Brazil: Dealing with International Shocks

Abstract

On January 15, 1999, the Brazilian central bank, in the face of massive speculative attacks on the Brazilian real, decided to let the real float. In the foreign exchange markets, the real fell sharply. The Brazilian economy appeared to be entering a severe recession. The Brazilian financial crisis represented another fallen domino in the global contagion that had started in the summer of 1997 in Thailand. This case describes the set of macroeconomic policies known as the Real Plan that the Brazilian government had implemented since 1993, its impact on the Brazilian economy, and the impact of global contagion on Brazil. It was written as an exam case for the first-year economics course at Darden. It may be used in a course on open economy macroeconomics and international finance.

Excerpt

UVA-BP-0509

Brazil: Dealing with International Shocks

Brazil became an independent nation in 1822 after three centuries under the rule of Portugal. In 1985, Brazil ended 21 years of military rule and returned to democracy as a federal republic. By far the largest country in South America and the fifth-largest country in the world in both population and land area, Brazil was considered to have the potential to become an important global economic power. But for much of the 1980s and early 1990s, the Brazilian economy suffered from debt crises, stagnation, and high inflation.

Brazilian economic policy took a dramatic turn in 1993 when President Itamar Franco appointed Senator Fernando Henrique Cardoso as his fourth finance minister. In December 1993, Cardoso announced his plan for the economy—the Real Plan—aimed at addressing a number of economic problems, including a four-digit inflation rate, a collapsing currency, a government budget deficit, and intrusive government involvement in the economy.

The first stage of the economic stabilization program, the Immediate Action Plan, cut government spending by (U.S. dollars) USD6 billion and implemented measures to improve tax collection and to speed up the privatization of state-owned companies. In the second quarter of 1994, Cardoso implemented one of the key components of the Real Plan, the creation of a new currency—the Brazilian real (BRL)—and the establishment of a new exchange rate policy that tied the real to the U.S. dollar. Under the new exchange rate regime, the upper limit of the BRL/USD exchange rate was fixed at a 1:1 parity; the real was free to appreciate against the dollar, depending on market conditions. In addition, Cardoso introduced a series of reforms aimed at further globalizing Brazil's closed economy through deregulation, trade liberalization, and encouragement of foreign direct investment (FDI). Cardoso also continued to liberalize capital flows and effectively made the real a convertible currency with relatively few restrictions on either Brazilian residents or foreign residents to exchange the real for hard currencies. The impact of these policy changes was dramatic as documented in Exhibits 1 and 2.

Having slain the inflation dragon and restored growth, Cardoso easily won the presidential elections in October 1994. But he had little time for celebration.

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Keywords: Brazil, open economy, macroeconomics, international finance, financial crisis, currency crisis, exchange rate regime