Two months after the devaluation of the real, the specter of Brasilia defaulting on its domestic debt still hangs over Brazil. The market is concerned because the inference-whether merited or not-is that if Brazil cannot honor its domestic debt, it also may not be able to honor its external debt.
A Brazilian default, in turn, would spell big trouble for other emerging markets and would embarrass the International Monetary Fund and other international financial institutions, which have staked their credibility on halting the spread of the economic contagion.
Yet unless Brasilia is able to bring down the cost of rolling over the domestic debt to levels deemed manageable, default is unavoidable, say some observers. To roll over domestic debt in early March, Brazil was paying real interest rates of almost 38% on local currency-denominated debt, in contrast to about 29% before the devaluation.
Given that each percentage point rise in interest rates costs the government about $2 billion more in debt service payment, the longer rates remain at these levels, the greater the doubts about Brazil’s wherewithal to continue meeting its debt obligations.
Considering the country’s ballooning fiscal deficit, many market players perceive this situation as unsustainable. “There doesn’t seem to be a way out,” said Larry Krohn, senior Latin American economist at Donaldson, Lufkin&Jenrette.
Nevertheless, as long as the markets continue to roll over the debt, Brazil has a window of opportunity in which it can try to get its fiscal house in order and thus avoid having to default, fall into arrears, or restructure its debt.
With the IMF’s help, Brasilia has put together a program that some believe will create the economic and political environment in which it can lower the debt-to-GDP ratio (a key gauge to assess a country’s ability to service its debt) down from the current 50%. The plan aims to lower the debt-to-GDP ratio by reducing debt while minimizing the contraction in GDP this year.
In particular, the government is trying to raise the surplus in the primary balance-the balance of expenditures and revenues, excluding interest payments-from the initial target of 2.6% of GDP to 3.1% of GDP via a combination of additional spending cuts and an acceleration of the timetable for privatizations.
Meanwhile, to ease the debt burden, the central bank wants inflation growth targets-goals that, if perceived as believable, will help lower interest rates. Observers say that the new central bank chief, Arminio Fraga, is not only counting on Brazil’s relatively low level of imports to soften the price impact of January’s devaluation, but he is also gambling that inflation will be checked by the economic contraction and the elimination of indexing.
A commonly held view is that the government’s IMF-sanctioned economic program is viable, but that the risk lies in whether the new Congress will approve the program and convince the market of its commitment to fiscal discipline.
For this to happen, says one analyst, the government and the new Congress will have to work together differently than they have in the past. “As far as I can see, there is nothing new that will lead me to believe that will be the case,” he added.
For Riordan Roett, head of Latin American Studies at the Johns Hopkins School of Advanced International Studies, a greater concern is the apathy of Congress. “This new Congress, just like the previous Congress, doesn’t really care about the crisis,” he said. “All they care about is protecting their electoral base and their own personal interest, such as salaries and perks.”
Monetize or Restructure?
Cognizant of the difficult challenges the government is facing and Brazil’s poor track record in bringing down interest rates, Wall Street is now openly ruminating about what options Brazil has. Thus far, there is no consensus as to what course Brasilia will take, but the two leading options appear to be either monetizing or restructuring of the debt.
Monetization of the debt means that when bondholders choose not to roll over the debt, the central bank would print money to buy back the debt. That would increase the money supply and thus heighten inflationary pressures.
Higher inflation, in turn, would help the government meet its debt obligations in the near term because typically Brazil’s government expenditures are not linked to inflation, but revenues are. Thus, there are large savings to be gained from postponing expenditures.
Among those favoring monetization over a restructuring is John Welch, chief economist for Latin America at Paribas, who says that inflating away the debt is a better option, not only on an economic basis, but also because no well organized lobby against inflation exists in Brazil.
“It is a feasible economic option because with only $12 billion in money supply and between $26 billion and $27 billion in foreign exchange reserves (around $36 billion if IMF money is included), the central bank can afford to print money,” he noted.
DLJ’s Krohn also points out that monetization would be less costly on the political front because the pain isn’t immediate. The political costs, of course, depend on how much inflation monetization creates. If it leads to a return to hyperinflation, it is hard to see how President Fernando Henrique Cardoso can survive politically, as he has built his political career on price stability. The question is whether Cardoso wants to take this risk.
According to a recent JP Morgan report, hyperinflation is exactly what Cardoso will face if he follows the monetization route. In that report, JP Morgan argues that “inflating the debt away is not an option; only hyperinflating the debt is.” To support its case, JP Morgan notes that the public debt outstanding-nearly 340 billion reais-is close to 10 times larger than the monetary base. The report also points out that because of Brazil’s history with hyperinflation, any suspicion of a return to the past would lead to political pressure to start indexing the economy again.
In regards to restructuring, few observers believe a forced restructuring, akin to what Brazil did under President Collor in the early 1990s or what happened in Argentina in 1989, will be pursued, or even work if attempted.
Fraga himself rejected this option in his confirmation hearings as head of the central bank. “All that a forced restructuring will do is buy time and trigger a barrage of lawsuits and an even bigger fall in credibility,” said Paribas’ Welch.
In regards to a forced restructuring, the central bank’s new head of research, Sergio Ribeiro da Costa Werlang, wrote in a report while he worked at Banco BBM, “we know from our previous experience that these measures do not help lower inflation, or the growth rate of the country.”
On the other hand, a voluntary restructuring does have its supporters. They take heart from the fact that most of the debt is held locally by Brazilians and that nearly 40% is owned by banks, some of which are government controlled. And while the financial sector’s heavy involvement in this problem is cause for concern among many analysts, DLJ bank analyst Steve Dreskin says that banks have priced in a restructuring “by building in some flexibility into their balance sheet management.”
In a recent report, Dreskin also argues that Brazilian banks would probably agree to some sort of restructuring, as long as they could recognize interest income monthly at prevailing market rates. He adds that banks may even accept a restructuring at below-market, fixed rates on the condition that they were attractive enough at the end of a specified term. But he warns that while most Brazilian banks could get away with such accounting exemptions, they may be a problem for Unibanco, which must follow US GAAP standards due to its ADR listing.
SG Cowen banking analyst Yolanda Courtines pointed out at LatinFinance’s Predictor conference in January that much also depends on the type of government debt that is being restructured-floating rate versus dollar indexed debt, for instance. So, says Courtines, if the government decides to restructure all floating rate debt into fixed rate instruments, the balance sheet of a bank like state-controlled Banespa, which is up for sale this year, would be greatly affected since it only holds floating rate notes.
Unibanco’s asset quality, on the other hand, would be less vulnerable to such a move because of its relatively lighter load of floating rate debt.
Whatever the government does, however, it must expect balance sheet pressures in the financial system as the recession worsens. Nor can it continue to count on the banks for financing-a fact that makes further progress on the fiscal front pivotal.
Indeed, no matter what road Brasilia takes, there is no silver lining. “If Brazil monetizes or restructures its debt, in effect it is still an abdication of fiscal responsibility,” said DLJ’s Krohn, “and the country’s overall creditworthiness will still suffer.”
The best that Brazil can do for itself is to avoid having to make this choice, which is possible only if Congress can convince the market that Brasilia is fully committed to fiscal discipline. But it must hurry, as there is little time to make that case.