator inthe process to reducing risk and exposure to such events. The importance of having such an indicator is based on the fact that “This time is different” in itself is a mindset that encourages one to overlook clear signs of trouble. This is a specifically true of those in power at the time of a financial bubble. The authors also note that inorder to reduce this mindset, policy makers need ot have “2. A regulatory scheme with teeth – When this-time-is-different syndrome takes hold, capital crosses borders in search of the lightest regulations. And regulators turn a blind eye to rules regarding leverage” (Reinhart and Rogoff, 2009). To avoid future crises, regulators must take an international approach to regulation and enforce the rules – even when everyone believes that the situation truly is different this time.

The above chart reveals the historical exchange rate of Brazil and how it has changed in comparison to normal rates throughout the globe. The chart reveals the impact overvaluing Brazil’s currency has had on its actual value in comparison to the U.S. dollar.  The chart makes it clear that starting in June of 1995 the real began to decline compared to the U.S. dollar, and by 2000, the practice of Brazil overvaluing its curency resulted in a severe discrepancy in the exchange rate between the real and the U.S. dollar, a difference of nearly twice the value.

The above chart shows the current Real GDP and Real Value added by Sector for Brazil from 2012 to 2014. While showing the impact the decline in currency had on the GDP in the 2014 quarter 1 specifically, the fact that the economic crisis which initially occurred in 2013 revealed its most substantial impact in the first quarter of 2014, it also reveals that Brazil may be on its way to recovery. The chart parallels data from Fig 3: Current Account and Reserve (Cardoso & Teles, 2010), in how it demonstrates due to factors like chronic underemployment or a continued current balance debt, Brazil is always reliant in the interest of foreign investors and always vulnerable to a complete bottoming out within its market.

 Conclusion

In sum, the main cause of the Brazil’s financial econ comic crisis can be attributed to the government placing too much confidence in the continued interest of foreign investors to effectively regulate its currency. This was the cause of the financial crisis in 1998 as well as the cause of the crisis that most recently occurred in 2013. The main difference between the crisis in 1998 and the 2013 crisis is that in 1998 Brazil had just created the real for the purpose of reducing inflation. All financial occurrences that happened out of this action were unprecedented. The Brazilian government was essentially dealing with uncharted territory, but in 2013, they had the opportunity to learn from their mistakes. During the 2008 global financial crisis, Brazil was nearly unaffected by the period and it showed signs of possibly being a new country with an even brighter economic future, but 2013’s decline in real value, combined with the country’s chronic underemployment demonstrates how vulnerable and reliant the economy is to foreign investment.

References

Cardoso, E., & Teles, V. (2010). A brief history of Brazil’s growth. Growth and Sustainability in Brazil, China, India, Indonesia and South Africa, 19-50.

Evangelist, M., & Sathe, V. (2006). Brazil’s 1998-1999 Currency Crisis. Unpublished manuscript.

Inman, P. (2013). Brazil’s real economic crisis lies in its overvalued currency. The Guardian.

Pempel, T. J. (1999) The Politics of the Asian Economic Crisis. Ithaca, NY: Cornell

University Press. http://books.google.com/books?id=sTAuUXE_ANsC&pg=PA1&lpg=PR7&ots=WS_vYm7o8n&focus=viewport&dq=+Pempel,+T.+J.+(1999)+The+Politics+of+the+Asian+Economic+Crisis.&lr=&output=html_text

Reinhart, C. M., & Rogoff, K. (2009). This time is different: eight centuries of financial folly. princeton university press.

World Bank. (2014). Brazil real gdp and real value added by sector. Washington, DC: Author.