Latin America after the currency crash in Brazil: Why the optimists may be wrong

The currency crisis in Brazil and its adverse effects on neighboring countries are widely perceived to be short-lived phenomena. However, optimists—stressing favorable growth and investment prospects in Latin America—tend to ignore home-made causes of Brazil's crisis and -underrate the risks ensuing for the region as a whole. • Financial turmoil in Asia and Russia induced several speculative attacks on the Brazilian real. However, domestic policy failure caused the currency collapse: The Real Plan of 1994 was undermined by delaying fiscal consolidation. Thus, crisis was looming since 1997, mainly because soaring public sector deficits eroded the sustainability of the exchange-rate peg to the US dollar. • After the decision for floating the real, Brazil still faces serious policy dilemmas. Devaluation has not prevented a further rise in interest rates. Mounting debt-service obligations represent a fiscal time bomb. Restructuring short-term debt involves the risk of prolonged financial volatility. It cannot be ruled out that Brazil will impose capital outflow controls, the drawbacks of such a move notwithstanding. Brazil's crisis affects neighboring countries in several ways. Contagion transmitted through financial markets has remained limited so far. If financial turbulence continues in Brazil, however, the pressure on exchange rates, interest rates and stock markets is likely to increase in other Latin American countries. Contagion through trade hits Brazil's Mercosur partners in the first place. Mexico, too, may be affected as the devaluation of the real impairs the international price competitiveness of Mexican exporters on third markets. In addition, the crisis may disrupt intra-Latin American investment relations. Short-term economic prospects of Latin America would deteriorate if the United States were no longer prepared to absorb rising exports of crisis-ridden emerging markets. Protectionist sentiments may also spread in Latin America, especially if world-market prices of the region's major commodity exports remain depressed. In the light of Latin America's strong reliance on foreign capital, the greatest risk appears to be that external financing of current account deficits will be curtailed. The current crisis may have as a result that structural reforms, required for Latin America's successful participation in globalized production, will take second place for the time being. This applies especially to Brazil where fiscal discipline required for short-term stabilization clashes with public investment needs, notably in education. Deregulation of labor markets may be postponed in other Latin American countries, too, in order to contain unemployment in the short run. Yet, Latin American governments should signal their determination to stick to reforms even under conditions of financial turmoil. Privatization and public sector reforms supporting better governance are of critical importance in this respect.