The Coming Year: Will Brazil Come Crashing Down?

Brazil will be lucky if 1999 is merely dismal. The year ahead will likely be catastrophic.
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Recent troubling developments suggest that Brazil will not make it through this year without another globe-quaking crisis, which will probably involve an uncontrolled devaluation of the real.

And that awful fate appears to await the country even though the

International Monetary Fund

last year made more than $40 billion available for protecting the currency.

The downward spiral has already begun.

Congress

late last year voted against important elements of the fiscal reform package put together by Brazil in return for the IMF cash. Other crucial budget-cutting measures are getting held up in the machinery of Brasilia. Just this week, one high-profile governor threatened to withhold payment on his state's debt to the federal government. Others may follow.

As a result, it's now almost inevitable that the government of President

Fernando Henrique Cardoso

will fail to significantly trim its out-of-control budget deficit, which stands at a burdensome 8% of GDP. High interest rates will continue to strangle the economy, causing a recession in which GDP may shrink by more than 3% in 1999, according to some economists.

What does this mean? Government debt will continue to soar. The IMF will likely become frustrated with the lack of fiscal improvement and -- after much hand-wringing -- slam shut its coffers, according to some Brazil analysts. If that happens, panic-selling of the real would force the currency out of its dollar-pegged regime. And Cardoso's gallant but tactically deficient effort to bring low inflation growth to Latin America's largest economy would collapse.

Overly pessimistic? Well, consider what's happened since the IMF signed off on its $41.5 billion credit line for Brazil in November last year.

Blame It on Brasilia

In mid-December, the uncooperative lower house of Congress voted down two critical proposals for increasing taxes on social security payments. These defeats show how dangerously out of touch Congress really is. The social security system's debts alone add up to 4.7% of GDP, according to

Flemings

. The politicians did not have the courage to grasp this huge nettle -- even though the next House elections are four years away. The government has said it intends to reintroduce these social security measures this month.

In addition, what was going to be the biggest single measure of the fiscal package -- an increase in the financial-transactions tax -- will probably not be implemented until the second part of this year. This could result in a loss of up to $5.8 billion from the $23 billion that the fiscal package aims to raise.

To make up for this possible shortfall, Cardoso last week introduced a range of new measures that aim to save $5.6 billion, only a third of which must be approved by Congress.

Tax, Tax and Tax Again

So far, Cardoso's team has fought back from every defeat -- something that should give confidence to investors. But there's a big problem with its approach. Walter Molano, economist at

BCP Securities

, says Cardoso's team is relying too much on tax increases for its savings, which will hit businesses and therefore exacerbate the recession. "It would've been much better to announce additional spending cuts," he says.

Molano surmises that Cardoso is reluctant to slash public-sector wages and jobs. He points out that in 1990

President Fernando Collor

faced a ferocious backlash after announcing big layoffs.

Socialist Nostalgia

But it may be that, at heart, Cardoso is ideologically opposed to such measures. For many years, he was a New Left guru. The market assumes that he left all that baggage behind when he entered government earlier this decade. But, as economic hardship and unemployment grow, he may be rethinking his commitment to free-market ideals. Indeed, there are already signs that Cardoso is revisiting some of his old theories.

In a speech to visiting South American heads of state Monday, Cardoso railed against what he calls an "asymmetrical globalization" that only benefits some countries, by which he presumably means the First World. This sounds suspiciously like Cardoso's old dependency theory, which, very crudely, says that the interests of developed countries will override those of the developing world.

Plus, from a technical point of view, it seems odd to favor tax hikes over spending cuts. The fiscal savings package is based on a 1% decline in GDP this year. But most economists expect a shrinkage of 2% to 3%. And

Goldman Sachs

estimates that for every 1% fall in GDP, tax revenues drop by 0.25% of GDP.

The Hidden Debt Mountain

There's another threat to fiscal targets that the press and most analysts have failed to pick up on: hidden losses in government accounts.

ING Barings'

eagle-eyed economist Arturo Porzecanski points out that the IMF's loan

agreement with Brazil refers to $21 billion of hitherto unrecognized debts from now-privatized companies, euphemistically termed "unregistered liabilities."

As a result, the government now has to spend all this year's expected privatization revenues in filling this black hole. But the big issue now is how much more debt is hidden in the system, according to Porzecanski. "The government faces huge unfunded pension and other liabilities that make one wonder just how big the iceberg of debt is that the Brazilian ship of state is running toward," he says.

IMF End Game

Brazil will almost certainly fail to meet the IMF's fiscal requirements this year. The big question is how the IMF and, more important, the U.S. Treasury will react to this likely failure.

The IMF wants Brazil to have a fiscal surplus of 2.6% of GDP in 1999 (excluding interest payments) and an overall deficit, or public-sector borrowing requirement (PSBR), of 4.7% (including interest payments). However, ING Barings is expecting a PSBR of 7.5% for this year.

Brazil has already drawn $9.3 billion from the $42 billion IMF package. It can probably get another $10 billion or so before the IMF starts to balk at giving more money.

But the conditions under which Brazil can make additional drawdowns virtually ensure that Brazil-IMF relations will become strained in the second and third quarters of this year. In each quarter, the IMF says that the PSBR must be lower than the same quarter in the previous two years. Porzecanski thinks it will be the third-quarter target that will be the hardest for the Brazilians to meet.

If it's missed only slightly, the IMF would be prepared to disburse more cash (assuming Brazil wants or needs it). But if the numbers are way off, then don't expect the IMF to cough up. After all, it walked away from Russia in the end, despite all the talk about the country turning into a nuke-laden Weimar republic.

Many opinions exist as to what would happen if the IMF got tough. The optimists say the Brazilians would make massive efforts to cut spending -- and fiscal accounts would quickly look better. Others say that the IMF will demand some sort of controlled devaluation of 10% to 15%. A weaker currency, it is argued, would allow interest rates to come down and the economy would get an extra boost from higher exports.

But Latin American countries with their backs against the wall rarely engineer such orderly escapes. And, regrettably, the evidence available at this stage overwhelmingly suggests a much nastier outcome.