Modern Day Greece’s Brazilian Odyssey
22 February 2010
In recent weeks there has been considerable discussion about the pressures on peripheral European economies. Fast rising public sector debts have led to speculation that developed economies could suffer crises akin to those which have faced many of the global emerging markets (GEM) between 1997-2002. In this article we look back at the situation facing emerging economies a decade or so ago, analysing in detail one example, Brazil, to see whether any useful lessons can be learned for their OECD counterparts.
In many respects, balance sheet weaknesses in parts of peripheral Europe mirror the plight of GEM countries in the late 1990s. Indeed, on some metrics, the debt dynamics of Greece today look worse than Brazil did back in 2002. Brazil’s debt to GDP ratio then was around 65%, with a fiscal deficit some 3.5% of GDP, and a primary budget surplus of around 3% of GDP. Greece, on the other hand, presently ‘enjoys’ a debt to GDP ratio of around 120%, a fiscal deficit of 12% and a primary deficit of some 8% of GDP. Other countries such as Spain, Portugal, Italy and Ireland have somewhat similar figures. It is important to point out though one major, critical difference between the GEM in the past and the Eurozone now, namely that GEM debt was typically denominated in US dollars. Hence as the local currency depreciated in response to economic and financial crises, the ability to fund future debt issuance was severely curtailed. Conversely, being part of the Eurozone, and able to issue in the liquid European bond markets, has allowed them greater latitude than countries such as Brazil would ever have been permitted by the markets!
It is worth examining the time-path of events: in 1997 the Asian crisis commenced with a devaluation of the Thai Baht, followed by contagion throughout regional financial markets. In 1998 Russia devalued and defaulted on its debt. In 1999 Brazil devalued its currency. Argentina followed suit in 2001, after two painful years of recession, and this in turn fed back to Brazil whose debt came under tremendous pressure. In fact, EMBI spreads (the amount Brazil must pay to finance its bonds over and above the yield from US Treasury bonds) reached a staggering 22% in 2002. This vicious price action suggested that the market was highly confident that Brazil would default on its debt. It had been seen as ‘the next weak link in the chain’. In fact, Brazil never did default, despite having to pay onerous amounts to roll over its debt. Given the crises that had run amok across Asia, Eastern Europe and Latin America, why did this chain reaction stop?
The answer is that a combination of factors caused a change in Brazilian asset prices, some of which have relevance for European debt markets today. Global growth, monetary policy and domestic fiscal policy all came into play, combining in a favourable way to bailout Brazil. First of all, the US stock market bottomed in late 2002 as investors anticipated the end of the recession the following year. The global economic recovery gathered pace in 2003 and 2004 which supported trading economies such as Brazil. Looking back at the path of global monetary policy during the GEM crisis, the US reduced interest rates considerably, from 6.5% in 2000 to 1.25% in late 2002. Alongside this, the US dollar began a lengthy period of depreciation. Such a relaxation of monetary policy also had a major bearing on the market’s tolerance for risk assets. This time around OECD interest rates are very low, and the wild card is the start of the withdrawal of quantitative easing by the ECB and other central banks. The speed and impact of these changes in unorthodox monetary policy tools could have a major impact on investor appetite for risk assets. The fear will be that a policy error may be made, until investors can be more certain that the recovery in economic activity will not be damaged.
In terms of domestic politics and fiscal policy, back in 2002 Brazil had incoming President Lula – over whom the markets had great trepidation. Some investors were fearful that the President would default on the country’s debt obligations. In the event, Lula did vow to honour debt obligations in the run up to the Presidential election, followed by a plethora of fiscal tightening measures and bolstered by IMF support. In each instance, the announcement was initially greeted sceptically. Eventually, though, investor confidence did turn, when all of the positive drivers were seen to line up resulting in an increased appetite for Brazilian assets.
In conclusion, certain interesting lessons can be drawn between the situation facing parts of Europe today and Brazil’s experience of a decade or so ago. One aspect is the importance of a favourable global economic environment driving exports; hence as well as countries such as Greece, Portugal and Spain implementing tax increases and spending cuts, it would assist their adjustment process considerably if other countries such as the US, Germany and France implemented measures to boost demand, and thus regional and global trade. Secondly, Brazil was supported by easy monetary policy and the depreciation of the US dollar; European countries have suffered from the appreciation of the euro in 2008-09, but in recent weeks the currency has begun to depreciate as investors take a less positive view. The ECB would argue that monetary policy remains loose and that banks can access plentiful liquidity. Thirdly, the Brazilian experience shows the importance of political commitment to reform that can take some time before the market place sees announcements as sufficiently credible. While financial markets are more sophisticated in Europe than their GEM counterparts, in other ways there are similarities, such as the importance of investor greed and fear, and the reaction to political uncertainty, similarities which make comparisons on debt crises useful whatever the state of the economy.
Jason M. Hepner, Investment Director, Global Strategy, Standard Life Investments
This article was first published in Professional Adviser on Thursday 4th March 2010.
