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In
January 1999, Brazil abandoned its dollar-peg
and devalued its currency, the real, sparking
a financial crisis. The devaluation resulted when accelerating
capital outflows rapidly depleted government reserves,
which are crucial for maintaining a relatively constant
exchange rate. But what caused capital outflows to accelerate
suddenly—and why did investors change their stake
in Brazil so quickly?
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 Financial
contagion.
Investors had worried the real was overvalued, leaving Brazil vulnerable
to financial contagion. Contagion occurs when a financial crisis
in one country motivates investors to remove their funds from other
countries with similar weaknesses. When financial crises swept Asia
in 1997 and Russia in 1998, investors who were pulling their investments
out of those countries also began to withdraw them from Brazil.
To discourage the outflow of dollars, which the central bank would
have to supply to maintain the pegged exchange rate, Brazil raised
interest rates—a step intended to entice investors to hold
their money in Brazil to earn high interest rates. Chart 1 reveals
Brazilian interest rate surges, which reflect investor nervousness
during the Korean and Russian financial crises.
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 Fiscal
problems.
Brazil's growing fiscal deficit also frightened investors. Chart
2 breaks down the deficit between the portion attributed to interest
payments—marked interest—and the portion—labeled
primary—that is the difference between government expenditures
on goods and services and the government's income from taxes and
fees. The primary deficit is not large on a year-to-year basis,
but the year-in/year-out accumulation of these deficits by a country
that has a history of debt moratoriums can worry investors—especially
in the context of financial crises in Asia and Russia. While the
primary deficit was not large, the increases in interest rates made
the overall deficit much greater. Last year, the two parts of the
deficit—the primary and interest portions—summed to about
8 percent of GDP. That, together with signs that the primary deficit
problems might continue, made investors nervous.
Politics.
By December 1998, skittish investors were taking capital out of
Brazil at rates as high as $350 million per day. If a particular
event could be said to have triggered Brazil's devaluation, it was
a state governor's decision to suspend debt repayments to the national
government. Capital outflows accelerated even more rapidly, and
by mid-January, Brazil announced pegging was over.
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Pegged
vs. Flexible Exchange Rates
Governments
peg currencies to the dollar to stabilize their value.
To maintain a peg, the central bank attempts to control
the dollar price of its currency by intervening in currency
markets. For example, if the market's dollar supply
is not enough to meet dollar demand at the official
exchange rate, then the government supplies dollars
out of its reserves. This action prevents traders from
demanding more currency for dollars and causing a currency
to depreciate.
When
a currency's exchange rate is flexible, the government
does not intervene in markets to control its value.
Markets alone determine the exchange rate.
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William
C. Gruben is the director of the Center for Latin American
Economics and a vice president at the Federal Reserve
Bank of Dallas; Sherry Kiser is an associate economist
at the Federal Reserve Bank of Dallas.
SUGGESTED
CITATION:
Gruben,
William C. and Sherry Kiser (1999), "Why Brazil
Devalued the Real," Federal Reserve Bank
of Dallas Expand Your Insight, July 1, http://www.dallasfed.org/eyi/global/9907real.html
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