Real Trouble? Brazil Scrambles to Immunize Itself From Argentina

The country hopes the latest rate cut and (possibly) more help from the IMF will help it avert contagion.
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Brazil is preparing for the worst from Argentina.

The

Brazilian Central Bank

raised interest rates for a fifth time this year Wednesday night -- an effort to muffle rising inflation due to currency weakness from Argentina jitters. Talk is also building that the Brazilian government is planning more budget cuts and considering asking for further help from the

International Monetary Fund

to put its fiscal house in order. In an interview with a local newspaper, President Fernando Henrique Cardoso conceded that the government could increase its budget surplus target and ask the IMF for more resources if necessary.

Fears that Argentina will default on its $130 billion foreign debt obligations have kicked the Brazilian real into a puddle this year. Worry that the unraveling in Argentina will spread to Brazil escalated last week when Argentine politicians wrangled over President Fernando de la Rua's budget cut plan, drawn up to facilitate the payment of the debt obligations. The Brazilian real fell to a record low of 38.5 cents to the U.S. dollar.

A severe energy crisis in the country and political turmoil also have hurt the currency, but Argentina has been the driving force behind the real's pain.

"The rate hike is directly linked to weakness in the real, which is directly linked to Argentina," says Lara Rhame, economist at Brown Brothers Harriman. "There is a lot of concern that this bout of weakness could lead to long-term inflation."

The Central Bank raised its inflation forecast for the year to 5.8% from 4.8% in its most recent quarterly report, well above the bank's 4% inflation target for the year. The lower real makes imports more expensive -- in particular oil, which is in high demand due to the energy crisis facing the country.

Still, the real may have seen the worst of its downturn. Some economists think a potential devaluation in Argentina is already priced into Brazil's currency.

"

The real has dropped 25%

against the U.S. dollar since beginning of the year, and your typical devaluation is between 25% and 40%, so I wonder how much further

it would go," Rhame says. "The real is getting deeper and deeper into bargain territory."

Meanwhile, the Brazilian economy is in good shape relative to Argentina, while further budget cuts and additional IMF help carry their own risks. Any additional measures to counter contagion likely will depend on developments in Argentina, where a controversial budget cuts plan stalled in Congress.

"We think that the government is likely trying to decide the timing and magnitude of the measures," wrote UBS Warburg economist Michael Gavin in a report published this morning. "While the government wants to be proactive and avoid further deterioration of expectations regarding Brazil, it is also aware of the political costs of the measures under discussion, as well as of the risks of using all its bullets at once."