The currency crisis in Brazil is a sharp reminder that the world economy remains vulnerable to regional turmoil after last year's crises in Asia and Russia. Yesterday's decision to widen the real's trading band against the US dollar is effectively a devaluation. It was triggered by persistent capital flight in recent days and the announcement last week of a moratorium on debt payments to the central government by Minas Gerais, one of the richest states in the federation.
It is a highly inauspicious start for President Fernando Enrique Cardoso's second term in office. In coming days he will have to maintain the credibility of the $41.5 billion agreement reached last November with the International Monetary Fund (IMF) after his election victory. The money was advanced from the IMF, the World Bank, the Inter-American Development Bank and the Group of Ten industrialised countries to tackle the Brazilian economy's deep structural problems. They include budget deficits amounting to eight per cent of GDP per annum, reforms of social security, public administration, expenditure, tax policy and revenue sharing. Given Brazil's exposure to international turmoil as the world's eighth largest economy, it can readily be seen that this crisis will test the credibility of all concerned.
On the currency front, the objective will be to contain the devaluation within the wider band in as orderly a fashion as possible. Great efforts were made to sustain the strong outgoing exchange rate against the dollar, including the imposition of cripplingly high interest rates which deepened the country's economic recession. This decision should in principle ease that pressure. But it has come too late to prevent the destabilising effects of the debt moratorium in Minas Gerais, which calls into question Mr Cardoso's capacity to deliver on the austerity and reform package as a whole.
President Cardoso insists that debts will be honoured and has moved to rally other states to his position and discipline the errant one. Several of the reforms agreed with the IMF are going through the legislature. Mr Cardoso has a good record in stabilising the Brazilian economy, having overseen the defeat of hyper-inflation as finance minister, through pegging the real to the dollar. He will now need to demonstrate tough and decisive leadership if his country is not to fall prey to international speculators and the world economy pushed closer to greater instability. It is important not to overstate the impact of these events. But it would also be foolish to underestimate the sheer irrationality of markets confronted with such uncertainties - despite the welcome evidence yesterday that they were not over-reacting immediately. There is an urgent need to find more effective means of regulating the international economy, rather than letting markets dictate the pace and content of political reaction to such events.