A Non-Circuit Breaker Agenda for Brazil
Mohamed A. El-Erian, one of the world's most respected emerging markets experts, writes that Brazil needs a "circuit breaker" to halt the vicious cycle that has trapped its economy. Brazil's turmoil—a shrinking GDP, soaring public and private debts, high interest rates, a depreciating currency, and a corruption scandal—is attributed by El-Erian (in an op-ed in Bloomberg View) to adverse self-fulfilling expectations that must be reversed by measures that he does not specify. He does say they would consist of "a series of official decisions designed by the government and passed by the legislature that restore the country's growth dynamic, contain its fiscal deterioration, and reverse mounting inflationary pressures." Doing nothing, he suggests, can only deepen the crisis, whereas a program of action can enhance confidence and normalize financial markets, reduce public borrowing costs, and strengthen the currency.
But El-Erian's analysis is simplistic and incomplete. Brazil's turmoil results from inconsistent policymaking and lack of credibility. Vaguely defined circuit breakers will not help. The urgent need is to apply damage control measures and send signals of positive policies to be adopted in the future. Damage control might include reserve-selling direct intervention in exchange markets and capital controls if outflows cannot be stopped by outright interventions in spot and futures markets. Policy signaling would involve rigorous adherence to Brazil's Fiscal Responsibility Law, which envisages ceilings for public sector debt. Public sector debt limits would prevent harmful excesses such as those caused by recent Treasury lending to public banks, as discussed in my recent PIIE Policy Brief , a type of quasi-fiscal dominance of monetary policy.
Brazil's threat of a crash does not resemble the multiple equilibria crisis El-Erian describes. Rather, the country is caught in a more traditional trap classified by economists in the category of "first generation crisis models." Brazil is running a nominal deficit of nearly 7 percent of GDP resulting from several years of fiscal mismanagement. That deficit will increase as its recession worsens and interest rates rise to lower runaway inflation. Budget rigidities that make fiscal consolidation overly dependent on tax hikes also prevent the deficit from falling: Rising taxes will likely hurt the economy, which will in turn reduce revenue collection.
The central bank, over the last several years, has stepped up its regular repo operations above and beyond what would be normally required for liquidity management. This year alone, these operations have amounted to a loss in the central bank's books of some 1.1 percent of GDP. Put differently, the central bank has been acquiring Treasury bills in excess of what liquidity management would entail. This suggests that the central bank has been actively financing the Treasury, a situation that is commonly referred to as fiscal dominance and is one reason why markets have lost faith in the government's ability to deliver any type of circuit breaker as described by El-Erian. Add to that the fiscal cost of operations of the Brazilian Development Bank (BNDES)—discussed in my Policy Brief —alongside political dysfunction, and all the elements are in place for a first-generation crisis, one without multiple equilibria, one where turbulence happens because policies are bad and the government has lost any semblance of credibility.
In Brazil's favor, the country has a floating exchange rate regime and (thus far) plenty of reserves. Some of that stock of reserves can be used to halt the kind of currency devaluation that would stretch private sector balance sheets. The public sector does not hold much foreign-currency–denominated debt. Corporate foreign exchange–denominated debt in Brazil has increased considerably in recent years, however. Although most companies appear to be properly "hedged," there is no telling the amount of damage that sharp and uncontrolled devaluation could inflict. Petrobras, the gigantic state-controlled energy corporation that is at the heart of the country's bribery scandal, has $120 billion in dollar-denominated debt. If it needs to be rescued, Brazil's $370 billion in reserves will have to be tapped.
What are the options for Brazil? With interest rates at 14.25 percent, there is unfortunately little room for further rate hikes. With short-term domestic rates at these levels and global interest rates at close to zero, one would be hard pressed to argue that remedies used in the 1990s—specifically abrupt interest rate hikes of a high order of magnitude—would make a big impact on reversing capital outflows. If market pressures continue unabated and exchange interventions are ineffective, Brazil might well need to resort to capital controls. A further credit downgrade might follow, and the stage would be set for the type of inevitable crash that many economists imagined they would no longer see. While a crisis cannot be fully avoided—arguably, it is already happening—the government could still take some action to instill confidence. A strong commitment to prudent fiscal management over the medium term might help attenuate market turbulence even if the government's hands are tied in the short run by political dysfunction. Instituting debt limits as discussed above would be a good start; Poland's experience is testament to how fiscal credibility can be enhanced through their adoption. In Brazil's case, debt limits have an additional advantage: They would send the right medium-term signals without being as overtly unpopular as the other measures and reforms the country desperately needs.