Brazil's Debt Path Could Make It a Whole New Ballgame

Rudiger Dornbusch is the Ford international professor of economics at the Massachusetts Institute of Technology

When Mexico's former Finance Minister Jesus Silva Herzog brought the news in 1982 of his country's inability to pay its debts, the chief message that he received from the International Monetary Fund was unanimous: Don't act unilaterally.

Herzog followed that advice, and so did all the other problem debtor nations. Instead of defaulting, they went to their creditors to negotiate "new money" that they would not receive for many months. At the same time, they agreed to austerity programs that worked instantly in reducing living standards.

But the adjustment process has not been working. There have been no defaults so far, but Peru set a precedent when it unilaterally limited its debt service and got away with it. The country actually enjoyed strong growth, and apparently experienced no major problems in financing trade. But Peru was not enough to set off a domino effect.

Now the attention is on Brazil. Last month, acting unilaterally, it announced a moratorium on its debt payments. If Brazil does not resume these payments, most of Latin America is bound to follow, playing by new rules of the game.

Today's debt impasse is the result of three factors:

--Debtors cannot service their debts and also invest and grow at the same time. Their limited resources can finance either interest payments or investment in their home economies, but not both of them.

--Commercial banks are reluctant to make further loans to countries that are already unable to pay. But if they do not make at least limited loans to these nations, the banks cannot expect any interest payments, simply because the debtors have no money to pay. The Ponzi game of lending the money to pay interest has little logic other than to avoid crisis now.

--Policy-makers help roll the snowball of debt simply to avoid an outright and immediate crisis of the world financial system.

Problem debtors owe the major U.S. commercial banks nearly $90 billion, and the prospect of these loans going into default is a threatening one. A stalemate has set in. The debtors are reluctant to suspend payments because of potential sanctions such as the elimination of trade credits, trade restrictions and legal action. Creditors, though, cannot afford to stop lending, because their loans would go into default. Policy-makers do not like the idea of forcing the banks into write-offs, but they also see the risk and foreign-policy consequences of the frightening decline in living standards in the debtor countries.

Someone has to cut the knot.

Brazil's finance minister, Dilson Funaro, may well be the one who made the decisive move. Despite taking some disastrous steps with the economy, this determined man is gaining power by the day. When the Central Bank ran out of reserves, he did not hesitate to choose the moratorium rather than go to the International Monetary Fund for an austerity program and a bridge loan. The moratorium precipitated an immediate decline in bank stocks because it marked a dramatic shift in the debt crisis. Now Brazil is being watched to see where the system moves from here.

Sometime in the next few months Brazil must decide how to bring its relations with creditors back to some normality. It is quite unlikely that the country will simply default. It is equally unlikely that Brazil will decide to go the way of orthodoxy: an austerity plan, a bridge loan and a resumption of debt service at interest rates highly rewarding to the creditors.

The more likely course is for Funaro to announce that the country will pay in cash only a fraction of its interest each year, and that the remainder will be added to the debt for future payment.

The essence of this step is the unilateral decision. If Brazil adopts this strategy, commercial banks are likely to lose. It is true that an outright default is avoided, but banks will find themselves lending Brazil much more money than they have imagined, and at thoroughly unprofitable rates. And other countries will follow the example. Banks will flirt with the idea of sanctions, but they will realize that any attempt in that direction may well lead to even larger losses.

All this has happened before. In 1937 Brazil announced a moratorium and suspended debt service. All of Latin America did the same until a token and tolerable debt service was resumed much later. Must the same script be reenacted today?

The International Monetary Fund needs to change its role from that of a debt collector to that of an evenhanded intermediary between the debtor countries and their creditors. At the same time, it needs to change the international debt process from one of collecting interest to one of providing development financing for investment and growth. The IMF's new managing director, Michel Camdessus, was elected by a Latin majority over the contending Dutch candidate, whose predilection for austerity lost him the job. Brazil will be Camdessus' test.

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