A Tree Falls in the Amazon Forest . . .

DAVID C. ROCHEMake no mistake. Without radical and urgent fiscal reform, Brazil will be the next emerging-market domino to fall. Foreign exchange has been pouring out of the economy at a rate of $1 billion a day--although it slowed recently--and the stock market has fallen nearly 50% in the past year. Foreign-exchange reserves, which totaled more than $70 billion at the end of July, have plummeted to about $45 billion. The currency, the real, is under heavy pressure.Brazil matters. It represents about half of Latin America in terms of size, people and GDP. Moreover, Brazil is a cornerstone among global emerging markets, maintaining one of few surviving stable exchange-rate regimes with a solid peg to the U.S. dollar. If the real goes, the chasm will widen again between the rich world and the poor, as capital flees emerging markets for the safer havens of European and U.S. government securities. Pressure will grow on China's renminbi, the Hong Kong dollar peg, the South African rand and so on.No wonder the International Monetary Fund and the U.S. Treasury have been hinting at offering Brazil funds to help bolster its currency. Such talk has helped stir a rally in Brazil's equity market. But any such bailout, unfortunately, would not work. If the Brazilian government had the right policies in place, it would not need funds. As things stand, however, multilateral funding would only buy a little time. Why give funds to a country with $45 billion in foreign-exchange reserves (which are rapidly disappearing) when it has failed to control government spending or carry through promised reform? Just as the IMF's last handout to Russia was a waste of money, so would be another to Brazil. If the IMF and the U.S. decide to bail out Brazil, it will be the worst case yet of moral hazard. And it won't stop the real getting rubbished.In the mid-1990s, Russia and Brazil adopted similar exchange-rate regimes to kill hyperinflation. They tied their currencies to the U.S. dollar in a crawling peg so that they depreciated at a slower rate than domestic inflation. The approach helped squeeze inflation out of both economies. Currency pegs can help countries suffering from hyperinflation, because they lend a level of credibility to monetary policy that a country's central bankers and politicians cannot command. But they are no panacea. A peg is only as strong as the policies underpinning it. If governments don't balance their books, if they suffocate the private sector or if they paint the external accounts red, pressures on the peg will grow and public support will wilt. Worse, a peg makes retribution for inconsistent policies swifter and more visible than under a flexible exchange-rate regime. PAGE 1| With shares and currencies gyrating, governments are finding it harder to resist temptation to meddle in the marketsThere's the rub. Both Russia and Brazil have been mismanaging their pegs. Public sector deficits amount to 8% to 10% of GDP in both countries and crowd out the private sectors' productive investment. Bloated public deficits zap savings and provoke flight capital because smart citizens know what they herald: confiscatory and arbitrary taxes and exchange controls. As a result, the external accounts in both countries are in the red.Brazil and Russia are hooked on foreign capital to finance their deficits. Over the next year Brazil needs to borrow from abroad the equivalent of 5% to 6% of GDP to sustain economic activity and maintain the currency's strength. Unfortunately, it simply cannot get that kind of financing in today's world. It's likely to follow Asia's scenario: capital flight and rocketing interest rates will lessen the need for external financing as domestic demand plummets and the economy heads toward recession. Brazil's public-sector domestic debt is 38% of GDP; before its collapse, Russia's was only 14%. Brazil just hiked interest rates to nearly 50%. So, with inflation at less than 4%, real interest rates are now above 45%. The extra monthly cost of servicing that debt is equivalent to nearly 1% of GDP! That will take the budget deficit to more than 10% of GDP for 1998. If those levels were maintained for a year, debt servicing as a share of government expenditure would double, to more than 25%. That's higher than Russia's level (nearly 20%) just prior to its collapse.Brazil's government, meanwhile, is suffering a credibility crisis. It claims it can fix things through its newly created Fiscal Control and Management Committee. The new body plans to announce a three-year reform strategy in mid-November, soon after presidential and congressional elections. But the previous fiscal package, created in 1997 during Brazil's last currency crisis, was quietly dropped when things improved. Even if Fernando Cardoso is re-elected, he may face a Congress with little inclination to implement the reforms necessary to bring the public sector deficit down. And so foreign currency keeps on pouring out. If investors continue to doubt the government's commitment to reform, Brazil's real will simply crash. If the currency goes, don't blame the peg, blame the politicians.|PAGE 2 With shares and currencies gyrating, governments are finding it harder to resist temptation to meddle in the markets