Latin American Economies on the Brink
International Herald Tribune
June 23, 2001
David Roche

Economic reform is in big trouble in Latin America. The region has a triple bane: low savings rates, high government borrowing and debt as well as an addiction to foreign capital.

Argentina and Brazil tried to break that stranglehold. In 1991, Argentina created a dual currency system that pegged the peso and the dollar at parity. The credibility of the currency peg was supposed to give Argentina the benefits of U.S.-style low rates of interest and inflation.

In practice, interest rates stayed prohibitively high. The country entered a prolonged slump. It has a chronic current account and budget deficit, a fatal combination for currency pegs. International Monetary Fund bailouts didn't work.

In desperation Domingo Cavallo, author of the currency law, was brought back to save the peg, but it looks as if he is going to destroy it. He has announced that the peg will be debased by introducing the euro into the basket as well as the dollar. Bang went the simplicity and transparency of the system, and people's trust in it.

Mr. Cavallo has now introduced a surreptitious 7 percent devaluation of the peso for exporters. Exporters are to be subsidized through the budget for the theoretical difference between the actual peso exchange rate and the devalued peso exchange rate, assuming the euro were already part of the Argentine peg. Importers are to be penalized by as much.

The focus of Argentine policy is wrong. Mr. Cavallo's aim is a quick fix of the peso peg. But Argentina's growth deficit has come about because of the rigidities of the Argentine economy, not the exchange-rate mechanism. Politics may dictate this policy, but economics ensures its failure.

In Brazil much more has been done about getting the domestic economy right. Massive privatizations have succeeded in attracting almost as much foreign money to Brazil every year as China receives. Fiscal policy has been highly conservative. Devaluation in the wake of the Asian financial crisis was successful. Since 1992 Brazil's per capita gross domestic product has risen 19 percent, compared with 11 percent for Argentina.

But all is not well. Brazil's huge foreign debt burden has made it highly vulnerable to any domestic or foreign shocks. And now there are two: a financial drought of foreign capital and a real drought that is creating a power shortage.

I reckon foreign direct investment will fall by nearly 50 percent this year to $16 billion, leaving a foreign funding gap of a record 8.5 percent of GDP by 2002. After receiving foreign investment, Brazil will still have an external financing requirement larger than its $35 billion of foreign exchange reserves. The only option will be higher real interest rates and lower growth. That mix endangers budget stability.

And the energy crisis is for real. Brazil's economy is facing a large supply shock as the government is forced to cut electricity supply by 20 percent partly because of drought.

The government of President Fernando Henrique Cardoso cannot deflect responsibility for the energy crisis, which not only a matter of rainfall but also of a terrible drought of investment in infrastructure that makes Brazil overdependent on hydroelectric power.

The energy crisis is eroding the popularity of all reformers, stopping laws being passed that are fundamental to the reform process.

Brazil is on a knife-edge. There is now a serious risk that Brazil's crisis will take out Argentina. So don't ask for whom the bell tolls if Brazil goes belly up.

Don't be complacent about the effects on global markets, either. Together, Argentina and Brazil account for 45 percent of emerging market bonds. Spanish and U.S. corporate investors provide more than 55 percent of Brazil's annual foreign investment inflows of $37 billion. Brazil and Argentina also account for a huge slug of Spanish and U.S. banks' overseas loans.

Even Asia would not be immune to a Latin American crisis. Hong Kong's peg would survive a collapse of Argentina's, but Malaysia's would not. That would topple the government of Prime Minister Mahathir bin Mohamad, plunging Southeast Asia into further turmoil.

The writer, managing director of Independent Strategy, an investment advisory company, contributed this comment to the International Herald Tribune.

[Not to be reproduced without the permission of the author.]

Copyright © 2006 the International Herald Tribune