Brazil Lets Its Currency Drop; Markets Soar

Abandoning a costly defense of its currency against overwhelming doubters at home and abroad, Brazil let the real float free Friday, heightening economic uncertainty here, in emerging markets and in the United States.

The move is expected to plunge Brazil, the world’s ninth-largest economy, deeper into recession and possibly reignite inflation. Yet the action was seen as the only way to halt a hemorrhage of money from the country.

The currency promptly lost another 9% of its value against the dollar, on top of an earlier 8% plunge this week. Meanwhile, Brazil’s leading stock index soared Friday by a near-record 33.4%, propelled in part by foreign investors grabbing up newly cheapened shares.

Stock exchanges on Wall Street and across Latin America also registered major gains, signifying relief that Brazil had finally taken what markets saw as an inevitable step that in the long term will be positive.

A stable currency has been the cornerstone since 1994 of Brazil’s remarkable recovery from decades of hyperinflation and a big reason for its growing appeal to foreign investors. But continued defense of the real, which has cost Brazil $50 billion in foreign currency reserves since August, became a cross it could no longer bear.

Rather than settle things, the decision by Brazil’s central bank Friday to stop propping up the currency and let the market determine its value raises more questions and uncertainties for Brazil’s already besieged President Fernando Henrique Cardoso.

While the move will make Brazilian exports more attractive and has--at least for now--slowed the flight of foreign capital, it has shaken Cardoso’s political standing and made the enormous investment by U.S. and other foreign firms here in recent years appear suddenly risky.

For the Brazilian people, the devaluation makes imported goods more costly. In effect, their spending power has declined nearly 20% in the past three days. At the same time, by creating more demand for exports, it creates more jobs, said Edmar Bacha, former head of Brazil’s National Development Bank and now president of BBA Securities in New York.

Cardoso addressed the nation Friday night to explain why he ultimately jettisoned a four-year commitment to keep the real loosely linked to the value of the dollar.

“I had to allow the currency to float freely to protect currency reserves, keep away distrust and to create conditions to lower interest rates,” Cardoso said, alluding to soaring loan rates that are slamming the brakes on Brazil’s economy.

Friday’s market reaction was a likely prelude to further volatility. After starting the day at 1.32 to the dollar, the real fell as low as 1.60 but recovered to close at 1.46, a 9% one-day loss of value. It had lost 8% on Wednesday when the government made a last-ditch attempt to salvage the real with a “contained” devaluation.

The dramatic stock gain, meanwhile, merely recouped what Brazil’s stocks had lost in the previous two weeks of trading. As investor confidence ebbed, world markets have been nervously watching events for weeks in Brazil, the most populous country in South America and the United States’ 11th-largest export market.

There was hope Friday in some quarters that devaluation would--like Mexico’s in 1994--be a painful first step toward recovery by boosting exports. That is because the cheaper real makes domestic products less expensive overseas.

“The only way to protect the reserves was to let the real reach the value the market says it has,” said John Mein, president of the American Chamber of Commerce for Brazil in Sao Paulo. He said more than 400 of the 500 largest U.S. companies are now operating in Brazil.

Citibank of Sao Paulo estimated foreign reserve losses at $200 million on Friday, down from $1.7 billion on Thursday and $1 billion on Wednesday. The country still had about $37.5 billion in reserves by day’s end Friday, Citibank estimated--including $9.3 billion as the first installment of an International Monetary Fund bailout granted last November.

But the move carried a significant economic cost. The devaluation this week will probably add 4 percentage points to the 1.5% inflation previously expected in Brazil in 1999, said Ernane Galveas, former central bank chief and past critic of Cardoso’s policy of defending the real.

By making imported goods more costly, the devaluation will further dampen consumption, an integral part of economic activity. Brazil’s economy could shrink by as much as 4% this year, some economists are projecting.

How Brazil, the region and global markets at large withstand the shock over the longer term remains to be seen and will depend on critical events in upcoming days, said Sebastian Edwards, a UCLA professor and former chief Latin American economist at the World Bank.

“This is only the beginning,” said Edwards, recalling that the repercussions from the Asian crisis are still playing out after problems began somewhat innocuously with a devaluation of Thailand’s baht in July 1997.

Brazil must get the IMF to sign off on the devaluation, which was not factored into the $41.5-billion bailout. Brazil wants assurances that it will still receive the $32 billion in remaining disbursements, including $10 billion Feb. 28.

Brazilian Finance Minister Pedro Malan flew to Washington on Friday to meet with officials of the IMF and the Clinton administration.

An IMF spokesman said Friday that Brazil’s move to allow the real to float in value against other currencies in foreign exchange markets “appears to be a wise decision.”

Brazil also desperately needs to restructure about $270 billion in dollar-denominated government and corporate debt, at least one third of which is owed to U.S. banks, companies and financial institutions, or sink deeper in red ink, UCLA’s Edwards said. The devaluation has in one swoop made that debt more expensive to service.

Brazil is faced with a $32-billion trade deficit, most of it interest on its foreign debt. The cheapened currency should help narrow that gap.

The country also must proceed with a fiscal reform package that is just as politically tenuous as it was before Friday’s dramatic move. Cardoso’s fiscal cuts designed to reduce the whopping 8% budget deficit ran into political troubles in December. A special session of Congress is now meeting to consider the measures.

Another question mark is the new monetary policy that Brazil will lay out next week to replace the real plan. Economists were predicting either a permanent currency float like Mexico’s or, more likely, a new, even broader trading band like the one that was in place for four years.

Many economists are holding their breath to see if Brazil also introduces capital or price controls, along with the new currency regime.

Details of the new currency policy are not expected before early next week. Cardoso’s Cabinet is meeting over the weekend in Brasilia to hash out the details.

Gary Hufbauer, a senior fellow at the Institute for International Economics in Washington, is one of many experts who believe that Brazil should consider solidly pegging its real to the U.S. dollar, as Argentina has.

For Brazil, the devaluation will almost certainly mean a deeper and more profound recession than the one that was coming anyway in 1999. Even before the devaluation Friday, economists were predicting economic growth would shrink to a modest 4% in 1999.

Hufbauer said the importance of Brazil to the United States lies not as a trading partner in itself: U.S. exports to Mexico are about five times the $16 billion in goods and services sold here last year by U.S. firms. Latin America as a whole takes one-fifth of all U.S. exports.

“We have to believe that as so goes Brazil, so could go Latin America. Thailand, which set everything off in Asia, was a small country. Here the start is with the big country, and that has to have some ripple effect on Brazil’s neighbors,” Hufbauer said.

Paula Gobbi in The Times’ Rio de Janeiro Bureau contributed to this report.

* CALM IN ARGENTINA: Brazil’s neighbor expresses confidence in its own economy. C1

* MEXICO’S EXPERIENCE: Devaluation has brought triumphs and travails. C1

* U.S. RALLY: Wall Street’s sigh of relief sent stocks surging. C2