A Real Solution with Real Consequences: The Plano Real, Capital Flows, and the Brazilian Devaluation Matthias McCoy-‐Thompson Honors Capstone in International Studies Spring 2014 Professor Arturo Porzecanski School of International Studies American University 2 Abstract: In July 1994, Brazil implemented an inflation stabilization program known as the Plano Real that eliminated hyperinflation through the use of a crawling peg exchange rate anchor, a type of semi-‐fixed exchange rate regime. While this policy was highly effective at controlling inflation rates, it created macroeconomic distortions in the current account (trade balance), interest rates, and public debt that ultimately led Brazil to devalue its currency, the Real, in January 1999. This capstone explores the role of foreign capital during the Plano Real and its devaluation with a focus on how capital movements precipitated the crisis. The study was conducted in three parts: a historical overview, a statistical analysis, and an evaluation through the Mundell-‐Fleming framework, a model that explains the relationship between the exchange rate, interest rates, and capital movements.
The paper focuses on policies of the Brazilian government and their effect on short-‐term and long-‐term capital. It also emphasizes the effect of global economic crises on short-‐term capital flows. The study found that Brazilian investment policies and the crawling peg system helped limit the macroeconomic adjustment after the devaluation. This paper offers important lessons on the costs and benefits of a managed exchange rate regime and provides a recent economic history of a rising economic power, Brazil.
3 In the wake of Brazil’s strong economic performance in the past decade, it’s hard to believe that only twenty years ago the country was experiencing hyperinflation. Brazil recorded annual inflation of 1,928% in 1993 and prices climbed even faster in the first half of 1994. Despite eight stabilization plans in the prior seven years, inflationary forces kept returning at faster and faster rates (Baer 2001). President Itamar Franco, newly sworn in after President Collor’s resignation, appointed Fernando Henrique Cardoso as his finance minister and charged him with developing a new plan to control inflation (F Cardoso 2006).
This plan, which became known as the Plano Real, introduced the Real, a new currency with a crawling peg initially set to the US dollar, and used a transitory price-‐indexation mechanism known as the Unidade Real de Valor for the transition from the old currency to the new (Da Fonseca). The new currency, along with certain fiscal austerity and other economic measures, was wildly successful in eliminating hyperinflation for good. The year-‐on-‐ year inflation rate collapsed from 4,922% when the Plano Real was implemented in July 1994 to 33% twelve months later and eventually to a low of 1. However, this rock-‐bottom inflation rate coincided with a currency crisis in Brazil and the first major devaluation of the Real from 1.20 BRL/USD to 1.
And yet, despite the devaluation, Brazil was able to avoid a return to uncontrolled inflation largely thanks to conservative fiscal and monetary policies, which included a regime change away from exchange rate targeting and to inflation targeting (Bulmer-‐Thomas 1999). Although Brazil emerged from the currency crisis relatively unscathed, the question remains: in 4 what ways did the Plano Real contribute to the devaluation of January 1999, and why were the effects of that devaluation not disastrous in terms of precipitating banking, debt or growth crises? This paper will examine Brazilian economic policies during the 1990s and their role in setting the stage for Brazil’s devaluation in early 1999. A key aspect of any managed currency regime like the one Brazil instituted under the Plano Real is the central bank’s ability to buy and sell foreign currencies in order to maintain the value of the exchange rate. Therefore, a significant portion of this analysis will focus on Brazilian policies regarding foreign capital inflows, the main source of foreign reserves for the Central Bank of Brazil.
During the Plano Real years, Brazil’s government used high interest rates, privatization campaigns, and capital control reforms to draw foreign investment into Brazil. The increase in investment inflows and a currency managed to stay strong, however, led to a reversal in the current account of the balance of payments, as Brazilians started to import more than they exported (Amann 2000). The relatively high interest rates, used to keep inflation under control and the currency strong, also contributed to keeping the Brazilian government in deficit because of mounting interest expenses (De Paula 2003). In the months prior to the devaluation, domestic debt concerns and foreign crises abroad (mainly in East Asia and Russia) caused foreign investors to reassess their positions in Brazil.
As contagion effects from the foreign crises spread, investors became concerned about Brazil’s ability to defend its currency and pay its debts (Frieden 2001). As foreign capital movements reversed themselves, Brazil was forced to sell foreign reserves in order to maintain the value of the Real. With 5 foreign reserves rapidly declining despite an injection of funds from an emergency IMF loan, Brazil decided to devalue. Brazilian policies designed to attract investment during the Plano Real period had a profound effect on the country through the devaluation and beyond.
While the Plano Real created an artificially high exchange rate that attracted foreign investment, it was careful management of investment policies, especially direct investment, that prevented economic collapse after the devaluation. While most countries in Latin America now have a floating exchange rate, the lessons from Brazil’s experimentation with the Plano Real are important today. Although the plan was extraordinarily effective at controlling inflation, it resulted in adverse consequences that made Brazil more vulnerable to a currency crisis. Understanding these consequences is especially important for the multitude of countries that still use managed exchange-‐rate regimes, including five that use a crawling peg system (IMF 2006).
More specifically, Brazil’s experience demonstrates the importance of good management of monetary, exchange–rate, and fiscal policies. Also, an examination of Brazil’s policies and economy during the 1990s provides a strong foundation for understanding Brazil’s reduced macrofinancial vulnerabilities nowadays, as evidenced by the successful way the country came out the global financial crisis of 2008-‐09 and the European financial crisis of 2010-‐11. Brazil radically changed its economy during the Plano Real and set it on the track of increased economic openness and stability. As Brazil continues to struggle with inflation, interest rates, and exchange rate issues, albeit much less so 6 than before, we can look to the lessons of the past for ways to address these problems going forward.
Clarifying Key Concepts A few months before the conversion from the old Cruzeiro Reais to the new Real, the government created the Unidade Real de Valor (URV) that was indexed to the Cruzeiro Reais (Averburg 2002). All contracts were slowly denominated in the URV, which the Central Bank adjusted daily to parity with the US dollar. This method of indexing the URV to inflation kept its value constant and therefore the URV was used as a nominal anchor to keep relative prices stable. When the Real replaced the URV in July 1994, the people were already used to price stability in the new currency and the contracts prevented price inflation in the short term (Da Fonseca 1998).
The Central Bank of Brazil (Banco Central do Brasil, BSB) would pursue a stable exchange rate through the use monetary policy, including through intervention in the market for foreign exchange. By stabilizing the Real to the US dollar at a rate of about one-‐to-‐one and guaranteeing that the BCB would keep it there through intervention, the Brazilian government was able to create confidence in the stability of the Real. However, it soon became apparent that the relationship between the BRL and the USD was not a fixed-‐exchange rate in the traditional sense. Instead, it was a “crawling peg,” whereby the exchange rate was allowed to float within a highly restricted band and was depreciated slowly over time (Campa 2002).
This differs from the two extreme types of exchange-‐rate regimes: fixed and freely floating. Under a fixed exchange rate, governments will always buy or sell currency at a 7 predetermined price. Under a floating exchange rate, governments do not buy or sell currencies but rather let market forces determine the relative exchange rate. The “crawling peg” system is a variant of the fixed exchange rate regime in that the authorities intervene in order to have the currency move along a predetermined path or corridor.
The crawling peg system in Brazil and the subsequent devaluation can be seen in Graph 1 below: Graph 1 Exchange Rate 2.5 Jul-‐94 Nov-‐94 Mar-‐95 Jul-‐95 Nov-‐95 Mar-‐96 Mar-‐97 Jul-‐97 Nov-‐97 Mar-‐99 Jul-‐99 Nov-‐99 Nov-‐96 Mar-‐98 Nov-‐98 Jul-‐96 Jul-‐98 The Mundell-‐Fleming model can portray both of the two types of exchange rate regimes in an open economy. This model helps explain the relationship between the balance of payments, monetary policy, interest rates, and output. Under this model, if the domestic interest rate changes due to changes in fiscal or monetary policy, then a differential will open up between the domestic and foreign interest rate causing capital to move into or out of the country (Sanders 2008). Under a floating exchange rate, the exchange rate will appreciate or depreciate to accommodate any resulting changes in supply or demand for foreign exchange.
Under a fixed exchange rate regime, the central bank must buy or sell foreign currencies into or out of its official reserves in order to maintain the exchange rate 8 at the targeted level or range, which then increases or decreases the money supply, respectively. This model has been used to explain why governments cannot have a fixed exchange rate, run an independent monetary policy, and allow for free capital movements at the same time, because with free capital movements either the exchange rate will change or else monetary policy will do so (as a result of intervention operations) in order to accommodate movements of capital (Sanders 2008). A central aspect of the Mundell-‐Fleming model is the concept of interest rate parity. The theory of interest rate parity holds that domestic interest rates in different countries with completely open economies will move towards equilibrium after accounting for each country’s respective exchange rates and inflation rates (Chinn 2006).
This is because foreign investors will always invest their money where real interest rates are the highest. In these countries, either the exchange rate will change or monetary policy will change to address the capital inflows causing the real interest rate to decrease. This has a profound effect on the balance of payments, or the net value of all trade plus the net value of all capital movements into and out of the country.
