Brazil teetered on the brink of an Asian-style financial collapse last night after an effective devaluation increased pressure on its currency and the international repercussions caused substantial falls on all the major stock exchanges.
The world's eighth largest economy faces a crucial few days to see if its new monetary strategy can survive predicted speculative attacks and avert a potentially catastrophic crash that analysts fear could plunge the world into recession.
The devaluation - of approximately 8 per cent - happened as soon as the central bank removed the mini-band in which the Brazilian real traded against the dollar. The real immediately hit the top of the new, wider band.
By changing the exchange rate, the central bank was effectively admitting that a cornerstone of its monetary policy since hyperinflation was quashed five years ago - tightly pegging the real to the dollar - was not working. Speaking on a live television address, however, President Fernando Henrique Cardoso played down the shift by describing it as opening up a "breathing space" rather than signalling a change of direction.
The decision claimed the scalp of the central bank president, Mr Gustavo Franco, who resigned, saying he now saw the need for "flexibility" in setting exchange rates. He was replaced by his deputy, Mr Francisco Lopes.
Brazil was thought to be over the worst of its financial crisis last November when the International Monetary Fund agreed an unprecedented $41.5 billion (#38.6 billion) rescue package to shore up investor confidence.
However, the money is dependent on fiscal reforms to balance a vast public deficit which President Cardoso is already struggling to achieve. A maverick governor's moratorium last week on repaying his state's debt to the federal government sent jitters through investors, who started to pull dollars out of the country at levels unseen since before the IMF intervened.
On Tuesday $1.2 billion left the country, reducing foreign currency reserves to about $35 billion.
Analysts in Brazil were yesterday fearful that the central bank's actions would increase the instability of the real - which is still thought to be overvalued by about 20 per cent. "I think they would have been better off with the old system because changing it increases uncertainties," said Mr Constantin Jansco, of MCM consultants in Sao Paulo.
Economists point to the precedents of Mexico's peso crisis and the Asian crisis of 1997 when countries trying to devalue in a controlled way were crushed by the force of speculators and the currencies went into free-fall. Brazil, however, has different circumstances in that it has much larger currency reserves and is also following a structured IMF rescue package.
Both the Rio de Janeiro and Sao Paulo stock exchanges dropped by 10 per cent shortly after opening, triggering circuit breakers. By mid-afternoon they had started to recuperate but were still showing substantial losses.
President Cardoso was hoping that his government would regain the initiative at last night's vote in Congress on four parts of the fiscal adjustment, which are expected to be passed comfortably.
One of the consequences of keeping the real pegged to the dollar was that, to stop dollars leaving the country, interest rates had been set at around 30 per cent - a high level that was pushing the country into recession. Unemployment is already at its highest level in recent memory.
With a weaker real it is hoped that interest rates can soon be dropped to stimulate the economy.
The success of pegging the real to the dollar in 1994 was that virtually overnight it eliminated decades of hyperinflation. While a return to high levels of inflation is a worry as a long-term effect of devaluation, the slow current economic conditions are not expected to trigger price increases.
