[From Stanford I had a closer look at the Brazilian economy, which resulted in this column in Business Standard of 4 November 1999. Latin American economies have frequent crises; they give Latin American economists broader experience. Gustavo Franco, who was governor of central bank, fasinated me.]
The Fall of the Real
When I went
to Brazil in 1986, its currency was the Cruzeiro. In a few years its value fell
to a fraction, and every amount contained too many zeros. So Brazil introduced
a new currency called Cruzado. It too depreciated to nothing despite six
stabilization plans. Then in May 1993, Fernando Henrique Cardoso became finance
minister. He brought in a professional economist, Gustavo Franco, to help him
devise a plan to break Brazil’s chronic hyperinflation. Next year Cardoso was
elected President, and Franco became Governor of the Banco Central do Brasil.
He introduced a new currency called Unidade Real de Valor, or Real for short.
As Frankel saw it, Brazil’s inflationary cycle was fed by
the prevalence of indexation. Most wages and salaries were indexed. Now suppose
prices rise up to a certain date and then stop rising. At that point, they will
be higher than a year ago, and they will remain higher than a year earlier for
one year. So measured year-on-year inflation will remain positive for a year;
over the year it will fall to zero. But if wage increases are based on changes
in a price index, they will continue to rise for a year even after prices stop
rising. In other words, indexation rules out wage and price stability.
The architects of the earlier stabilization tried to
freeze prices or wages or both. But workers were wedded to indexation; they saw
it as essential for protecting their standards of living. So indexation could
not be eradicated; even if it was curbed, it eventually returned, and with it,
hyperinflation.
So Franco worked out a different device. Private
research institutes publish the most trusted price indexes in Brazil: the
government does not have the credibility for its price indexes to be generally
accepted. Franco persuaded the research institutes to calculate a new price
index in terms of the dollar: the old price index was used to calculate what
the value of the dollar would have been at various points in the past, and a
price index was calculated from these values. Thus on the day the Real was
introduced, its value was fixed at the dollar exchange rate, namely 2750
Cruzados. Suppose that the prices had risen tenfold over the previous year;
then the exchange rate of the dollar a year ago worked out at 275 Cruzados. Now
divide the price index by the rise in the exchange rate of the dollar; thus,
inflation in terms of the dollar came down to zero. This new index of dollar
inflation was used for indexation, which thus came to a virtual end.
Once people were convinced inflation was under control,
another problem arose. As long as inflation raged, those who could kept some of
their wealth in US dollars obtained through a black market. So part of the
demand for currency was for dollars, and part of the current account earnings
was used to buy these dollars. Thus the current account was in surplus to the
extent that dollars were purchased. Once inflation subsided, the demand for
dollars also fell; but the current account surplus did not disappear. This led
to an appreciation of the Real; by January 1995 the Real had appreciated by
about 10 per cent, and the real effective exchange rate had strengthened by
almost 30 per cent from its level in July 1994 when the Real was introduced.
This appreciation of the new currency, which is common in
stabilization episodes, actually helps in bringing down inflation since it
cheapens imports. But this effect is obviously greater in the case of tradable
goods, and less in the case of non-tradables. This differential impact is also
very noticeable in Brazil. Thus between June and October 1994, the
(dollar-based) wholesale price index rose 9 per cent, whilst the retail price
index rose 16 per cent. Within the retail price index, the prices of industrial
goods rose 3 per cent, of food 16 per cent, and of services 56 per cent. Thus a
halt in inflation leads to enormous changes in relative prices.
The next few years brought in substantial capital
inflows. First, foreign direct investment, went up from $2.6 billion in 1994 to
$26.1 billion by 1998. Second, the interest paid by the government on foreign
debt was 606 basis points above the US Treasury Bill rate in 1992-93; by 1997
it had fallen to 395 basis points above, and its average maturity had moved up
from 3.9 years to 9.1 years. And finally, whereas virtually all imports in the
1980s had to be paid for in cash, in 1995, 80 per cent were financed by credit
over 30 days.
During these years, a substantial degree of trade
liberalization was carried out. So imports rose faster than exports, and the
current account worsened. But capital inflows more than compensated for the
worsening of the current account, and reserves mounted rapidly. Thus in effect,
the central bank prevented the large capital inflows from appreciating the Real
by buying dollars off the market. It worked out a very effective technique of
market intervention. It would ask all banks for bid-ask spreads on the dollar,
and buy at the lowest offer or sell at the highest bid as the case may be; most
of the time it bought. It also initiated an innovative forward market in the
dollar, in which the difference between the forward price and the spot price
was settled in Reals. So the forward trading resulted in no change in reserves,
but it gave the central bank an indication of how the exchange rate should
move. From July 1995 till April 1998, the central bank depreciated the currency
from 0.90 to 1.15 Reals per dollar through a crawling peg. Its reserves mounted
to $75 billion. But these huge reserves did not save Brazil. The Russian crisis
bled the reserves down to $33 billion by the end of 1998, the President lost
his nerve, and Gustavo Franco had to step down.
