Brazil-Capital Flows and the External Debt Exchange Rates and Foreign Trade

Much of Brazil's economic experience in the past two decades has been dominated by large capital inflows that attained record levels in the 1970s, only to collapse after 1983 in the wake of the Mexican debt crisis. For the rest of the decade, Brazil coped with the consequences of this collapse, and only in the 1990s did capital again begin to flow into the Brazilian economy, with a substantial increase after the Real Plan.

The enormous inflow of external capital to Brazil that ended in 1982 had its roots in a number of policies and institutional changes in the preceding two decades. The military government that seized power in April 1964 quickly reformed existing laws governing direct foreign investments, including liberalizing restrictions on remittances of profits and simplifying procedures for reinvestment of profits. The changes did not address the effects of inflation in the currency of the lending country, however, so that the real returns on a direct investment were affected negatively by inflation in dollar prices. The negative effect of dollar inflation on a direct foreign investment in Brazil arose because the original investment was registered in a fixed dollar amount, on which allowances for profits and remittances were calculated. A million-dollar investment in 1964, for example, would still be registered as a million-dollar investment in 1974. Higher nominal dollar profits in 1974 would then result in a substantially higher nominal profit rate and a heftier Brazilian tax, thus lowering the real return.

Financial lending to Brazil was different because the interest rate on the loan, usually denominated in dollars, incorporated the market's expectations of inflation. The asymmetrical treatment of financial capital flows and direct investment was one of the reasons total capital flows to Brazil in the post-1964 period were dominated by bank lending, which at times was ten times as great as foreign direct investment.

Among the other changes that encouraged large financial capital flows to Brazil was Law 4,131, which allowed final borrowers to deal directly with foreign lenders after approval by the Central Bank of Brazil (Banco Central do Brasil--Bacen; see Glossary). Another vehicle for capital flows was Resolution 63, which permitted Brazilian banks and authorized subsidiaries of foreign banks to obtain dollar loans abroad and reloan the proceeds to one or more domestic borrowers. Finally, the increasing participation of the Brazilian government as a borrower itself, backed by explicit "full faith and credit" guarantees and by the implicit assumption that taxes could be levied to pay for loans to the government, made lending to Brazil an increasingly attractive option for foreign banks.

Equally important in explaining the sharp rise in financial lending to Brazil after the mid-1960s were changes in international financial markets. International banks began to negotiate variable interest rate loans, in which the borrower and the lender agreed to reset the loan's interest rate at specified intervals, usually six months, on the basis of a rate that neither the borrower nor lender controlled (usually the London Interbank Offered Rate--LIBOR), or the United States prime rate. Added to this underlying rate was a "spread," or premium charged to borrowers like Brazil, based on the market's assessment of any additional risk compared with the risks associated with prime borrowers. Finally, the rise in syndicated bank lending, in which one "lead" bank organized the loan and then sold portions of it to other international lenders, permitted banks to expand substantially their loans to borrowers like Brazil.

Together, these innovations cleared the way for lending on a scale that was unprecedented in Brazil's history and with few parallels elsewhere in the world. Because the loans were denominated in the creditor country's currency, they were isolated effectively from inflation in cruzeiro prices. As long as the value of Brazil's export revenues grew at rates exceeding the interest rates charged on the loans, an assumption that appeared valid throughout the 1970s, the burden of the external debt in relation to Brazil's capacity to repay it would fall.

Although it is easy from the vantage point of the 1990s to criticize the volume and terms of much of the bank lending to Brazil, at the time it appeared to be an extremely attractive option for a borrower like Brazil. When inflation in the currencies of the lending countries is subtracted from the rates charged on loans to Brazil, real interest rates on these loans in the 1970s were negligible and often negative. The nominal and real interest rates in the markets in which Brazilian external borrowing occurred do not include the spread paid by Brazil, which during the 1970s and early 1980s was generally between 1 percent and 2 percent. Nevertheless, these rates do show clearly why foreign borrowing appeared to be such an attractive option for Brazil.

The debt crisis that began in Mexico in August 1982 had an almost immediate impact on the ability of other Latin American borrowers to maintain capital inflows. Even though Brazil's trade balance and current account had improved slightly in 1981, loans from international lenders became increasingly scarce. Interest on new loans increased, and most lenders refused to roll over on existing loans. New lending dried up in the second half of 1982, reducing capital inflows, which had reached a peak in 1981, by more than a third. Private borrowers in Brazil encountered a total cutoff of loans from foreign lenders, while official borrowing dropped sharply. By 1984 net capital inflows (public and private) were negligible by comparison with earlier years, and by 1986 the country was experiencing a net capital outflow of US$7.3 billion, a sum nearly equal to Brazil's trade balance. The principal components of Brazil's balance of payments show this sharp drop in the net inflow of foreign capital after 1982 (see table 13, Appendix).

The 1982 crisis interrupted for many years private Brazilian external borrowing. Private loans contracted under Law 4,131 had leveled off in the late 1970s, and after 1982 net private borrowing under this law became negative. The fall in private borrowing under Resolution 63 was even more pronounced. After a rapid rise in such borrowing between 1979 and the 1982 debt crisis, this source of financing virtually collapsed, as the level of outstanding Resolution 63 debt was more than cut in half between 1982 and the end of 1987.

Part, if not all, of the increase in external debt reported by the Central Bank after 1982 was simply forced lending to finance interest payments. It did not have a real counterpart in the form of new resources entering the country through the capital account. As a result, Brazil's ability to tap external saving to finance either public-sector borrowing or private-sector investment collapsed after 1982.

A number of Brazilian economists have made the point that before 1982 net capital inflows more than covered service payments (net interest, profits and dividends, and reinvested profits). After 1982 interest payments alone far exceeded net capital inflows, which turned negative after 1985. Although 1982 is usually viewed as the turning point, the net capital transfer from the rest of the world actually began to decline in the mid-1970s. Brazil was only able to avoid an external payments crisis in the late 1970s because lenders were willing to finance debt service through further lending. After the Mexican debt crisis in 1982, Brazil's own crisis could no longer be postponed.

The 1986 Cruzado Plan exacerbated capital outflows. Real exchange-rate overvaluation, with increasing expectations of a future adjustment, was one factor. A second factor was the increase in uncertainty about future fiscal and monetary policy, as the shortages and informal markets produced by the price controls undercut the euphoria of the first few months.

During the rest of the 1980s, net capital outflow continued, further reducing Brazil's capacity to finance investments needed for future economic growth. In real terms, however, the external debt began to decline in the late 1980s, both as a result of debt renegotiation and a marking down of some of the debt by public and private lenders. Despite temporary interruptions in debt servicing, domestic political pressures in Brazil for a permanent repudiation of the external debt were rejected. As interest rates in international financial markets declined substantially in the early 1990s, the costs of servicing the remaining external debt were reduced further.

Although the debt crisis that exploded in Brazil in the early 1980s had not disappeared a decade later, it was no longer regarded as Brazil's central economic problem. Its effects, however, lingered on in several forms. First, the steep fall in the availability of international reserves (see Glossary) after 1982 sharply curtailed Brazilian investment. The resulting decline in capital formation was evident a decade later, as Brazilians faced the consequence of lower levels of investment in plant, equipment, and essential infrastructure. Second, international confidence in the financial soundness of external lending to Brazil remained low. When foreign capital began to return to Brazil in the early 1990s, it took a rather different form from the capital inflows of the 1970s. Foreign capital inflows to Brazil in the early 1990s were smaller and were no longer dominated by loans from international banks. Instead, foreign lenders sought equity investments in Brazilian enterprises. Foreign firms with the capacity to manage direct investments in Brazil began to replace commercial banks as the primary source of foreign capital.

Data as of April 1997

The single most important policy tool for influencing Brazil's balance of payments is the exchange rate. Brazilian exchange-rate policy has evolved over the past several decades. Policy makers and Brazilian exporters believed that trade flows in the 1960s and 1970s were most effectively managed through trade policies such as tariffs (see Glossary), import controls, or export incentives. Beginning in the 1980s, they began to recognize that balance of payments adjustments may be more efficiently pursued using the exchange rate, rather than tariffs, subsidies, and direct controls on trade. This evolution in thinking reflects in part the increasing skepticism among many Brazilians, both economists and policy makers, about the government's ability to maintain external balance using trade policy without creating severe economic distortions.

Even more important, however, was the exchange-rate experience of the early 1980s. Following the onset of Mexico's debt crisis in 1982 and the resulting inability of Brazil to continue to finance its current-account deficit through external borrowing, the cruzeiro was devalued sharply against the dollar in February 1983. Unlike the earlier "maxidevaluation" of December 1979, which was soon undermined by rapid increases in internal cruzeiro prices, the real depreciation of the cruzeiro resulting from the 1983 adjustment was maintained for the next several years. Exports increased substantially in 1983 and 1984, and the value of imports fell by over US$5 billion between 1982 and 1984. Although some of this decline resulted from the fall in petroleum prices from their record levels in 1981, the response of the trade deficit to the large and sustained real depreciation of the cruzeiro provided clear evidence that Brazil's external adjustment problem could be addressed through exchange-rate policy. The experience of the early 1980s, in fact, led to the recognition that Brazil's real problem was not the private sector's lack of response to the exchange rate, but the inability of the domestic economy, particularly the public sector, to generate the net saving that is the counterpart of a current-account surplus.

Brazil's success in moving the current account into surplus after 1982 implied a corresponding adjustment in either net private saving (private saving minus private investment) or in public-sector saving (tax receipts and other public revenues minus public expenditures). Because net public-sector saving actually deteriorated in the 1980s, the burden of adjustment fell on the private sector, particularly on investment. The dramatic fall in investment after 1982 had important consequences for Brazilian competitiveness and hence for the potential benefits that Brazil would derive from trade reform.

Thus, the experience of the early 1980s suggests that the Brazilian economy had responded to real exchange rates (see Glossary) that facilitated external adjustment, but the policy also reduced domestic private investment and future economic growth. In retrospect, the delay among policy makers in using the exchange rate as the primary tool for achieving external balance is surprising. Their approach may have been influenced in part, however, by the success of the "crawling-peg" policy instituted in August 1968. This policy consisted of small but frequent adjustments in the nominal exchange rate in line with Brazilian inflation and price changes in Brazil's major trade partners, primarily the United States. It ushered in a long period of real exchange-rate stability, broken only a decade later by the December 1979 devaluation. The crawling-peg policy was a marked improvement over the earlier exchange-rate regime, in which the combination of domestic inflation and a nominal exchange rate fixed for long periods of time resulted in large fluctuations and uncertainty about the real exchange rate. The real rate may in fact have been too stable, however, leading Brazil to delay the appropriate exchange-rate response to the external shocks of the 1970s.

A rise in the real exchange rate represents an increase in Brazilian price competitiveness in international markets. Such an increase in price competitiveness could be caused by a depreciation of the cruzeiro against the dollar, a rise in United States prices, or a fall in Brazilian prices. A slowing of inflation in the 1970s made Brazil more competitive, while the rapid acceleration of inflation in the second half of the 1980s substantially eroded Brazil's price competitiveness. Unlike other episodes in which the actual effects of a devaluation were rapidly undercut by Brazilian inflation, the 1983 real devaluation was maintained through frequent adjustments in the nominal exchange rate, sufficient to maintain Brazil's price competitiveness in international markets until the 1986 Cruzado Plan froze the nominal exchange rate (see fig. 11; table 12, Appendix).

A number of implications for Brazil's balance of payments policy are clear from exchange-rate trends and movements in the current account. First, by the 1980s it was clear that Brazilian trade flows were strongly responsive to the real exchange rate. If "elasticity pessimism," which hypothesizes that trade responses to relative prices are low, was ever justified in the Brazilian case, those days were long past. Since the late 1960s, Brazil has ceased to be a developing country in terms of its trade flows. Traditional primary products, such as coffee, cocoa, or sugar, in recent years have accounted for less than a third of the value of Brazilian exports. The increasing importance of manufactured exports, as well as the variety of local import substitutes, makes Brazil's trade balance responsive to real exchange-rate changes. This responsiveness removes one of the traditional justifications for extensive tariff and import restriction policies and for administrative intervention in trade to attain external balance. The evidence of the past several decades suggests that Brazil can attain external balance without extensive market intervention, however harsh the domestic effects of external adjustment.

Second, the introduction of a degree of indexation of the nominal exchange rate in the form of the crawling-peg policy has permitted the external sector to avoid some of the consequences of domestic inflation that would otherwise have produced much more severe external payments crises. Real exchange rates remained relatively stable for a decade after the policy's introduction in 1968. Unlike several other Latin American countries such as Argentina, Brazil avoided the sharp swings in the real exchange rate resulting from domestic inflation and infrequent adjustment of the nominal rate. When Brazil departed from this pattern, as it did in 1986 during the Cruzado Plan, policy makers soon learned that this was a mistake. Subsequent stabilization plans, even if they were failures for other reasons, at least did not succumb to the temptation to use the exchange rate as an anti-inflationary weapon.

Finally, and perhaps more negatively, Brazilian exchange-rate policy transformed Brazil's external adjustment problems of the early 1980s into more intractable domestic balance problems in the early 1990s. Contrary to the initial expectations of many observers, Brazil was able to solve its external balance problem after the 1982 debt crisis with surprising speed. The cost was a sharp increase in the demand for domestic saving to replace lost foreign capital inflows. With little increase in net public-sector saving or in private-sector gross saving, investment fell substantially, undercutting the growth of the Brazilian capital stock and the economy's potential growth in competitiveness.

Capital Flows and the External Debt

Much of Brazil's economic experience in the past two decades has been dominated by large capital inflows that attained record levels in the 1970s, only to collapse after 1983 in the wake of the Mexican debt crisis. For the rest of the decade, Brazil coped with the consequences of this collapse, and only in the 1990s did capital again begin to flow into the Brazilian economy, with a substantial increase after the Real Plan.

The enormous inflow of external capital to Brazil that ended in 1982 had its roots in a number of policies and institutional changes in the preceding two decades. The military government that seized power in April 1964 quickly reformed existing laws governing direct foreign investments, including liberalizing restrictions on remittances of profits and simplifying procedures for reinvestment of profits. The changes did not address the effects of inflation in the currency of the lending country, however, so that the real returns on a direct investment were affected negatively by inflation in dollar prices. The negative effect of dollar inflation on a direct foreign investment in Brazil arose because the original investment was registered in a fixed dollar amount, on which allowances for profits and remittances were calculated. A million-dollar investment in 1964, for example, would still be registered as a million-dollar investment in 1974. Higher nominal dollar profits in 1974 would then result in a substantially higher nominal profit rate and a heftier Brazilian tax, thus lowering the real return.

Financial lending to Brazil was different because the interest rate on the loan, usually denominated in dollars, incorporated the market's expectations of inflation. The asymmetrical treatment of financial capital flows and direct investment was one of the reasons total capital flows to Brazil in the post-1964 period were dominated by bank lending, which at times was ten times as great as foreign direct investment.

Among the other changes that encouraged large financial capital flows to Brazil was Law 4,131, which allowed final borrowers to deal directly with foreign lenders after approval by the Central Bank of Brazil (Banco Central do Brasil--Bacen; see Glossary). Another vehicle for capital flows was Resolution 63, which permitted Brazilian banks and authorized subsidiaries of foreign banks to obtain dollar loans abroad and reloan the proceeds to one or more domestic borrowers. Finally, the increasing participation of the Brazilian government as a borrower itself, backed by explicit "full faith and credit" guarantees and by the implicit assumption that taxes could be levied to pay for loans to the government, made lending to Brazil an increasingly attractive option for foreign banks.

Equally important in explaining the sharp rise in financial lending to Brazil after the mid-1960s were changes in international financial markets. International banks began to negotiate variable interest rate loans, in which the borrower and the lender agreed to reset the loan's interest rate at specified intervals, usually six months, on the basis of a rate that neither the borrower nor lender controlled (usually the London Interbank Offered Rate--LIBOR), or the United States prime rate. Added to this underlying rate was a "spread," or premium charged to borrowers like Brazil, based on the market's assessment of any additional risk compared with the risks associated with prime borrowers. Finally, the rise in syndicated bank lending, in which one "lead" bank organized the loan and then sold portions of it to other international lenders, permitted banks to expand substantially their loans to borrowers like Brazil.

Together, these innovations cleared the way for lending on a scale that was unprecedented in Brazil's history and with few parallels elsewhere in the world. Because the loans were denominated in the creditor country's currency, they were isolated effectively from inflation in cruzeiro prices. As long as the value of Brazil's export revenues grew at rates exceeding the interest rates charged on the loans, an assumption that appeared valid throughout the 1970s, the burden of the external debt in relation to Brazil's capacity to repay it would fall.

Although it is easy from the vantage point of the 1990s to criticize the volume and terms of much of the bank lending to Brazil, at the time it appeared to be an extremely attractive option for a borrower like Brazil. When inflation in the currencies of the lending countries is subtracted from the rates charged on loans to Brazil, real interest rates on these loans in the 1970s were negligible and often negative. The nominal and real interest rates in the markets in which Brazilian external borrowing occurred do not include the spread paid by Brazil, which during the 1970s and early 1980s was generally between 1 percent and 2 percent. Nevertheless, these rates do show clearly why foreign borrowing appeared to be such an attractive option for Brazil.

The debt crisis that began in Mexico in August 1982 had an almost immediate impact on the ability of other Latin American borrowers to maintain capital inflows. Even though Brazil's trade balance and current account had improved slightly in 1981, loans from international lenders became increasingly scarce. Interest on new loans increased, and most lenders refused to roll over on existing loans. New lending dried up in the second half of 1982, reducing capital inflows, which had reached a peak in 1981, by more than a third. Private borrowers in Brazil encountered a total cutoff of loans from foreign lenders, while official borrowing dropped sharply. By 1984 net capital inflows (public and private) were negligible by comparison with earlier years, and by 1986 the country was experiencing a net capital outflow of US$7.3 billion, a sum nearly equal to Brazil's trade balance. The principal components of Brazil's balance of payments show this sharp drop in the net inflow of foreign capital after 1982 (see table 13, Appendix).

The 1982 crisis interrupted for many years private Brazilian external borrowing. Private loans contracted under Law 4,131 had leveled off in the late 1970s, and after 1982 net private borrowing under this law became negative. The fall in private borrowing under Resolution 63 was even more pronounced. After a rapid rise in such borrowing between 1979 and the 1982 debt crisis, this source of financing virtually collapsed, as the level of outstanding Resolution 63 debt was more than cut in half between 1982 and the end of 1987.

Part, if not all, of the increase in external debt reported by the Central Bank after 1982 was simply forced lending to finance interest payments. It did not have a real counterpart in the form of new resources entering the country through the capital account. As a result, Brazil's ability to tap external saving to finance either public-sector borrowing or private-sector investment collapsed after 1982.

A number of Brazilian economists have made the point that before 1982 net capital inflows more than covered service payments (net interest, profits and dividends, and reinvested profits). After 1982 interest payments alone far exceeded net capital inflows, which turned negative after 1985. Although 1982 is usually viewed as the turning point, the net capital transfer from the rest of the world actually began to decline in the mid-1970s. Brazil was only able to avoid an external payments crisis in the late 1970s because lenders were willing to finance debt service through further lending. After the Mexican debt crisis in 1982, Brazil's own crisis could no longer be postponed.

The 1986 Cruzado Plan exacerbated capital outflows. Real exchange-rate overvaluation, with increasing expectations of a future adjustment, was one factor. A second factor was the increase in uncertainty about future fiscal and monetary policy, as the shortages and informal markets produced by the price controls undercut the euphoria of the first few months.

During the rest of the 1980s, net capital outflow continued, further reducing Brazil's capacity to finance investments needed for future economic growth. In real terms, however, the external debt began to decline in the late 1980s, both as a result of debt renegotiation and a marking down of some of the debt by public and private lenders. Despite temporary interruptions in debt servicing, domestic political pressures in Brazil for a permanent repudiation of the external debt were rejected. As interest rates in international financial markets declined substantially in the early 1990s, the costs of servicing the remaining external debt were reduced further.

Although the debt crisis that exploded in Brazil in the early 1980s had not disappeared a decade later, it was no longer regarded as Brazil's central economic problem. Its effects, however, lingered on in several forms. First, the steep fall in the availability of international reserves (see Glossary) after 1982 sharply curtailed Brazilian investment. The resulting decline in capital formation was evident a decade later, as Brazilians faced the consequence of lower levels of investment in plant, equipment, and essential infrastructure. Second, international confidence in the financial soundness of external lending to Brazil remained low. When foreign capital began to return to Brazil in the early 1990s, it took a rather different form from the capital inflows of the 1970s. Foreign capital inflows to Brazil in the early 1990s were smaller and were no longer dominated by loans from international banks. Instead, foreign lenders sought equity investments in Brazilian enterprises. Foreign firms with the capacity to manage direct investments in Brazil began to replace commercial banks as the primary source of foreign capital.

Data as of April 1997

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