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Brazil Scrambles to Demonstrate That It Can Avoid a Debt Default


By: Jonathan Karp, Michael M. Phillips and Craig Karmin
 The Wall Street Journal , June 24, 2002



Brazil enters a perilous week that could determine whether local and international leaders are able to convince investors that a debt default isn't inevitable.

So far, the International Monetary Fund and Brazil's economic team, among the most respected in the developing world, have failed to calm markets. Treasury Secretary Paul O'Neill tried Friday, after first fanning investor qualms by suggesting the U.S. opposes further IMF aid, comments many Brazilians considered careless.

Now, the unlikeliest market booster is stepping in: Left-wing presidential front-runner Luiz Inacio Lula da Silva, a major source of investor anxiety because of fears he will mismanage the economy, pledged Saturday to honor debt obligations, keep inflation low and maintain budget surpluses as long as necessary to contain Brazil's debt burden.

Mr. da Silva's Workers Party is to finalize its campaign platform for October elections at the end of this week. But to placate investors, he brought forward the announcement of key economic policies and -- for the first time -- put them in writing. In his "Letter to the Brazilian People," Mr. da Silva blamed market turbulence on the "fragility" of Brazil's current economic model. He pledged to change it but only through political consensus. "The new model can't be a product of unilateral government decisions," the former union activist said.

Financial markets will test Mr. da Silva's pledge Monday. Economic stability forged since 1994 by President Fernando Henrique Cardoso is at stake, as investors question Brazil's ability to roll over its $290 billion public debt. On Friday, Brazil's currency plunged to a historic low of 2.84 to the dollar, and its credit-worthiness fell to its lowest point since a chaotic 1999 devaluation. Brazilian sovereign-bond yields are higher than Nigeria's and second only to Argentina's.

The selloff Friday defied a statement by Finance Minister Pedro Malan that Brazil's economic fundamentals don't justify such high risk. Central Bank governor Arminio Fraga went so far as to declare that there is no chance of a default. He added that investors are confusing "an adverse environment with structural problems" and that the $10 billion in IMF credit released last week is enough to see Brazil through the current market storm.

But sentiment soured after Mr. O'Neill intimated that the Bush administration will block additional IMF loans, despite U.S. confidence in Messrs. Malan and Fraga. In an interview with Bloomberg News, Mr. O'Neill said, "Throwing the U.S. taxpayers' money at a political uncertainty in Brazil doesn't seem brilliant to me." He added, "The situation there is driven by politics. It's not driven by economic conditions."

Mr. O'Neill's comments appeared to be off-the-cuff thoughts, rather than formal policy. They came as a surprise to others in the administration, for whom a cap on IMF funds is but one of several policy choices being considered should Brazil ask for more aid, something it hasn't yet done. But the Treasury secretary oversees U.S. relations with the IMF, so his words carry the weight of policy pronouncements.

At first, senior Treasury officials refused to clarify whether Washington is ruling out a larger rescue package. Late Friday, after high-level contacts between the U.S. and Brazilian governments, Mr. O'Neill issued a statement leaving that question unanswered but offering encouragement to Brazil. "To clarify my earlier comments, the Brazilian government is implementing the right economic policies to address the current difficulties," said the statement. "Brazil has not requested any new [IMF] funds and its economic fundamentals are strong. Brazil is a critical regional and global partner of the United States."

By then, the markets were closed and the damage was done. Brazilian officials, already smarting from downgrades by two credit-rating agencies Thursday, were furious, but they refrained from commenting publicly. Others weren't so coy. In an editorial, the Estado de Sao Paulo newspaper blasted Mr. O'Neill for what it called "stupid arrogance." Expressing the financial community's frustration, former Brazilian Finance Minister Mailson da Nobrega said, "O'Neill's statement showed that his knowledge of Brazil is very low, but it placed enormous stress on the market, hurting the currency and our risk premium."

The fallout was broader. Investors last week sold debt from the Philippines, Mexico and Russia -- economies with no direct links to the Brazilian economy. Also hurting markets was a further setback in Argentina, where Central Bank governor Mario Blejer, a former IMF official, said he will resign after five months on the job.

To be sure, market participants are divided on whether Brazil's woes are solely the result of political uncertainty given Mr. da Silva's strong lead in opinion polls and whether Brazil is headed for a default. "I think the true likelihood of default is lower than what the market is indicating right now," says Eric Fine, head of emerging market-bond research for Morgan Stanley.

Brazil's debt amounts to 54.5% of gross domestic product, lower than many emerging markets. Most of that debt is domestic, but some 80% of those bonds are linked to interest rates or foreign-exchange rates. What's more, high interest rates and risk-averse global investors inhibit Brazil's ability to grow out of its potential debt trap.

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