Brazil Devaluation Could Spell End to Fixed Exchange Rates

The real's devaluation could actually be -- gasp -- good for the country, and instructive for other emerging economies.
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Showing a remarkable capacity to impose order on chaos, Brazil could be the first large developing country this decade to survive an uncontrolled currency devaluation. In fact, it might even profit from the real's nosedive.

If Brazil, which in January unpegged the real from the dollar, succeeds in making its devaluation work, other countries with fixed exchange-rate regimes -- most relevantly China -- may be tempted to follow suit.

What's more, if its new floating exchange rate ends up securing sustainable growth, Brazil will see off a serious challenge to its domination of Latin America by neighboring Argentina, which has gained prestige for keeping its fixed exchange-rate system intact during two years of emerging markets turmoil.

Most pundits predicted dire economic scenarios for Brazil when it let the real slide. Recent data, however, suggest the gloom was misplaced.

After the devaluation, the value of the real against the dollar was almost halved, falling to 2.18 in early March. Since then, however, the real has bounced back to 1.74 on the dollar. On balance, the fall adds up to a 30% devaluation.

Plenty of

investors saw the currency skid as a buying opportunity. In dollar terms, Brazilian stocks are now 23% above their predevaluation level, according to the

MSCI Brazil Free Index

. It took Mexican stocks more than 2 1/2 years to regain the dollar losses they suffered after the December 1994 devaluation of the peso, according to the MSCI index for that country.

The economy is also looking a lot better than people expected. Industrial activity in Sao Paulo, a reasonable proxy for the country as a whole, registered a 6.1% month-on-month increase in February.

The surprising strength of the economy is leading some economists to forecast a much less severe recession. For example, Ernest Brown, Latin economist at

Morgan Stanley Dean Witter

, now thinks the economy will contract 2.3% this year, as opposed to his original forecast of 4% shrinkage.

To cap it all, inflation, once a scourge, has stayed dormant, at least by Brazilian standards. As a result, Brown has lowered his 1999 inflation forecast to 15% from 21%.

And the good news continued Monday when the central bank, now headed by ex-

Soros Fund Management


Arminio Fraga

, cut its key interest rate to 39.5% from 42%.

"Brazil is starting to look like a demonstration of the virtues of floating," said Paul Krugman, the


economist, in an email interview. In an influential article published earlier this year in

Foreign Affairs

, Krugman wrote that it was difficult for emerging nations to benefit from devaluation, as the U.K. did after it left the European

Exchange Rate Mechanism

in 1992. But he now says that Brazil "looks a lot more like the U.K. in 1992 than Mexico in 1994 and Indonesia in 1998."

In fact, this optimistic conclusion is being reached in places that will immediately benefit Brazil. "Growth will probably be better in Brazil now that they have devalued," says a senior economist at the

International Monetary Fund

who requested anonymity. The IMF is leading a $42 billion aid package for Brazil.

This international financial assistance certainly helped save Brazil from Armageddon. But other factors also contributed. The country had manageable amounts of dollar debt. The banking sector was reasonably healthy. Foreign reserves were substantial. And after an initially ramshackle response, the authorities put in place credible policies to deal with postdevaluation conditions.

Of course, Brazil has many structural reforms left to implement if it wants to keep the market on its side. Still, advocates of floating exchange rates argue that tough reforms will be much easier to implement now that the country does not have to keep interest rates high to defend a currency peg.

Policymakers, they say, can now use the exchange rate as a shock absorber to soften the impact of reform on elements in society that may resist change. "The exchange rate can be used as way of keeping domestic interest groups at bay," says Walter Molano, Latin America economist at

BCP Securities


Argentines Are Watching

The Brazilian experience, of course, is being closely followed by its neighbors. Argentina, because it maintains a fixed exchange-rate regime, can only gain competitive advantage by keeping inflation below that of its trading partners, and by upping its productivity.

The problem is Argentina has notoriously rigid labor laws and strong unions. Quite possibly, if the government had control over the exchange rate, it may have been able to relax economic policy more than it has this decade, thereby assuaging workers.

Instead, the country has chosen to cushion reform through massive offshore borrowing -- the government's total foreign currency debt has soared to nearly $100 billion from around $80 billion in 1995.

The interest on this debt is the sole cause of the government's budget deficit. Before interest payments, the government had a budget surplus equivalent to 0.8% of GDP last year; after them, it had a deficit of 1.1% of GDP.

Investors are spooked by this increasing debt burden: The Argentine 30-year bond trades at 5.8 percentage points over U.S. Treasuries, compared with 4.4 points for Mexico's.

However, it'll take some time for the "floaters" to gain intellectual respectability in Latin America, since the proponents of fixed regimes have marshaled a lot of very persuasive evidence. A recent report from the

InterAmerican Development Bank

, headed by chief economist Ricardo Hausmann, shows that countries with floating exchange rates do not have it easier.

In fact, between September 1997 and February 1999, domestic interest rate spikes were a lot more violent in Mexico, with its floating regime, than Argentina. In addition, Hausmann argues that wages in Latin America tend to rise when devaluations occur, offsetting much of the competitiveness gains.

Research by Steve Hanke, a professor at

Johns Hopkins University

and a well-known evangelist for fixed exchange-rate systems, shows that between 1950 and 1993 fiscal deficits were 65% larger in countries with central banks, as opposed to dollarized countries or those countries with currency boards.

"Floating exchange rates can't be maintained in emerging markets," Hanke says. "Central banks don't have the necessary credibility and they have to keep real interest rates too high."

But domestic real interest rates in Mexico are currently only a percentage point higher than in Argentina.

While decades of irresponsible economic policies in Latin America certainly support Hanke's assertion, things may be changing. Since 1995, Mexico's economic management has been more or less on par with Argentina's.

Mexico had to go through a wrenching adjustment to get where it is today -- and its banking sector's wounds have not healed -- so it's unlikely to be much of a model to nations contemplating ridding themselves of rigid exchange-rate regimes.

But if Brazil continues to do well, other countries -- even Argentina -- may be tempted to wriggle out of their currency straitjackets.