Brazil continues to fly under the radar among troubled economies

Anyone who thinks that the world’s emerging market woes will be confined to the likes of Argentina, Turkey and Venezuela has not being paying attention to the brewing Brazilian economic and political crisis. 

In particular, they have not noticed the dramatic swoon in the Brazilian currency. Since the start of this year, the Brazilian real has plunged by around 25 percent. That has taken it to levels last seen in 2016 in the depth of its worst economic recession in the last 70 years.

{mosads}Sadly, especially at a time that the Federal Reserve is engaged in taking away the punch bowl that fueled the last emerging market economic boom by raising U.S. interest rates, there are three reasons to believe that Brazil could very well be on the road to a full-blown exchange rate crisis.

The first is that Brazil’s public finances are on the most unsustainable of paths. Not only is the country presently running a budget deficit of over 8 percent of GDP, it also has a public debt-to-GDP ratio that has already reached a dangerous level of around 85 percent.

With no economic policies on the horizon to halt Brazil’s rapid public debt build-up, it is far from clear that in a more challenging global liquidity environment, both domestic and foreign investors will be willing to meet the government’s large financing needs next year. Those needs are estimated to amount to a staggering $300 billion, or 15 percent of the country’s GDP.

While markets might not be as focused as they should be on Brazil’s shaky public finances, Brazil’s public debt vulnerability has not escaped the International Monetary Fund’s (IMF’s) notice.

In its most recent staff report, the IMF warned that a delay in implementing much-needed fiscal reforms, especially in the area of pension reform, would jeopardize the country’s debt sustainability.

The IMF also noted that, even under benign circumstances, within three years the country’s public debt-to-GDP ratio would approach 100 percent, and it could rise even higher should Brazil’s borrowing costs rise or its economy falter.

The second reason to expect that Brazil’s currency could slump even further in the months ahead is the country’s very unstable politics. This political instability has to raise serious questions about the country’s political willingness to restore order to its public finances and to get its moribund economy moving again.  

With a corruption scandal at Petrobras, the state oil company, which has tainted much of Brazil’s political elite, support for centrist political parties has collapsed.

This raises the very real possibility that following Brazil’s October 6 presidential election, the country will be led either by a right-wing populist president, who will not enjoy congressional support, or by a far-left government that will take the country in the direction of fiscal recklessness. 

A third reason to expect mounting pressure on the Brazilian currency in the months immediately ahead is the likely contagion from the worsening Argentine and Turkish exchange rate crises.

If those crises were indeed to deepen, they must be expected to accelerate the capital flow reversal out of the emerging market economies, which has already been evidenced since the Federal Reserve signaled a more aggressive path for its monetary policy normalization earlier this year. 

Given the depth and liquidity of its asset markets, Brazil must be expected to be the first in line for any further reduction in investor exposure to the emerging markets. 

A currency crisis in Brazil could be very much more damaging to the global economic outlook than a similar crisis in Turkey. After all, the Brazilian economy is around 2.5 times the size of Turkey’s, and it has a public debt level of around $ 1.75 billion.

Coming on top of the economic meltdowns in Argentina and Turkey, a full-blown Brazilian currency crisis could pose a real challenge to the global economic outlook.

Earlier this year, Fed Chairman Jerome Powell reassured us that somehow this time was different and that the emerging market economies would easily manage the Fed’s planned increase in U.S. interest rates.

Hopefully, he is closely monitoring the most recent emerging market currency slump and by now is less complacent about the fallout of Fed tightening on those economies. If not, the global economy should brace itself for yet another emerging market economic meltdown similar to of the 1998 Asian economic crisis.  

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.