DEVALUATION - THE PRICE! J. Paul Groom and H. Sellers McKee II The devaluation of the Brazilian Real on January 12th was, in our opinion, a positive event. However, this newsletter presents the argument that the devotion of the Brazilian Government to its limited devaluation policy had outlived any economic rationale that may have supported it previously. Further, the devaluation, carried out as a reaction to events beyond the government's control, was so poorly implemented that it damaged the government?s credibility. To prove that we are not being wise after the fact we provide below some quotations from a newsletter dated November 4th 1997, entitled " Brazil in Turmoil - What Price Devaluation1 ". The newsletter, was written in the context of the then recent Asian crisis and made the following points: 1 Copies of the full text of the November 1997 newsletter are available on request. " The question is not simply why did the Brazilian government not devalue the Real instead of taking the above measures. The real question is why a devaluation of some degree was not included to try to alleviate those aspects of the package that would work against economic growth? " Another concern is that Brazil is now marked as a country with a fundamental problem, an overvalued currency. This means that any international weakness will cause investors to re-evaluate the risks of Brazil, and further turmoil may be expected until it is perceived that the currency has achieved an acceptable parity ". Devaluation is not a panacea for economic ills, but in an economy that has high levels of international debt, and where export performance is important to balance a propensity to import, foreign investors will focus on the price that is being paid for the currency. Any solution to Brazil's economic difficulties that does not take into account the overvaluation of its currency is doomed to be temporary". The Brazilian government has taken some unpopular steps, but it has failed to address the real fundamental problems and has left itself open in the future to exactly the same pressure that it has experienced recently ". The vulnerability of the Brazilian Real is clear when the inflation rate above that of the USA during this period ( July 1994 to September 1997 ) is 44.7%, and the Real depreciation against the US Dollar over the same period has been only 9.8%". LOST TIME After the Asian Crisis of late October 1997, the Brazilian Government maintained its rigid policy of allowing the foreign exchange rate to fluctuate within a restricted band ( effectively allowing 7.5% devaluation p.a. ). The Russian crisis that occurred in the summer of 1998, brought additional pressure to bear on the Real. Brazil's response was, in part, to rely on speculative money by doubling domestic interest rates to 46% p.a. Not surprisingly, with the Government being the only party able to borrow at such rates, the level of government indebtedness rose from 5.5% of GDP in November of 1997 to 8.3% in January of 1999. THE DEVALUATION Since the Asian crisis, we have taken the position that the devaluation of the Real was inevitable, and that the best the Brazilian government could hope for was the opportunity to pick the time and place of devaluation and thus control the process. Our theory of devaluation management is: The degree of currency volatility after the devaluation of a currency will be inversely proportional to the degree of control retained over the devaluation process by the government of the devaluing country. Given this theory, we were not surprised to see the depths to which the Real has plummeted in the last few weeks. A controlled devaluation would have had the following characteristics: The devaluation would have occurred during a tranquil period in foreign exchange markets, when the government would not be using precious reserves to support the currency. As reserves would have been plentiful, the issue of devaluation would not have been in the thoughts of investors, and if, in passing, the issue had been raised with the government, all suggestions of devaluation would have been dismissed as ridiculous. The devaluation would have been by a specific percentage and would have justified the extent of the devaluation in the context of a comprehensive economic plan with associated measures. Future foreign exchange policy and strategy would be presented at the time of devaluation to provide credibility to the devaluation policy, and would be consistent with the previously mentioned economic process. The government would support the devaluation timing, parity and policy through representatives appearing in the media to provide the government's " spin ". It will be clear to anyone who followed the Brazilian devaluation that none of the above occurred. Rather, the devaluation was forced upon a reluctant Brazil on January 12 as a desperate measure to stem the flow of reserves. The government had no room to control the process. The devaluation occurred in the following context: The moratorium on R$ 15 million of debt owed to the Federative Republic of Brazil, declared by Governor Itamar Franco2 of the State of Minas Gerais was not an event that merited worldwide news3. However, in an already charged atmosphere where confidence in the government's ability to defend the Real was fragile, the moratorium was the straw that broke the camel's back. One billion dollars flowed out of Brazil the day after Governor Franco's announcement, joining the six billion that had already left in the first few days of 1999. 2 It is interesting how Itamar Franco, the Governor of Minas Gerais has gained instant notoriety, while Itamar Franco, the former President of Brazil remains unknown. 3 In an article entitled " A New Ripple Effect ", New York Times, January 22 1999, Moisés Naím argues that the actions of Itamar Franco in declaring a debt moratorium are affecting the average family in the USA far more than President Clinton's impeachment! The initial devaluation merely widened the government controlled trading band to between 1.22 and 1.32 Reals to the dollar. This allowed for an immediate devaluation of up to 8.24%. The policy also permitted incremental devaluations every three days of only three basis points, which implies a total adjustment against the dollar allowed in a one-year period of only 12.5%. This would mean, over a twelve-month period, a devaluation of only four per cent more than that allowed under the previous band. As market expectations for a devaluation were in the 20% - 30% range, it quickly became clear that the government had not gauged the magnitude of the lack of confidence. For the two days that the new band functioned, the Real traded only at the bottom of the band, i.e. 1.32, with the government as the only seller of dollars. Thus, with two billion dollars leaving the country on the first day of the new band, ( twice the volume of the previous day in the previous band ), the government had little choice but to remove all limits and devalue ( float ) the currency again. During previous crises, Brazil's President, Fernando Henrique Cardoso, has appeared on CNN's " Newshour with Lou Dobbs" to explain the policies of the Brazilian Government. This time, however, the government remained mute during the crisis. Thus, the airwaves were left to " talking heads " comparing Brazil to Russia, Indonesia and Thailand without highlighting important differences that mitigate the Brazilian experience. Such differences include, i ) the level of reserves remaining; ii ) the diversity of Brazil's economy; iii ) the strength, and level of capitalization of private sector companies; iv ) the success of the government in passing the measures required to meet the IMF's goals and, v ) the levels of strategic foreign investment in Brazil in recent years. THE FUTURE What about the future? For consumers and businessmen alike, the future is uncertain. The following are some of the indicators that will affect the business climate: Domestic Interest Rates. Under the previous foreign exchange regime interest rates were kept high to reward investors for holding Reals despite the threat of devaluation. Therefore, with a floating exchange rate, it might be expected that there would be no need for high interest rates. However, in the short-term, ( since the devaluation ) rates have actually risen and will stay high for the foreseeable future. The following are issues affecting the level of domestic interest rates. 1. The government has reached an agreement with the IMF. We can expect an adherence to strict IMF deflationary doctrine which has often highlighted the need for high domestic interest rates as an inflationary antidote. 2. Brazilian exporters often fund themselves with hard currency loans priced at Libor plus a spread. These loans or advances are known as either " ACE's " ( Adiantamento sobre Contrato de Exportação ), or "ACC's" ( Adiantamento sobre Contrato de Cambio ). Often the exporters will draw down on these maximum 180 day advances, whether they need the liquidity or not, in order to gain arbitrage income by placing the money on deposit with a local bank at domestic interest rates. These advances represent short-term increases to Brazil's foreign exchange reserves as they are anticipations of hard currency export revenues. After the devaluation, with interest rates only in the low 30% p.a. range, most exporters shunned the ACE/ACC market as too risky for arbitrage. Thus, the government raised domestic interest rates to induce them to borrow ( anticipate export revenues ). After the rise in interest rates exporters drew down US$ 145 million, but the FX rate at that time was 1.60 Reals to US Dollar 1.0. It is far from certain that the rise in interest rates will adequately compensate those that chose this route. 3. A similar rationale to that with the ACCs and ACE's holds for " Rural " borrowings. For most banks these were an easy arbitration based upon the difference between foreign borrowing costs and domestic dollar rates. 4. A general loss of credibility. FHC appears to have lost touch. Until the government can demonstrate political leadership and a rational economic program, there is little that can be done to lower interest rates. The government has a vested interest in reducing domestic interest rates as soon, and by as much as possible, due to the effect of high interest rates on the nominal internal debt. Thus far the government has been strangely mute on the subject, except to say repeatedly that it will not default. Inflation With Brazil's history of inflation, the investors may be forgiven for wondering whether a return to hyper-inflation is a possibility. Indeed, the Economist, among other journals, has raised this specter. This scenario might develop as follows: The drain on Brazil's reserves would continue. Disbursed IMF reserves would disappear, and the IMF and associated institutions would refuse to disburse further amounts into this environment. The downturn in economic activity makes it impossible for the government to produce the budget surplus negotiated with the IMF. Therefore, the Brazilian government would be left with one of two options. Either it would be obliged to restructure and renegotiate both internal and external debt, or the government would be obliged to print money. This latter action would give a substantial twist to the inflationary spiral. An array of inflation projections from interested observers, have suggested that inflation might be between 8% to 12% this year. Salomon Smith Barney, has taken note of Brazil's worsening fiscal situation, and the new floating rate foreign exchange policy, and has predicted that inflation may reach 35% in 1999, as GDP falls by 6%. Foreign Loans The debt markets are closed to Brazil, and may remain closed for some time. While foreign financial institutions evaluate the ability of their clients to deal with the new economic environment, they will be unwilling to extend financing, even for short periods of time. In a broader context, the rating agencies have downgraded Brazil and there is no chance in the short term that financial institutions would add to their existing exposure without shareholder and regulatory disapproval. There has been a suggestion that Telefónica Internacional, the owner of the Telecomunicações de São Paulo- Telesp fixed wire line concession could go to the market with a debt issue. Certainly this is the type of issue that could be successful, but in order to attract investors Telefónica would have to provide a review of the effects of the devaluation and accompanying measures on its business, business plan and projections that will take some time to evaluate and prepare. There is always the chance that the Federative Republic of Brazil could also make a " flagship " issue, but this would have to await some market stability to be successful. Many telecommunications companies which recently won fixed wire line " mirror " licenses, or hold limited service authorizations, are starting network build-out. Other companies are planning significant upgrades to their networks such as digitalization of mobile cellular systems, and the installation of fiber optic cable by the existing fixed wire line operators. With the dearth of funding sources, the operators have turned to suppliers for financing. Thus, many suppliers have numerous potential sales, all dependent upon supplier financing, that will not, in most cases, be available. The choice for these operators may be higher levels of equity, BNDES finance, or a combination of both. Projections Business plans, projections and analyses completed prior to January 12, 1999 are worthless. Even those telecommunications operators that rely on locally manufactured equipment and local financing, and which are not obliged to pay management fees, royalties and dividends outside the country, will have a hard time predicting demand, the extent of the rise in delinquencies, inflation etc. Those, that have substantial US Dollar debt from banks and or suppliers, are no doubt presently counting the cost. Operators will be analyzing the Anatel regulations on tariff rate adjustments and carefully reviewing the options available to them to increase revenues via value added services. In fact, the regulations for fixed wire line service provide for adjustments in line with inflation, but at the same time, reduce the base of tariffs based up on a formula that in the year 2001 provides for the maximum adjustment to be 90% of the preceding period's inflation. For mobile cellular operators the adjustment is inflation corrected by IGV-DI. CONCLUSION In the short-term, the Brazilian Government's reluctance to devalue the Real until there was no option has placed Brazil in a difficult situation. The manner in which the devaluation was carried-out compounded the difficulties by eroding the government's credibility. There is such a lack of confidence that the Brazilian currency is not trading at the expected 25%-30% discount to its previous value, but rather at a 70% discount, with doubts about future trends. The prime goal of devaluation was to reduce the need for Brazil to maintain such high domestic interest rates. In fact, the government has been forced to increase domestic interest rates four times since the devaluation. Public sector debt suffered with the devaluation as the government has US$ 63.4 billion in foreign currency bonds outstanding, and R$ 80.5 billion of local currency debt that is dollar indexed. Unfortunately, with local interest rates at the 39% p.a. level ( "CDI" ) and futures pointing to 52.25% p.a., the public sector domestic debt will continue to rise until confidence has been restored. The fact that the government was forced to devalue and permit the Real to float has left it looking inept and inert. The visit this week of IMF officials to Brazil will surely result in further stringent economic measures to restore confidence in the government and the Real. The only significant, short-term, positive effect will be the boost to exports. Many remember the excellent performance of the Brazilian export sector during the 1980's, and have lamented that such a dynamic sector has been restricted by an overvalued currency. However, after three weeks of unmitigated bad news there have been some positive developments for investors: Armínio Fraga has been chosen to succeed Francisco Lopes as President of Banco Central. Fraga was an associate of international investor George Soros. The government reported a 1.4% primary surplus for its 1999 budget. Februaray 1, 1999 saw only the second day of net inflow of foreign funds this year. The Real, early on February 2 had gained 10% on the US Dollar. Notwithstanding the current difficulties, we believe that Brazil, a country adept at dealing with change, will meet the challenge of adapting to this situation with its customary ingenuity and enthusiasm.

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