After reviewing the Defending the Brazilian Real case study, I was amazed at what I learned. How can a country that is such a known for its festive atmosphere and abundance of natural resources, be going through such economic turmoil? I’m sure no one in the United States could imagine their rent doubling every 10 weeks. That their credit card charged 25% interest. That the costs for food and clothes increased by 40%. That the value of their savings declined 2000%. In a year! Well in my research, I learned that this is what the citizens of Brazil experienced for ten years, 1987 to 1997. During those ten years, 40% of GNP was eaten up by inflation, which means nearly everyone got rid of cash as fast as possible, because it literally lost value in their pockets. And the majority of people were reduced to buying only the essentials of life, which had a devastating effect on industries that produced all kinds of goods and services.
In the case study, the reader is introduced to the Brazilian economy at its turning point away from hyperinflation, with the introduction of the Real Plan. With steady economic improvement, the Brazilian government pursued economic policies to transform its previous system to a market based system. The real plan (also known as the Plano Real) was designed by then Finance Minister, Fernando Henrique Cordoso, to drive inflation out of the Brazilian economy. When implemented in 1994, annual inflation rate was running at 1000%. This level discouraged economic activity and foreign direct investments (FDI).
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To fight inflation, the Brazilian government replaced it’s previous currency, the cruziero with the real. The real was pegged to that of the US dollar. Interest rates were repeatedly increased to maintain the value of the real to that of the US dollar. For Brazil, the high cost of credit helped reduce expansion of the monetary supply and brought inflation under control. The Real Plan was a success. This plan ignited economy growth and increased FDI’s in Brazil.
The study further explained, in the midst of all of the economic growth, the trade deficit continued to grow. When I read this, I was baffled. How can Brazil still be in trouble if the economy was growing? According to the text, the trade deficit was due in part to an overvalued real, which hindered exports, while bringing imports into the country. Estimates showed the real was actually valued higher than the US dollar. It was also mentioned that the rigid structure of the government was to blame for the trade deficit. Taxes and constitutionally mandated budget items consumed 90% of the government revenues. With inflation now under control the government could no longer rely on it to reduce the value of public-sector commitments. Cordoso made several attempts to solve the structural deficit, but with limited progress.
In the wake of all their troubles, countries like Asia and Russia suffered financial crises that put further strain on the real. In response, Cordoso continued to raise taxes and interest rates, which helped stem the flow of capital and stabilize the real. This helped to slow the economy. Inevitably, the Brazilian bank entered the foreign exchange market and sought the support of the International Monetary Fund (IMF).
Of course there were many critics to the IMF package, but the announcement alone helped stabilize the real. Brazil’s economic troubles didn’t end. The government employee pension tax proposals attached to the IMF package were defeated in Congress, while a Brazilian state declared moratorium on debt payments owed to the central government. This debt moratorium caused the Brazilian stock market to decrease.
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Though the largest nation and economy in South America, Brazil has long functioned well below its potential. The “Real Plan” brought the economy under control and stabilized Brazils currency. In spite of its problems, Brazil continues to attract large amounts of foreign investment. I believe that there will always be a great deal of concern about Brazil’s ability to maintain its reserves and exchange rate should the global markets suddenly lose faith in the government’s plans. Further privatization and general fiscal reforms are should be watched closely as are the economies of Brazil’s neighbors on whom so much depends.
Discussion Questions
1.
Explain the mechanism by which the real plan helped to defeat hyperinflation in Brazil.
The mechanism by which the real plan defeated hyperinflation was the introduction of the real. In this, a tight monetary policy was enforced. To implement this policy, the value of the real was pegged to that of the US dollar and depreciated by under 7.5 percent per year. Brazilian authorities had to raise interest rates repeatedly to keep the value of the real against the dollar, to keep depreciation under 7.5 percent. Overall, the high cost of credit helped reduce the expansion of the money supply.
2.
What actions does the Brazilian government need to take to defend the peg of the real against the US dollar?
To defend the peg against the real, the Brazilian government had to allow the Brazilian central bank to enter the foreign exchange market by using its foreign exchange reserves to purchase reals in the open market. Second, the government announced $10.8 billion to follow through with budget cuts. Third, the Brazilian government repeatedly raised interest rates in order to increase the attractiveness of holding the real.
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3.
Do you think the Brazilian government was correct to place a high value on defending the peg of the real against the US dollar? What were the costs to Brazil of this policy? What were the benefits?
No, I don’t think the Brazilian government was correct to place a high value on defending the peg of the real against the US dollar. According to critics, this action actually hindered exports while pulling imports into the country. By most estimates, the real was overvalued against the US dollar by 15-20%. The cost to Brazil to this policy was a loss of foreign exchange reserves. The benefit to Brazil with this policy was the support of the International Monetary Fund (IMF) and reforms associated with the partnership.
4.
What do you think might happen to the value of the real, and the Brazilian economy in general, if the Brazilian government abandoned its defense of the real and decided to let it float against the dollar?
If the Brazilian government abandoned its defense of the real and decided to let it float against the dollar, the value of the real and the Brazilian economy in general would benefit. By allowing the real to float, this would help Brazil keep its exports competitive. According to the text, it could also reduce the need for the county to raise interest rates to levels that severely depressed economic activity and dramatically increase the costs of servicing government debt.
5.
What would be the implications of allowing the real float for the rest of Latin America and for the economy of the United States?
According to the text, implications for allowing the real to float for the rest of Latin America and for the economy of the United States would trigger panic among international investors and undermine the credibility of a government that had “hitched its wagon to a pegged exchange rate policy.” Which in turn would suggest inflation.
