Brazilian Recession Will Deepen Due to Large Government Debt

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Gail D. Fosler
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For Immediate Release Release #4476A

BRAZILIAN RECESSION WILL DEEPEN DUE TO LARGE GOVERNMENT DEBT, CAUSING THE REAL TO FALL FURTHER, CONFERENCE BOARD ANALYSIS SAYS

Depreciation of Brazilian Real May Have a Positive Effect on North America

March 26, 1999 -- Despite today's interest rate cut, Brazil's economic problems are likely to worsen, according to an analysis released today by The Conference Board.

Because of its large domestic government debt, which totals more than 25 percent of Gross Domestic Product (GDP) and is overwhelmingly short-term, the current high level of interest rates in Brazil will continue to be a burden even if they come down substantially.

"The high government debt arises from a government sector that is large by emerging market standards and is running a total deficit in excess of 7 percent of GDP," says Gail D. Fosler, Senior Vice President and Chief Economist of The Conference Board. "Most of this deficit is due to interest costs. Brazil is in a period of stability and relief at the moment. But the challenges of debt repayment still lie ahead."

By contrast, the structural deficit (revenues less expenses excluding interest costs) is not particularly large. However, when combined with the interest costs on the public debt, the total rises to about 7.5 percent of GDP in 1998, up from 3.9 percent in 1996.

Writing in the latest issue of StraightTalk, a newsletter prepared exclusively for Conference Board Associates, Fosler said: "Brazil is a modern example of the 'dynamic economic inefficiencies' rule: When the real interest rate exceeds the real growth rate in an economy, rising interest costs cause the deficit and debt to spiral out of control."

THE REAL OUTLOOK

The Brazilian economy will likely decline 3% to 4% this year and the decline will probably extend into next year. This Conference Board forecast is based on the expected magnitude of the depreciation of the real and the rise in domestic interest rates. While both factors are roughly similar to the Mexican peso crisis, the impact will be different because of Brazil's different economic structure. The relatively moderate decline in Brazilian industrial activity so far supports the notion that the recession will be less severe than the one Mexico experienced in 1995.

The current high interest rates, prospective fiscal austerity, and substantial debt repayments this year will not benefit the real. The pattern of emerging market devaluation of the past several years is strikingly similar and appears to be playing out once again with respect to the real. Once governments lose control of the currency, it drops to less than one-half of its previous value relative to the dollar, before rebounding to a more sustainable value.

With the Mexican peso and Asian currencies sinking to about 45 percent of their previous value before rebounding, this pattern suggests a downside potential of 2.4 for the real before a rebound to around 2.2 finally occurs. Uncertainty over government debt restructuring will foster uncertainty about the currency for the rest of the year.

IMPACT ON THE WESTERN HEMISPHERE

The impact of Brazil's recession on Western economies will be limited. In contrast to the drag on South America, which will register only 2% to 3% growth this year, Brazil's recession will probably have a net positive effect on North America.

Brazil accounts for only 2% of U.S. exports and 1% of Mexican exports. While large multinational companies will feel both the impact of the recession and the currency devaluation because of the loss of an important market, the manufacturing sectors in both the U.S. and Mexico will be relatively unaffected.

The intensely domestic character of Argentina, the wide geographic trade diversification of Chile, and the close ties between Mexico and the fast-growing U.S. all point to limited external impact. Fosler says that the prolonged Brazilian recession will create political repercussions and underscore the need to reform global currency and financial systems.

WHY THE U.S. WILL BENEFIT

Brazil's recession and overall weakness in South America will help hold down short-term interest rates in the U.S. For the fourth year in a row, U.S. growth, which accelerated to more than 4% at the end of 1998, shows no signs of slowing down. The Conference Board now projects a 3.5% to 4% growth rate in 1999.

"A strong United States is essential to growth and recovery in the Western Hemisphere and short-term interest rates are critical to sustaining this strength," says Fosler. "Unless there is visible evidence of inflation, it is hard to imagine the Federal Reserve Board raising short-term rates. And low U.S. interest rates help stabilize Mexican interest rates, which are already headed down."

ASIA'S RECOVERY IS KEY

The slowdown in South America will subtract about 1 percentage point from previous regional growth projections, but will have little impact on the global economy. Because South America is a relatively unimportant player in global trade, the growth in global trade and the impact on commodity prices will continue to depend on the pace of recovery in Asia, which seems on a 3% to 4% growth track.

"The risks remain that the pace of Asian recovery will be greater than expected, and that the U.S. and the rest of the Western Hemisphere will be vulnerable to higher commodity prices and higher interest rates in the long run," Fosler concludes.

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Source: StraightTalk, Volume 10, Number 3, March 1999, The Conference Board