Brazil and its Financial Sector
Executive Summary
Through the efforts of the local administration in order to sustain its financial sector, Brazil was able to encounter significant development. In particular, its government enforced several controls and the tight monetary policy in order to address its budgetary deficit. Despite this, increasing the interest rate to lower the inflation rate and defend the real led to certain problems. One of the major financial issues faced by the country is the devaluation of its currency. Not only had this affected the local economy but the economies of other neighboring countries as well. Based on the gathered data and analysis, the current financial concern of Brazil did not originated from its initial decisions but on its failure to take a proactive approach on the rising consequences of these financial decisions. The government should have taken the appropriate actions before it had lost billions of reserves and lost its credibility.
It has then been suggested that the Brazilian government should either abandon its attempt to regulate the exchange or manage and fix the exchange rate without managing the local currency, which can be done through a currency board. In general, the plan of the government to resolve the issue should be directed on the restoration of the investors’ and people’s confidence to the government as well as the re-establishment of the credibility of its financial system.
Introduction
The monetary policy is defined as the economic terms pertaining to government actions related to the setting of public expenditure and how these expenditures will be supported. Governments utilize the policy in influencing the aggregate demand level; the purpose of which is to fulfill economic objectives including economic growth, full employment and price stability. There are a number of policy types. One of which is the contractionary monetary policy, which is characterized by reduced public spending or increased taxation. This type is also known as tight monetary policy. The main purpose of implementing this type of policy is to increase the interest rates. This in turn will help in controlling inflation, increasing the exchange rate as well as attracting foreign currencies. Such policy however, also has some drawbacks. In particular, this could reduce the money level in the economy for consumption, resulting to decreased demand and spending as well as increased pressure on prices.
Governments implement such policies in order to sustain the local currency and their countries’ financial state. In Brazil, its president has chosen to implement the tight monetary policy so as to defend the real. In this discussion, the different aspects of Brazil’s previous and present financial status are described. The reactions of various economic aspects to the local administration’s decision to implement this type of policy are also explained using facts and theories. Finally, recommendations or the probable courses of action the government could take to resolve its financial issues are provided.
Brazil and its Monetary Policy: Fact and Effects
President maintained the tight money policy in order to support the real as well as prevent the trade deficit from going out of control. The main purpose of implementing a tight money policy is to increase the interest rates. This in turn will help in controlling inflation, increasing the exchange rate as well as attracting foreign currencies, which can be useful in controlling current account deficit ( 2004). Though this may have resolved the economic problem of the country, the government also has the alternative of implementing a loose or expansionary monetary policy. The aim of such policy type is to stimulate the aggregate demand. This is typically done when the government thinks that that the unemployment in the country is too high or if the economy is not progressing fast enough. A loose fiscal policy then allows the people and businesses to have more spending money to make purchases. This in turn helps in generating demand as well as job opportunities, leading to economic growth and higher employment ( 2006).
By applying the tight monetary policy, the short term interest rates of the country will increase more that the long term rates. This is because tight monetary policy tends to reduce money level in the economy for consumption, resulting to decreased demand, spending and pressure on prices ( 2006). The short term capital cost is then driven up by the shortage of money and credit. Long term interest rates on the other hand stay low when this occurs. This is because foreign investors expect the monetary policy to loosen and the inflation to decline. Due to low long term rates, tight monetary policy then increases the demand for long term bonds.
Despite the effort of the Brazilian government, financial issues still arise such as the falling interest rates. One of the main causes of the decreasing interest rates in Brazil for the past years is the investment sector. It is known that when the interest rate increases, the investment rate decreases. When this happens, reduction of investment spending increases; this trend then follows the principle that as consumption and demand decreases, the aggregate demand curve will shift to the left, implying a contracting economy. However, for the past years, foreign investment in Brazil had remained strong, causing the interest rate to fall. The country continues to attract foreign investors through its large population as well as its GDP rate. The country has been considered a good site for investment as it has one of the largest markets within the Latin American region. In addition, industrialization efforts are well underway in the country.
According to the article authored by (2000), having a stronger business investment is one of the causes of the country’s growth in the past years, resulting to lowering interest rates. Specifically, both the import and export sectors have remained strong over the years. Having a stable currency, the presence of growth factors and low inflation, the country’s central bank was able to cut the short term interest rate by two percent.
Actions: Benefits and Consequences
The growing deficit of the country drove the local administration to take certain actions such privatizing its social security. The privatization of the social security system is said to generate considerable improvements to the country applying it. In a research done by (1996), the researcher made use of a model in order to determine the effects of social security privatization. The study revealed that the privatization of social security can be useful for producing major increases in living and output standards. Moreover, the gains of privatization are more significant if the resources are redistributed from initial to future generations. Welfare improvement or efficiency gains from privatization are also substantial. This also helps in enhancing the well-being of the lifetime poor relative as compared to the lifetime rich relative.
Privatizing social security will also help in improving national savings rate. In privatization, larger fiscal burden is placed on the initial order generation, resulting to a lower fiscal burden for the initial young and future generations. The higher tendency of the initial elderly to consume will then be reduced, resulting to increase national saving, investment as well as real wage growth (1996). The privatization of the social security system however has some risks as well. In particular, this system would make the workers encounter of financial market underperformance during their working careers. Individual accounts then become vulnerable to unavoidable and large fluctuations in the market. These fluctuations can negatively affect the savings of the retirees. This can be resolved by having long working hours; however, this will also result to significant pressures in the labor market due to lower wage growth as well as high unemployment rates. The national government then acts on this by implementing financial support programs, directing transfers to account holder or expanding social programs. In other words, should the market underperforms, the government would have to pay then creates a system of insured gambling (2006).
Aside from social security privatization, the government also made use of various means to control the currency. Using currency controls to defend the real has both benefits and costs. Through these currency controls, upward pressure is observed on price levels; this in turn is useful for reducing inflation. One of the main currency control used by Brazil in order to defend the real is to push the interest rate by almost fifty percent by the central bank. The higher the local interest rates become, the more profitable it is.
However, this can only occur if people who place their money on Brazilian savings accounts or purchase depressed Brazilian bonds are certain that the value of their savings in dollar will not be affected by devaluation. This is why the currency control applied through interest rate only resulted to increased costs of private and public servicing debts. The level of these costs became so high that the investors grew certain that problem will occur; this problem was the subsequent collapse of real’s dollar value. The inadequacy of the necessary factors can then cause the currency controls to backfire. In the case of Brazil, the cost of applying currency control to defend the real only resulted to rapid fall of the asset prices within its economy. Other effects include the increased risk and rate of bankruptcy, reduction of the collateral backing existing loans and the placement of the financial system to considerable burdens.
The attempts to save Brazil’s financial state and economy encountered several other issues. For instance, speculators had a consensus that the Brazilian currency is overvalued due to the financial situation of the country as well as the status of its financial factors. One of the main reasons for the speculation is the increasing account deficit of Brazil. The foreign exchange reserves of the country are decreasing as well. It is said that currency overvaluation is done by governments in order to lessen the amount of imports in order to finance their countries’ deficits. With this tactic, imported goods become less appealing to the local consumers. Trade sectors also become more narrowed and manageable with an overvalued currency. Currency overvaluation is then an alternative for capital flight; considering the financial state of Brazil, its currency then reached speculation. The Brazilian currency is said to be overvalued by fifteen to twenty-five percent ( 2001).
Choices and Decisions
In accelerating the depreciation or decline of the Brazilian currency, a number of tradeoffs must be considered by the president. One of which is its impact on product prices. Naturally, fast depreciation of the local currency will result to increased inflation. This in turn will cause the price of locally-produced products to increase. The consumption of the imported goods on the other hand will increase. The president should then consider his priorities in terms of addressing budgetary deficit as well as increasing local consumption and investment rate. The rate of real’s depreciation should also consider the local and foreign trade sectors.
It has been considered that if the administration has chosen to devalue the currency rather than defend it, these issues would not have been encountered. However, the recessionary impacts in Brazil are not particularly centered on its tight monetary policy, but on the timing of its decision to devalue. Considering the effects of the tight monetary policy, its can be said that this decision has resulted to a number of beneficial effects to the country. Through this, the strength of the country’s investment sector has been restored. Raising the interest rates and privatizing social security helped in covering budgetary deficits. However, it should be noted that this act has also resulted to some negative impacts to Brazil. Slow GDP growth, increase unemployment rate as well as the decreasing quality of the credit services of local banks was some of the notable disadvantages. The image of the president was even marred by the public’s perception that such financial decision was only favorable for the nation’s wealthy sector. With these, recessionary impacts of the monetary policy could have been avoided if the government has acted immediately on it.
The failure of the administration to act immediately further worsened the impacts. When all options were lost, the president and his advisers then decided that devaluation is the solution to the problem. This in turn made matters worst as the government initially pledged that the Brazilian currency will not be devalued. Due to this decision, the credibility of the government was negatively affected. This also reinforced the negative expectations from devaluation of the financial community and markets.
The destruction of the credibility of the government was realized by the central bank, causing its major officials to step down. When the local currency was devalued to about 8.6%a total of .2 billion reserves had already been lost. Upon the resignation of the central bank officials, further billion reserves were estimated to have left Brazil. It was when another billion of reserves was lost did the local government decided to let the currency float freely. Problems are already evident due to the previous financial decision; the government should have taken this signs more analytically. Practical and timely actions then could have been made.
With devaluation, the credibility of its government is not the only one affected. The devaluation of its currency can also cause negative effects to the local economy and to other foreign countries as well. The devaluation of the real poses a number of risks to the financial status of several Brazilian corporations, especially those that are exposed to foreign exchange risks. Consider the following example. If Company X is exposed to a high level of foreign exchange risk and also a major client of Company Y that has no of little foreign exchange risk, then any impact that will affect Company X will cause an indirect impact to Company Y. This effect has been observed a number of times within the local economy, firms and financial institutions. The devaluation of the Brazilian currency has also caused credit agencies to downgrade the country’s sovereign debt. In effect, the Brazilian economy will encounter more constricted credit conditions and higher borrowing costs.
Other Latin American countries will also be affected by Brazil’s decision to devaluate its currency. This is because most of these nations are very much dependent on capital inflows and foreign investment. Chile, Mexico, Uruguay and Argentina are some of the countries that will be most affected by the devaluation of the Brazilian currency. Except for Chile, the said countries have economies that are dependent on capital inflows. Aside from Brazil, the economy of Argentina will have the most losses, mainly because the investors do not differentiate capital allocation on a country by country basis. Considering the nature of Argentina’s currency board, its strong trade sector is affiliated with the Mercosur nations; due to its inability to implement monetary policy, the country will then encounter major capital outflow, resulting to recession and decreased supply of money.
Conclusion and Recommendations
The Real Plan appears to be the main link between the country’s history of hyperinflation and budget deficits. This plan has been made in order to design economic reforms as well as conduct structural development; in order to carry this out, a .5 billion loan was placed on the International Monetary Fund. This loan was intended to protect the currency from capital flight as well as to boost the country’s dollar reserves. The structural developments included in the Real Plan aimed to break the rising dollar equivalent wages observed in the country’s manufacturing sector, sustain profit rates as well as establish more attractive condition for foreign investment. If all went according to plan, the effects of failing capital asset prices as well as the institutional desperation for dollars will not be experienced. The plan however failed as the supported budget was not acquired; the economic reforms also failed to get through the local legislature. This then led to the implementation of various currency controls so as to address the country’s budgetary deficit.
From the given discussion, it became clear how the decision of Brazil’s local administration had affected its various economic aspects including its GDP, employment and investment rate. While the decision to defend the real through currency controls has helped the country with its budgetary deficit, this had also resulted to some major consequences. From this, the fault is not on the administration’s selected monetary policy but on its reaction rate to arising problems brought about by its decision. In this experience, it has been learned that acting immediately to financial concerns could have saved other neighboring economies and the country from losing considerable reserves.
Despite the financial problems being faced by the country, there are a number of ways on how the President can address the country’s current financial crisis. For instance, the local government can abandon the attempt to regulate the exchange rate; this in turn, will prevent the administration from gambling away the dollar reserves of the central bank in order to keep the currency within the target trading band.
The government may also choose to manage and fix the exchange rate without managing the local currency. This can be done by following the currency board of Argentina; through the currency board, difficult problem brought about by the fixed exchange rate regime can be addressed, leading to a more controlled local monetary growth. This recommendation however may take away the central bank’s ability and flexibility to address economic crises, resulting to greater economic downturns brought about by a freely floating currency. Whatever policy the Brazilian administration plans to implement, it is essential that the people’s and investors’ confidence are regained and the system’s credibility restored. It is essential that the government acts immediately on this financial turmoil before it worsens and affects other neighboring countries.
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