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Brazil Capital Flows and the External Debt

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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