Brazil's baleful bailout: Repetition of past mistakes

George Soros, Chairman, Soros Fund Management., Project Syndicate

The International Monetary Fund (IMF) came through last week with a larger rescue package for Brazil than world financial markets expected. This should have eased fears about Brazils future. So far, it hasn't.

After an initial rally, Brazilian interest rates have settled at levels incompatible with long-term solvency. Its benchmark bonds now yield around 22 percent in dollar terms. Brazil's debt equals 60 percent of GDP, of which 35 percent falls due within a year. The IMF has required that Brazil run a primary surplus (i.e. interest on government debt is excluded in the budget calculations) of 3.75 percent on its budget. But this will clearly not be able to prevent a big further deterioration in the country's debt/Gross Domestic Product (GDP) ratio, especially as high interest rates push Brazil into recession.

The fact that this package failed to bring relief indicates that something is fundamentally wrong with the international financial system. Brazil's problems cannot be blamed on anything Brazil has done wrong; responsibility falls squarely on international financial authorities. Admittedly, Brazil may soon elect a president that global financial markets do not like; but if international financial markets take precedence over democratic choice, the system is undoubtedly flawed.

Under the influence of market fundamentalism, the IMF does not benefit all of its members sufficiently. In recent years, the so-called Washington consensus as espoused by the IMF and World Bank has put its faith in the self-correcting nature of financial markets. That faith was and is misplaced.

Ever since financial capital began moving freely around the globe, crisis has followed crisis, with the IMF called upon to put together rescue packages of ever larger size. Market fundamentalists blame this state of affairs on the moral hazard created by IMF bailouts.

In the aftermath of Asia's crisis of 1997, the IMF switched from bailouts to bail-ins that shifted more of the risk back to international lenders. By doing so, the true risks of investing in emerging markets were revealed. What is the result? Capital flows have reversed. Instead of capital flowing to economies on the world's periphery, it is leaving them and flowing to economies at the center.

If stability is to be preserved, financial markets need regulators and a lender of last resort. But there can be no lender of last resort without a modicum of moral hazard. Every developed country learned this lesson domestically decades ago, but the world has yet to learn it internationally. The system we have in place is lopsided. It is designed to preserve international financial markets, not the stability of emerging economies on the periphery. That is what rendered the risk/reward ratio of investing in emerging markets so unfavorable.

Once we recognize the problem, solutions can be found. The Washington Consensus starts by asking how big a budget surplus is needed in order to keep indebtedness within bounds; the higher the interest rates, the bigger the required surplus. In the case of Brazil, with 22 percent interest and 4 percent growth, the primary surplus would have to be 4.8 percent to keep the debt/GDP ratio from rising an obvious impossibility.

The right question to ask is this: what level of interest rates can be reconciled with reasonable growth? A primary surplus of 3.75 percent then becomes the maximum, not the minimum, that can be exacted, and it can support real interest rates of not more than 10 percent.

So the question then becomes: How do you bring interest rates down to that level? This may require some international credit enhancements or guarantees. The world's task is to find instruments that can minimize the possibility of moral hazard and yet keep the level of real risk within tolerable bounds.

I suggest that Instead of a traditional IMF package, the central banks of the developed countries should open their discount windows for Brazilian government debt. Brazilian bonds would rally and confidence would return at the sight of a lender of last resort. The risk would be minimized by not raising the amount the central banks are willing to lend in line with the rise in market prices.

Commercial banks would soon reinstate their lines of credit for Brazil, which would help ensure a recovery of exports. (Lifting of the bulk of US tariffs on Brazilian steel would also help here.) The crisis would then dissolve into thin air.

My proposal would achieve what the recently announced package failed to achieve, and at no higher a price. It is not too late to adopt it. Once it is in place, Brazil's incoming president (no matter who he is) would have no reason to contemplate interfering with Brazil's normal debt servicing commitments. As things now stand, he would be justified in demanding greater international support rather than allow his country to bleed to death as Argentina is now doing.

In political conditions such as those that now prevail in Brazil, markets are right to take into account the possibility of a debt reorganization or even of a default. But once they do, their actions soon become a self-fulfilling prophecy. This is why financial markets cannot be left to their own devices.