The Real Brazil Story: From Hyperinflation To 5th Largest Economy

Posted in Finance Articles, Total Reads: 8283 , Published on 02 March 2012
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The Catastrophe

In the 1980s, the Brazilian government had resorted to deficit spending. Irresponsible fiscal policy on the Brazilian government’s part continued as the government failed to realize enough tax revenues and continued funding its spending by borrowing.

Real Brazil Story

The creditors, when they realized that the government has failed over a period of time to generate tax revenues to cover its expenditure, demanded higher rates . Borrowing for the government became costlier. Brazilian government, in response to the costlier borrowing, committed a major blunder as a solution – Printing money.

Printing of money led to a drastic increase in money supply in the economy in the mid-1980s, which led to inflation. The situation worsened as the inflation slid off control and reached epic proportions, resulting in hyperinflation in the late 1980s.

In 1990, Brazil’s inflation rate was about 3000%. An idea of that inflation rate would be, for e.g. a good which costs $10 would cost $310 by year end.

The Real Plan

After a series of failed attempts at controlling inflation by the government like freezing prices and salaries, in 1993, Minister of Finance, Mr. Cardoso implemented the Plano Real. The idea was to create an index , named URV which would be pegged 1-to-1 with the US Dollar. Even if the prices continue to rise in Cruzeiros Reais, the existing Brazilian currency, but as the URV was pegged to the dollar, the prices in URV would have minimal variation. On 1st July 1994, the Cruzeiro Real ceased to exist and the URV became the Real - the new Brazilian currency.

The Capital Exodus and the Trade Boom

As the Plano Real took effect, the inflation was tamed and was well within the comfort range of around 10%,  but Mr. Cardoso had still not addressed the root cause of the inflation – Budget Deficits.

In later half of 1990s, the US GDP growth rate averaged around 4% from 1996 to 2000. As a result of this the USD got stronger. Since, the Real was pegged 1-to-1 with the USD , the Real also got stronger. As a result  of a strong Brazilian Real, Brazilian goods and services got costlier for foreign markets. Demand for Brazilian goods and services fell and there was an unmistakable fall in exports.

In Brazil, in those days, governors of states could default on their debt and pass on the debt to the national government. In one such scenario, one of the governors of a large state govt. defaulted on the state government debt and passed on the state government debt to the national government.

With state government’s default and then the national government carrying that debt, investors got worried. In fear of a default the investors started pulling capital out of Brazil. Equity investors, Bond investors and other asset investors started selling their assets in Brazil. The Brazilian market was soon flooded with local currency. The central bank tried to buy up the excess money supply in the economy using its dollar reserves but failed eventually to control that. The Brazilian forex reserves fell considerably in 1999 as the Brazilian central bank tried to soak up the excess local currency.

Capital exodus had two major implications.

1. Real no longer remained pegged and was now a free-floating currency. The Real exchange was completely decided by market forces, much like the USD.

2. Real had a massive devaluation. The huge devaluation of Real made  Brazilian goods and services cheaper for the foreign markets. Demand for Brazilian goods and services increased. Brazil with its growing exports experienced a trade boom.

Conclusion

Brazil has, owing to an innovative monetary reform, emerged from one of the worst cases of hyperinflation. It has posted an excellent growth trajectory since the early 2000s and now stands at 6th position in nominal GDP rankings after having overtaken UK recently. The inflation level is in the comfort zone of central bank as well.

This article has been authored by Shovik Kar from MDI Gurgaon

Image: Salvatore Vuono / FreeDigitalPhotos.net


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