Two questions have dominated economic debate in Latin America in recent years. First, when will the current period of great international liquidity end? Second, what will happen when it does?
We could also add a third, related, question: Are Latin America's governments preparing for that day?
In the case of Brazil, the answer appears ambiguous, at least at first glance.
On one hand, Brazil has remained more or less at a standstill in terms of economic reform after the start of President Luiz Inacio Lula da Silva's administration in 2003. Essential changes to the tax code, labor law and pension system have simply not been made.
On the other hand, whereas lenders once demanded commitments from Brazil that were often nearly impossible to meet because of the political situation, these same investors now generally seem completely satisfied with Brazil, despite its economic policy paralysis.
There are objective reasons for this change. For the first time in decades, Brazil has been able to take advantage of good economic times to reduce its external debt, thereby lowering the risk to lenders. Indeed, Brazil's foreign debt-to-export ratio last year was the lowest in 50 years.
Moreover, while Brazil's total gross foreign debt fell by US$50 billion during the past eight years, its foreign currency reserves rose rapidly, especially in the past two years, cutting the net foreign debt by more than US$120 billion since the 1999 crisis (see table).
Diminishing debt is important for investors because it shows a trend. If the rate observed last year and this year is maintained, Brazil will eliminate net foreign debt by the end of Lula's second term in 2010. This, together with its strong fiscal position, means that Brazil will be much better "armored" against a foreign crisis than ever before in the modern era.
Indeed, a country affected by a world recession or by falling export prices is much more vulnerable if its external debt is 40 percent or 50 percent of the value of its net exports than if it has little or no net foreign debt. When foreign credit dried up for Brazil years ago, the only way to avoid bankruptcy was to call in the IMF. Now, if something similar happens, the central bank will have the foreign exchange needed to service its debts while maintaining a stable exchange rate.
As a result, however, Brazil faces an uncomfortable fiscal dilemma. In order to compensate for the increase in money supply associated with the purchase of dollars, the government issues securities that pay a higher interest rate than the central bank receives for investing reserves overseas. While the result in terms of net public debt is neutral, reducing net foreign debt in the public sector -- which is already less than Brazil's international reserves -- and increasing domestic debt is not good business in terms of the cost of the official debt.
This is one reason why it is important that domestic interest rates fall, which in the coming months will very likely happen -- and relatively robustly. In the coming years, Brazil's government should also strive for fiscal balance (last year the deficit was still 3 percent of GDP), and then to attain a surplus, as Chile has done for years now.
Brazil is preparing partially for the day when the current period of great international liquidity ends. While structural reforms have lagged, the economy is far less vulnerable than it was in the past.
Fabio Giambiagi, a former adviser to Brazil's minister of planning, is an economist at Brazil's National Bank of Social and Economic Development. Copyright: Project Syndicate
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