How a Devaluation Occurs, What It Means

Here are some questions and answers about what’s going on in Brazil and the repercussions.

Q. What happened in Brazil on Wednesday?

A. Gustavo Franco, head of Brazil’s central bank, quit, citing personal reasons and policy differences. His replacement, Francisco Lopes, allowed the country’s currency, the real, to decline about 8% against the dollar, from about 1.21 reals to the buck to 1.32.

*

Q. Why did they do that?

A. As part of an effort to keep inflation in check--because a strong currency means a nation can buy more with its money--Brazil had been defending the real’s value by keeping interest rates high (to keep foreign and domestic money in the country) and by using government reserves to buy the real in currency markets.

But those measures had exacted a high price on Brazil’s economy. The government is running out of dollar reserves to buy reals, and the high interest rates--rates on some loans have soared to 50%--have been stifling the economy. Brazil hopes that by letting its currency decline, or devalue, it will be able to let rates fall and will spend less of its reserves defending the currency.

*

Q. Defending it against what?

A. Really, defending it against market forces, including currency speculators. For the most part, any nation whose economic fundamentals are deteriorating can expect that the value of its currency--which is, after all, a reflection of the country’s financial health--will decline relative to other currencies.

It doesn’t always work that way: Japan, despite its weak economy, has a strong currency. But especially with smaller nations, the move toward free-market policies worldwide over the last decade has left countries’ currencies vulnerable to sharp moves stemming from investor perceptions of economies’ shifting fortunes.

*

Q. The International Monetary Fund approved a $41.5-billion aid package for Brazil last fall. Shouldn’t that be helping the economy, and the currency?

A. The IMF aid package was approved on condition that Brazil take fiscal austerity measures, including spending cuts to rein in a huge government deficit. Some of those measures have yet to be approved, meaning the bulk of the IMF aid has not yet been released. But even if the IMF package had been in place, some experts say, Brazil may have had to devalue its currency anyway.

*

Q. How did Brazil decide that an 8% devaluation is the right amount?

A. The government is trying to take the currency down slowly, avoiding the kind of collapse hat hit the Mexican peso in late 1994 and many Asian currencies in 1997 and 1998. But many experts note that the market often takes over in situations like this--as occurred in Thailand in July 1997, when it attempted a modest devaluation, only to see its currency plummet in value.

“The experience is that when a country devalues by 5%, it becomes a devaluation of 30%, and that’s the fear driving the market,” said Enrico Porta, who manages $40 million in funds at Banco Credibanco.

One reason is that currency traders such as hedge funds may test the Brazilian central bank’s willingness to defend the new level it wants for the real. Those attacks are in the cards for Brazil’s new central bank president.

*

Q. Isn’t there a good side to devaluation?

A. Yes. A country that devalues its currency in effect cuts the price of its exports for other nations. That can boost exports significantly--which has happened with Mexico since 1994. Also, if interest rates finally come down, many Brazilian borrowers--individual and corporate--certainly will be better off.

*

Q. And what’s the major downside of devaluation?

A. A country loses purchasing power, meaning it cannot afford to import as much from other countries. Devaluations across Asia have dramatically slashed the purchasing power of South Korea, Thailand and other nations since mid-1997, triggering recessions.

And borrowers in such countries who had borrowed in stronger currencies, such as dollars, suddenly were unable to pay their debts.

What’s more, the first effect of a devaluation can be to raise interest rates rather than lower them.

Indeed, the annualized yield on the Brazilian government’s benchmark “C” bond -- the most widely traded emerging-market security -- soared to 20% on Wednesday, higher than during the worst of Russia’s debt crisis last August.

“The hike in interest rates will be serious,” said Raul Elizalde, global head of fixed-income research at Santander Investment Securities.

*

Q. Why are rates going up in Brazil, if the goal of devaluation is to cut rates?

A. One of Brazil’s most serious problems is that international investors have been pulling their money out of the country’s stock and bond markets because they’re losing faith in the government’s ability to get the economic problems under control. Every time the real falls, foreign investors take a hit as their Brazilian holdings lose value when translated back into their home currencies.

A gradual decline in the real’s value is bad enough, but an unexpected move like Wednesday’s can be even more unsettling. If investors keep pulling money out and selling their reals against other currencies, the real suffers further, creating a vicious circle.

Because they fear a worse decline ahead in the real, foreign investors are now demanding sharply higher interest rates on Brazilian securities to compensate for the risk of currency losses.

Thus, Brazil’s main task is to convince foreign investors that it is a safe place in which to invest. Even though some economists agree with the thinking behind Brazil’s currency devaluation, they say it comes at a bad time.

Francisco Larios, senior emerging-markets economist at Standard & Poor’s DRI, notes that Brazil’s crisis is intensifying as many emerging-market countries around the world are struggling, Europe’s economy is slowing and financial markets remain jittery. That will make it tougher to boost exports and raise fresh capital needed to keep the economy growing.