Euro-zone set to withstand Brazilian tremors

Date: 21/01/1999

By Simon Taylor

EU FINANCE ministers and officials are insisting that Europe can ride out the storm caused by the financial crisis in Brazil.

“The spillover effects are smaller now that we have the euro,” insisted Economics Commissioner Yves-Thibault de Silguy late last week, adding: “I think this crisis is manageable”.

European Central Bank watchers predicted that the upheaval in Brasilia would add to the pressure for another half a percentage point cut in euro-zone interest rates over the coming months.

The Brazilian real lost 20&percent; of its value against the US dollar last week after foreign investors pulled nearly €2 billion out of the country, forcing the central bank to abandon the currency's link with the dollar.

The move sparked fears that the crisis could spread to industrialised economies if US growth was hit by lower demand in Brazil. Latin America takes 20&percent; of US exports, and the real's devaluation will raise the cost of imports.

De Silguy's comments were echoed by other EU finance ministers, including France's Dominique Strauss-Kahn, who acknowledged that the situation in Brazil was “not good” but added that he did not believe the Union was facing “something similar to that which we saw either in Asia or in Russia last August”.

De Silguy urged the Brazilian government to restore market confidence by reducing its large budget deficit and demonstrating how it planned to control inflation.

Commission experts point out that the collapse in foreign investors' confidence stemmed largely from threats by one of Brazil's federal states to halt debt repayments to the country's central government, and not from poor economic fundamentals. Brazilian officials claimed this week that there was no support from other states for the move by Minas Gerias to halt repayments, and the dangers of widespread default were therefore limited.

They pointed out that that the country's parliament had approved the main planks of a reform plan agreed with the International Monetary Fund as part of a €35-billion aid package, including important commitments on tax collection.

Their claims were backed by the World Bank. “President Cardoso has consistently shown his commitment to implementing Brazil's reform package and continues to mobilise increasing support from Congress and the majority of state governments,” said one bank official.

But financial analysts warn that Brazil is not out of the woods yet, despite a rise in stock market values late last week following the Brazilian central bank's decision to allow the real to float.

“The risks are very high that a free-fall in the real is inevitable,” warned David Lubin, emerging markets analyst at HSBC in London, who said that foreign investors would become increasingly reluctant to lend to Brazilian companies if the real slumped further, causing a fall in the country's economic growth rate.

This could in turn hit the US economy if lower demand in Latin America affected US exporters. Stalling US growth could then have an impact on the rest of the world.

European analysts believe that the risk of a lower rate of US expansion will maintain the pressure on the ECB to cut euroland interest rates. “The growth and inflation outlook lead us to maintain our forecast that there will be a further easing of interest rates in the first half of 1999,” said Manuela Preuschl, financial market analyst at Deutsche Bank Research in Frankfurt, who predicted a cut of around half a per cent unless there was another round of crises in the second rank of emerging market countries.

The EU has enjoyed a trade surplus with Brazil since 1995, reaching €2.3 billion in 1997. But the drop in the value of the real will increase the cost of imports from the Union and make Brazilian exports cheaper.

EU governments are still trying to agree on how to liberalise trade between the Union and the four-nation trade bloc Mercosur. They have so far not been able to decide where to make concessions to entice the South Americans to strike a deal, but hope to find a common line in time for the first EU-Latin American summit in June.

Officials say the crisis in Brazil has made it more important than ever to find a way to get agreement on a trade deal with the Mercosur bloc. They concede, however, that problems such as the reluctance of EU governments to make concessions on farm imports will be difficult to resolve.