Once again the international investment community is questioning the sustainability of Brazil’s debt and the stability of its economy. The prospect of a change in economic policy as a result of the October elections and the habit of making simplified comparisons with Argentina have been the two principal sources of these fears. Nevertheless, Brazil is not Argentina and Lula, the Workers’ Party candidate now leading the polls, is not the Lula of 1994 or even 1998. While a debt crisis in Brazil, along with damaging spill-over to other parts of Latin America, remains a possibility, it probably will not – and certainly need not – occur.

The General Context.
The ongoing crisis in Argentina and renewed market fears in Brazil have begun to stoke speculation that the continent is about to suffer a new round of debt crises and a subsequent period of stagnation. Such a prospect is of relevance to both economic policy makers around the world and international investors -particularly Spanish companies which have invested more than €100bn in the region (€34.7bn in Argentina and €28bn in Brazil alone) and have already suffered from significant setbacks in Argentina during last year and a half .
Until recently, the consensus of opinion held that the kind of severe and unpredictable financial contagion unleashed by the Tequila crisis of 1994-95 and the Asian and Russian crises of 1997-98 had been successfully contained during the most recent problematic episodes in Argentina. As recently as July 8, for example, the BIS (Bank for International Settlements, the world’s club of central bankers) could still claim in its annual report that despite little improvement in Argentina, there had been a noticeable lack of contagion elsewhere in Latin American, supporting the idea that the markets see Argentina as a ‘special case.’
This report was perhaps somewhat behind the curve of market sentiment, as it was issued during an atmosphere of increasing market apprehension toward Brazil. But even much earlier in the year there were at least some causes for concern. Brazil’s GDP growth rate fell significantly in 2001 (to 1.5% from 4.4% in 2000) as a result of power cuts resulting from drought and a significant depreciation in the Real (from an average R1.83/$ in 2000 to an average R2.35/$ in 2001). The Real’s slide in 2001 was initially provoked by market scares of an Argentine spill-over and quickly took on a speculative overshoot dynamic. Given the possibility of some pass-through to domestic prices and the central bank’s continued commitment to containing inflation, the depreciation served to push the Selic rate (the Brazilian central bank’s reference rate) up from 15.8% at the end of 2000 to 19% at the end of 2001, thus contributing to slower growth. Domestic demand fell from a relatively healthy 4.5% in 2000 to a mere 0.1% in 2001, while Brazilian equity markets also registered an 11% fall during 2001 in local currency terms and a more significant 25% drop in dollar terms.
Yet the situation seemed to stabilise as the Argentine debacle came to a head at the end of last year. The collapse of the Real in the second quarter of last year to over R2.85/$ had reversed itself by December to R2.32/$. Because the Real had come to serve as the market’s universal bellweather on the state of affairs in Brazil, the currency’s strong recovery suggested that the 2001 overshoot failed to reflect the economy’s underlying fundamentals or the government’s continued commitment to sound economic management. Nevertheless, it  was a sign of continued market volatility in emerging markets.
Indeed, Brazil’s fiscal and monetary policy remained on track, a reflection that the country’s economic managers were not about to loosen the reins at such a critical juncture and in such a potentially explosive context. Inflation had rebounded slightly in 2001 to 7.7% (from 6.0% in 2000) but continued its long-term downward trend, while the annual percentage growth of the monetary base continued to be negative (-5.9%). Meanwhile the primary budget surplus continued to rise (to 3.8% of GDP from 3.6% in 2000, above the official target of 3.5%, a key component in Brazil’s strategy to maintain the stability of public debt levels).
As a result, Brazil’s slowdown in 2001 could reasonably be interpreted as the natural consequence of the world slowdown, and not as a result of contagion from Argentina, much in the manner that Mexico’s slowdown in 2001 could be seen as a direct result of the recession in the US.

The Recent Crisis.
Nevertheless, by the end of the spring, Brazilian markets were plunged into crisis once again. As the economy continued to slow, the recovery in the US and Europe remained clouded in uncertainty, and the situation in Argentina evolved from bad to worse, the prospect of a debt default in Brazilian began to be discussed openly in the press among Brazil watchers and international investors.
In June the Real plunged to as low as R2.95/$, and country risk (the spread between the country’s bond rates and US treasuries) increased from just above 700bp in March to more than 1700bp. The Bovespa (Brazil’s principal Sao Paolo stock market index) fell to some 20% below its level at the beginning of the year. GDP growth in annual terms during the first quarter came in at -0.7%, and although this was better than market expectations, industrial production in May fell 5.1% (0.9% in annual terms) from April (when it had rebounded 4.5%), the largest monthly fall since 1995, augmenting the fears of the markets. Most estimates now point to GDP growth well below 2% for the year, while country risk remains stubbornly high. Revival of more significant growth has remained increasingly in doubt, particularly given the pressure on interest rates and the depreciation of the real.
Perhaps the most significant factor in this reversal of market sentiment has been the strong showing of Luiz Inácio Lula da Silva in the polls for the presidential elections in October, and the fear that a Lula victory would compromise fiscal and monetary prudence and reduce Brazil’s willingness and capacity to service its external debt. This has served as the detonating issue for the markets within a general context of uncertainty given the doubts surrounding the international equity markets and the continuing problems in Argentina. While the effects on Brazil via real economic linkages from the Argentine crisis remain scant – exports to Argentina represent far less than 1% of Brazilian GDP – the combined psychological effect of the fragile world economy and full-blown depression in Argentina could easily become ‘contagious’ if the markets believe that the October election represents a tangible threat to economic policy in Brazil.
Against this background of market nervousness, the press quoted US Treasury Secretary Paul O´Neill as saying that more international financial support for Brazil would be a mistake. Although the statement was later retracted, it sent the markets closer to panic. On top of this, Morris Goldstein, a well-known economist at the Institute of International Economics in Washington, was reported by the Economist magazine to have claimed that Brazil stood a 70% chance of default in 2003, regardless of who won the upcoming presidential election. Other press reports have recently put the probability even higher. Nor have the markets failed to see that such statements are worryingly reminiscent of similar comments made by O’Neill and various US economists with respect to Argentina during its period of slow-motion agony in 2001.
Then on July 2, in the wake of  Fitch’s downgrade two weeks earlier, Standard & Poor’s reduced their rating on Brazil’s long-term foreign currency debt from BB- to B+ (long-term domestic currency debt remains at BB) and placing it on negative watch. With confidence rapidly evaporating, unemployment rising and real incomes falling, and the Real under continued pressure, the prospect of a some kind of debt default in Brazil has began to look more plausible in the minds of the market (see Debt & Fundamentals).

The Election Factor.
Among the number of factors relevant in analysing the Brazilian situation -and, by extension, the issue of possible contagion to other areas of Latin America and the emerging markets in general– the most important is the upcoming October general. Lula’s ratings rose to a peak of 43% in May (from 38% in April and 27% at the beginning of the year) although they later dropped to 38% in June and to 33% in July. This slippage in his margin strengthened the standard interpretation –at least until the most recent July 17 poll– that the ultimate second round victory would go to José Serra, the PSDB-PMDB candidate, and Cardoso’s chosen successor. While Lula could easily win the first round, the most likely outcome according to this reading would be a Serra victory in the second round, particularly given that this has been the historic pattern in recent presidential elections which have featured Lula as the principal opposition candidate.
Three other factors lead to a similar conclusion: (1) Serra is now scheduled to have just over 40% of the free air time allotted to presidential candidates, more than twice the proportion earmarked for Lula or Ciro Gomes, the candidate of the Popular Socialist Party (representing a PPS-PDT-PTB Labor Front coalition) when the campaign officially begins in mid-August; (2) as many as half the potential voters still appear to be undecided or undeclared and, in a large country like Brazil, TV campaign announcements traditionally serve as a deciding factor; and (3) the percentage of poll respondents admitting that they would ultimately vote for the government’s candidate rose from 38% in March to 44% in June. However Serra’s recent slip in the July 17 Ibope Survey to third place with only 15% of the intended vote has begun to place this conventional scenario in doubt. Perhaps this explains a recent statement attributed to Cardoso that while Serra would be the best president, he has not been the best candidate.
Clearly, a Lula victory is not outside the realm of the highly plausible. The markets, at least, have been taking this possibility seriously. Governments and the IMF should also get used to the idea. This leads to two important questions. What damage can be done to Brazil’s economic and financial position by the mere market uncertainty likely to persist through August and most of September? And, assuming that investor sentiment would rebound with a Serra victory, what are the chances that it would or would not rebound in the event of a Lula victory?
One potential scenario benefiting any new administration would be a pact with the IMF (styled along lines similar to the IMF agreement with Korea in 1997 during the run-up to its presidential elections) that would include an exchange of potential new support for a set of pre-election pledges from each of the major candidates to honour Brazil’s external obligations and to keep the country on sound macroeconomic footing -including a primary budget surplus of at least 3.75% (the government’s most recently revised objective), central bank independence and inflation-targeting.
Enrique Iglesias of the Inter-American Development Bank supports this idea, as does Mexican president, Vicente Fox. Anne Krueger, vice deputy director of the IMF, claims that the current IMF program with Brazil, scheduled to terminate at the end of this year, will not be renewed unless such a pre-electoral pact with the candidates is reached. Brazil’s Finance Minister, Pedro Malan, has also suggested this type of agreement as a way to calm the markets, finesse country risk back down to sustainable levels below 1000bp, and bolster the Real. Lula seems willing to agree, according to his economic adviser, Guido Mantega, particularly should market sentiment on Brazil’s debt continue to sour. However, Ciro Gomes, the other leftist candidate, now in second place in the polls as of July 17 with 22% and well ahead of Serra (15%), has so far rejected such a pact, and has instead taken on more old-Lula type positions. Gomes has upset markets by talking of scrapping inflation targeting, halting privatisation, regulating foreign access to securities markets, returning national priority to industrial policy and attempting a “voluntary swap” of short-term for long-term debt a la Cavallo which, after the Argentine debacle, smacks of a well-worn euphemism for –if not an imminent signal of– default.
The government has recently announced that it will exercise its right to draw down on some $10bn in special funds from the IMF –a kind of credit line negotiated precisely for this kind of pressure from the markets and granted on the basis of Brazilian success in previously carrying out reforms and maintaining prudent fiscal discipline. After all, with a minimum of historical perspective, it is difficult to deny that Brazil has moved forward with structural reforms and improvements in macroeconomic policy management at an impressive pace, particularly given the fragmented nature of Brazilian politics. Coupled with net international reserves of more than $28bn, these special funds should be more than enough to meet external public debt coming due in 2003 and 2004 ($3.5bn and $5.5bn, respectively, with only minor external public obligations remaining for 2002) and to help support the Real in the event of another serious run against it. The Institute for International Finance estimates that net direct inward investment (FDI) will remain constant next year at projected 2002 levels of $17.5bn, while net external borrowing needs will increase by $1.8bn to $5.5bn in 2003. Nevertheless, this additional borrowing requirement should not place excess strain on Brazilian financial capacity.
Even without the above-mentioned pact between the IMF and presidential candidates, a continuation of the current status quo in the market should not affect the Brazilian debt position too adversely, as there is no need to go to the markets for external finance in the short-term. Problems would develop, of course, if the newly elected administration sparks off more market tensions by announcing major shifts in economic policy, or if the current crisis level country risk spreads are maintained into next year, creating problems for the rollover of corporate debt and additional public finance. In the meantime, the IMF has endorsed Brazil’s current economic program. Recently it accepted Brazil’s proposal to lower the minimum acceptable floor for exchange reserves from $20bn to $15bn, a sign of flexibility and comprehension for the current demands on Brazilian reserves.
The combination of these factors produced a temporary turnaround in the markets in mid-July, with the Real strengthening to 2.79/$ and country risk falling below 1500bp. But there remains the possibility – made clear by the renewed slide in the Real following the July 17 Ibope poll showing Gomes in second place -- that a another pre-election run against the Real would threaten to introduce new inflationary pressures and unnerve the debt markets.  Ruling out any possibility for imminent debt default, such a scenario would raise two possibilities.
Theoretically, the central bank and the government could loosen monetary and fiscal policy in an attempt to improve the chances of José Serra, the government’s quasi-official candidate. Although Serra explicitly requested an interest rate reduction on at least two occasions during the last few months, both Pedro Malan, the current finance minister, and Arminio Fraga, governor of the central bank, have flatly rejected the possibility of allowing macroeconomic policy to be influenced by the electoral cycle. While this temptation theoretically exists, there would probably be too little time for such a radical divergence in strategy to pay off in electoral terms. The risks, on the other hand, would be huge – almost certainly provoking exactly the kind of market panic that both government and opposition candidates seem increasingly determined to avoid. Such a scenario cannot be ruled out, however, particularly now that the central bank surprised the markets with a cut in the Selic rate (the Brazilian central bank’s principal reference rate) on July 17 from 18.5% to 18.0%. At least this move enjoys the benefit of loosening credit in the current contractionary environment, possibly taking some pressure off the private sector and giving a boost to domestic confidence. Fiscal policy, nevertheless, remains the key variable in this equation –especially given that under a flexible exchange rate regime, while monetary policy does have the possibility to exert discretionary influence over output and income, fiscal policy does not. It would therefore appear unlikely that Malan will change course.
While markets have been concerned that a Lula administration might loosen the fiscal and monetary reins, and play tough on debt payment issues, no one is seriously contemplating this happening during the remainder of the Cardoso-Malan tenure. Indeed, while Cardoso has openly pointed to the dangers that a Lula administration would represent for continued economic and financial stability, in private Malan has argued that is it highly unlikely that Lula would significantly alter the current model of macroeconomic management. This would, of course, eliminate the need to risk debasing fiscal policy with the goal of influencing the electorate to vote for Serra in order to “save” the country from ultimate disaster. Committing the feared Lula unorthodoxy of loosening fiscal policy just to help avert a Lula victory does not appear to be one of Malan’s credible options.
An alternative scenario would see the recent Selic rate cut reversed later in the campaign in the event of another serious play against the Real. This of course would hurt consumer and investor confidence and possibly slow the economy even more. Thus, a continuation of the status quo – continued growth slowdown, a weak Real and high country risk – would seem to be the worst case pre-election scenario. But given the current government debt scenario –with no immediate need to roll over significant amounts of external public debt or raise fresh capital- such an eventuality does not pose a serious risk of default in the short run. The real test would be how the markets receive the new candidate-elect. Most recent attention has focused on whether or not the new reformist image of Lula is genuine and whether or not the markets would give the new Lula a chance. And, in the events that the markets put Lula to the test, how would he react?
During the last few months there have been increasing signs that a Lula administration would maintain the current direction of Brazil’s macroeconomic management. Lula and his advisers have taken pains to assure that the current fiscal targets and debt obligations would continue to be met. There has also been speculation that the current central bank governor, Arminio Fraga, might stay on in his post even under a Lula government. Perhaps the biggest risk would come after the elections should markets react negatively to a Lula victory, acting on suspicions that Lula’s election rhetoric is not reliable or simply testing his new-found orthodoxy. This would push down the Real and raise country risk still further with negative effects on debt sustainability. Yet, while it remains possible that Lula might then attempt to confront the markets, having shifted his electoral stance so far from his former positions, this scenario seems increasingly less likely.
Perhaps the most unsettling scenario would be a first round victory for Lula with Ciro Gomes defeating José Serra for second place. The most recent Ibope election survey, published July 17, gave Gomes a seven point lead over Serra (they had been tied only a week before). Some second-round simulations put Gomes in a technical draw with Lula or even in first place. Should Gomes maintain his current interventionist posture and continue to keep his distance from any possible pre-election accord with the IMF, the markets could renew their punishment of Brazil’s currency and bonds, placing further pressure on interest rates and debt service. August and September therefore remain the key months for evaluating the evolution of these possible scenarios.
On the other hand, should Gomes consolidate his second place in the polls and refuse to modify at least his populist rhetoric, Lula could ironically position himself as the candidate of moderation and protector of Brazil’s fragile macroeconomic and financial position. If Serra fades from the picture, despite his current structural advantages, the markets could rapidly begin to view a Lula victory as a relatively positive outcome, with the attendant improvement in the exchange rate and country risk.

Debt and Fundamentals.
The other key factor in this analysis is the exact nature of Brazil’s debt situation. In contrast to Argentina before its default, in Brazil the external debt load is relatively lighter for the state, and tends to be bulked in the private sector. This would suggest that default on the state’s sovereign debt is less likely than some limited pressure on corporate debt which the markets should be equipped to tolerate or absorb.
Total public sector external debt remained relatively stable in 2001, at US$93bn, or approximately 19% of GDP (up from 16% in 2000, but level with 1999 and lower than in the early 1990s). This relatively modest figure stands in stark contrast to the significantly higher debt figures frequently quoted in the press. For example, total external debt –the lion’s share of which is attributable to the private sector and only 11% of which in short-term– was 42% of GDP in 2001 according to the IIF. With further depreciation of the real, this measure could possibly breach 50% this year. Net government debt has been estimated by S&P to be at 44% of GDP for 1998-2002 and at 52% in 2002. According to the Brazilian central  bank, every 1% real depreciation in the Real over a period of 12 months worsens the consolidated public debt to GDP ratio by 0.23 percentage points, leading to the conclusion that the exchange rate variation this year alone –if it does not improve- could add some five percentage points to the overall debt ratio.
The equivalent figures for Argentina at the end of 2001, just as the corralito was being put into place, with default and devaluation only days away, were total public sector external debt at 32% of GDP, total external debt 51%, and net government debt 54% in 1998-2002 (with no currency depreciation effect having yet increased the ratios) and at 102% in 2002 (after the devaluation). While net external debt as a percentage of exports was 217% in Brazil for 1998-2002 (versus 210% in Argentina), net public sector external debt as a percentage of exports in Brazil was only 72% in 1998-2002 versus 164% in Argentina.
The most alarming analysis has come from international economists who have drawn attention to the most catching debt figures. For example, Morris Goldstein has focused on the external finance needed in 2003 and 2004 -$45bn and $50bn– in a context of increasing market sensitivity. However, most of this finance would required by the private sector, compared with the $3.5bn and $5.5bn external public debt coming due in the same years. The potential threat is therefore with corporate -as opposed to sovereign- debt, should the markets refuse to roll over corporate debt except at very taxing interest rates. While this threat is real, and could translate into economic problems similar to those generated by a sovereign default, the crucial variable remains the Real and the country risk spread.
Most international analysts are fond of pointing to the fact that 80% of Brazil’s total public debt is linked either to interest rates or to the dollar. While 70% of the external debt is in dollars, 60% has been privately issued, 50% is privately held, and only 12% is short-term. This means that the medium term risks of default remain principally corporate. An estimated $7bn in corporate debt will come due during the second half of this year, and perhaps only $2bn of this will be successfully rolled over. That implies that repayment of the balance will tend to put some downward pressure on the Real. The danger here is that markets misread the source of this currency depreciation: while it will likely be generated by companies meeting their debt obligations – a positive sign, at least in a strict sense -- markets could mistake this depreciation for a sign of increasing debt distress and loss of confidence.
Given that interest rates – both for bonds and internal credit – remain hostage to movements in the Real, a default possibility would basically be a self-fulfilling scenario. If the markets continue to bet against the Real, the debt burden will become increasingly more difficult to deal with; if the Real is allowed to stabilise or appreciate, the debt situation should not deteriorate, assuming that fiscal policy does not loosen. The worsening debt-GDP ratios (whether measured in dollars or in Reais) have been produced mainly by the Real’s depreciation which should be less severe in future given that the central bank seems committed to keeping the Real below 3.00/$. The crucial factor, then, is how the markets deal with the election and the new president-elect. In this regard, a possible pre-election pact among the principal candidates with the IMF would be a significant factor, as would any significant divergence from current rhetoric by either Lula or Serra once elected. The outside chance of a Gomes victory, of course, could upset the apple cart.
While the possibility exists for some corporate default, sovereign default does not seem likely. The net domestic government debt, even at more than 50% of GDP, should not be too difficult to continue to rollover, as less than 5% is held by non-residents. The total external debt, as mentioned above is principally private. One could argue that the total debt load is similar to that of Argentina before the tragic denouement of its crisis, but the Brazilian situation is fundamentally different. First, Argentina went down after more than three years of sharp recession. Brazil has still avoided a technical recession, and even if second quarter of 2002 GDP growth is negative, it is certainly not a given that Brazil would suffer a recession as long or as deep as that of Argentina, particularly given that the exchange rate is floating. Much does depend, however, on the international economic context, which remains uncertain. Clearer signs of recovery in the US, with a concomitant rebound in investor confidence, would probably help Brazil.
Also in contrast to Argentina, Brazil’s net inward FDI (foreign direct investment), even in 2003, should cover 95% of the current account deficit (88% and 81% in 2001 and 2002), as opposed to only 69% in Argentina in 2001, when that country was in the third year of recession and with a declining current account deficit. The banking sector, too, remains in decent shape, with an average capital adequacy ratio at 14% at end of March 2002 -- above the 11% required by Brazilian law and the 8% Basle standard. Current confidence in the banking system remains high and there has been no sign of a run on deposits like that which occurred in Argentina in 2001. Unlike in Argentina, where tax revenues fell by 9% in 2001 and by 12% between 1999 and last year, tax revenues have remained strong in Brazil, rising 9% YoY in June in the midst of market uncertain.
Furthermore, whereas the fiscal pact between the central government and the provinces was only reached after the default and devaluation in Argentina, Brazil’s Fiscal Responsibility Law, requiring the budgetary co-operation of the Brazilian states with the federal government was first passed in 1999, in the wake of the last crisis in Brazil. In addition, the CPMF financial transactions tax, considered to be a key to maintaining Brazil primary surplus, was extended for a year in June, assuring the government of its 3.75% primary surplus for 2002, despite the current slowdown. In Argentina, on the other hand, the primary surplus never rose above 1% of GDP and slipped to 0.7% in 2001. While further tax and social security reforms remain to be completed, and privatisation seems to have taken a pause, Brazil has a record of generating the necessary minimum political consensus for reform, whereas Argentina never demonstrated such a tendency, at least not in the fiscal terrain during the last several years.

Spain and the International Community.
Nevertheless, should the market’s punishment of the Real and Brazilian debt continue to be severe and last through the end of the year, the crucial variable becomes the posture and reaction of the IMF and the US. Despite O’Neill’s declared reticence to come to Brazil’s aid, two important factors would likely end up involving the international community should debt default become an increasingly likely possibility: (1) the weight that Brazil exerts within the continental economy (over 50%, excluding Mexico) and on the emerging market bond markets (now some 50% given the absence of much of Argentina’s traded debt); and (2) the key test case that Brazil represents for the emerging markets in general.
First, significant financial disruption in Brazil –even more so than in the case of Argentina– would surely affect the rest of South America and imply significant losses for international investors. Given the general level of uncertainty in the world economy today, it would seem prudent for the IMF and the US to help avoid a major meltdown. One thing is to allow Argentina to collapse into its current morass; it would be something altogether different to watch Brazil follow it down. Given that for many important Spanish companies, investment in Brazil is just as important as, if not more than, their investments in Argentina, Spain has a clear special interest in any diplomacy which helps secure the Brazilian scenario. Nearly 6% of all estimated net income in 2002 for all listed Spanish companies is set to come from Brazil, as opposed to less than 4% from Argentina.
Indeed, some of the larger Spanish companies, like Banco Santander Central Hispano and Telefónica, typically receive between a fifth and a third of their net income from Brazil. On the other hand, the likelihood that the Brazilian situation will disintegrate in a manner similar to Argentina remains small and the prospects are rising that even a Lula victory will not plunge Brazil into such a quagmire. The prudent posture for Spanish companies therefore would be to avoid high-profile changes in strategy which appear to include even a partial withdrawal from Brazil, particularly given that any such move during the current scenario would likely create a self-fulfilling panic in the markets.
Second, if Brazil defaults –regardless of whether such a default were the actual result of a self-fulfilling speculative dynamic in the markets or merely perceive to be so, the effects on the economic and financial policies of other emerging market countries would be difficult to predict. But given that this would be the second major emerging market crisis for Brazil in less than a handful of years, after significant improvements in economic management and structural reform -and sandwiching the Argentine debacle- many emerging market countries, including both their policy-making elites and electorates, could easily begin to seriously question their position and role in the entire globalisation project.

Paul Isbell
Analista principal Área Economía Internacional, Real Instituto Elcano