There is no magic point where an overvalued currency crashes back to earth. Sometimes traders will persist in driving it upward long after the overvaluation has become apparent. If the markets had held enough faith in Brazil to let it keep charging imports on its national credit card (that is, run up its current account deficit), the country might have continued on its merry way for quite some time. But in autumn 1998, investors in their infinite wisdom had suddenly concluded that the credit cards of all the world’s emerging markets were maxed out.
The upshot was that Brazil was being sucked into one of those vicious cycles similar to those that swallowed Thailand, Indonesia, South Korea, and Russia. To induce the Herd to keep money in reais, Brazil’s central bank had to raise interest rates to around 40 percent—an excruciatingly high level in a country with low single-digit inflation. Painful as this was for Brazilian companies, the even more urgent problem it posed was the impact on the government’s ability to meet its obligations on its $265 billion in debt. The government’s deficit of 8 percent of GDP went almost entirely to pay interest on borrowings, and when interest rates were high, the deficit rose in tandem, adding to the debt. The arithmetic was depressingly familiar to people who had observed Russia’s struggles with exploding debt dynamics. The bonds issued by the government to cover the deficit had an average maturity of less than seven months, and more than half of them paid interest that was indexed to the overnight lending rate. So high interest rates translated into a larger interest bill for the government, which translated into a wider deficit, which translated into more borrowing. Analysts who crunched the numbers in autumn 1998 estimated that on its current trajectory, Brazil’s deficit would nearly double in a year Just because of the higher interest costs. As market participants grew increasingly convinced that Brazil couldn’t afford to keep interest rates so ruinously high, the greater their inclination to dump reais, and the further rates had to rise—and so on, and so on, and so on.
Malan girded for battle like a Stonewall Jackson of the currency markets when the real came under renewed pressure following the Russian default. Brazil was no Thailand, he told IMF officials; nor was it Russia, nor was it Mexico, whose policymakers had lost a test of wills over the peso by letting slip that they might bend their fixed-rate system a bit. He shunned even the slightest hint of willingness to consider devaluing for fear it would become a self-fulfilling prophecy. Surrendering to the Herd’s hysteria and giving up on the Plano Real, in Malan’s view, would be a tragic mistake. Without the real as an anchor, he warned, Brazil would soon revert to its hyperinflationary ways.
At an emergency meeting of Latin American finance ministers in Washington in early September 1998, Malan Joked darkly to his colleagues that the opening line of Tolstoy’s Anna Karenina—“Happy families are all alike; every unhappy family is unhappy in its own way”—had been turned on its head by recent events. His point was that the Herd was acting as if all emerging markets were like Russia, instead of drawing distinctions among them. Once investors recognized Brazil’s fundamental strengths and the government’s willingness to tackle its fiscal imbalance, he believed, the country could put itself on a virtuous cycle in which interest rates and the deficit would fall instead of rising; in the meantime, Brazil had to stand firm to preserve its hard-won stability. He was interested in support from the IMF, provided it came in such a way as to reflect the differences between Brazil and the other more desperate countries that had turned to the Fund for help.
Malan’s argument found a sympathetic audience at the IMF, whose top officials issued numerous statements during September and October pledging their readiness to marshal a package of loans for Brazil and endorsing the government’s exchange-rate policy. To some degree, the Fund’s position stemmed from the fact that “we felt guilty” about having earlier scorned the Plano Real, according to one senior Fund official, who added ruefully: “I would have to say that because we had not given them the benefit of the doubt a few years earlier, we gave them much more, and maybe too much benefit of the doubt this time.”
The IMF, with Fischer in the lead, Joined with the top ranks of the U.S. Treasury in coalescing around a guiding principle: Since the Brazilian government was refusing to consider a devaluation of the real, the international community could not insist on one as the price of a loan package. Malan and his handpicked team of technocrats at the Finance Ministry were the most competent economic policymakers Brazil had had in recent memory, and if they feared a devaluation would destroy the country’s victory over inflation, then how could outsiders overrule them? “The Brazilians were absolutely committed to maintaining the exchange rate,” said the Treasury’s Tim Geithner. “And the question we faced was whether we could have sufficient confidence in our Judgment to force them to renounce that commitment as a condition for getting the money, particularly given how vulnerable the world seemed at that time. I argued that we should be hesitant to force them to blink.”
Still, senior policymakers in Washington did not lack misgivings over the Brazilian strategy. They could not overlook the cruel arithmetic that made it so daunting for Brazil to win market confidence. Fischer, among others, believed the real was sufficiently overvalued to Justify accelerating the 7.5 percent “rate of crawl” at which the Brazilian currency was allowed to decline against the dollar each year, and he and Ter-Minassian privately exhorted the Brazilians to speed up the crawl rate to around 12 to 15 percent.
The Brazilians adamantly refused. Malan and his aides feared such a move would only convey weakness that would lead to an uncontrollable run on the real, and they wondered whether the IMF genuinely understood the psychology of currency traders. Amaury Bier, the secretary for economic policy at the Finance Ministry, who was the former chief economist for Citibank in São Paulo, told IMF officials: “You never worked in the trading room of a bank. I have. If they see you even breathe a little stronger, you will transmit anxiety and doubts.”
Likewise, Larry Summers got a polite but firm brush-off when he pressed the Brazilians to devise a fallback position should it become impossible to sustain the value of the real. In meetings at his Bethesda home during autumn 1998, Summers urged Bier and other Brazilian officials to “hope for the best and plan for the worst,” and he repeatedly asked, “What’s your Plan B?” The Brazilians, who feared that discussing such matters would risk leaks, retorted: There is no Plan B.
Once again, the IMF was going to lay its tattered credibility on the line. Four times, Fund-led rescues had been followed by collapsing currencies. Yet now, despite their qualms, Fund officials, together with their main backers at the Treasury, pressed ahead with plans to provide a megabailout for Brazil shortly after the country held state runoff elections in late October. To the Europeans, it looked as if the IMF was being set up for another fall—and a ripoff by the Herd to boot.
The only way international support for Brazil made sense, the Europeans insisted, was if it were accompanied by a concerted effort to “involve the private sector,” as the international community had done in the Korean case by pressuring Seoul’s bank creditors to stop pulling their money out of the country. Without a similar arrangement in Brazil, a rescue would turn into another “foreign investor exit facility,” because it would prop up an overvalued real and thus encourage people to unload the Brazilian currency—or so Tietmeyer and others argued at the IMF-World Bank meeting in early October 1998 and in meetings and conference calls over the following weeks.
The Bank of England’s Mervyn King, and top officials of the U.K. Treasury, were particularly militant. Some sort of coercion was probably necessary to keep short-term money from fleeing Brazil, they argued, and they even raised the shocking suggestion that perhaps exchange controls were warranted. They demanded to know—and felt they weren’t getting useful answers—about the assumptions the IMF was making regarding how much money was likely to leave the country after the Brazilians received an international loan. Would the foreign banks stay in? Would domestic Brazilian r
esidents ship their capital abroad? If the chief problem was locals engaging in capital flight, then controls might be in order, the Brits said.
But the Brazilians rejected proposals to “bail in” the banks, Just as they did with proposals for devaluing the real. Their reaction may seem odd: What country, after all, wouldn’t like its creditors to be obliged to keep extending loans? But Malan and his technocrats were convinced that if the banks felt coerced, Brazil would suffer a blow to its long-term creditworthiness. The country had declared a moratorium on its debts in the 1980s, and banks were still demanding slightly higher interest rates on their loans as a result. Furthermore, the markets were still in an uproar over the way Russia had ended up forcing its GKO creditors to take losses, and the Brazilians wanted to distance themselves as much as possible from the appearance of bullying their bankers, for fear of reducing their access to foreign credit.
Malan agreed to go on a “road show” to financial capitals in the United States, Europe, and Asia, asking banks to maintain their credit lines on a voluntary basis. But he wouldn’t go further, taking the stance that he wanted to avoid any precipitous action that might have adverse consequences for the next ten or fifteen years on Brazil’s relations with the financial community.
The U.S. Treasury supported the Brazilian position on this issue as well. In arguments with their European counterparts, Summers, Geithner, and Truman questioned whether Brazil’s bank creditors would agree to a bail-in, and they raised concerns that such a move would backfire by sparking a panic—a reprise of the Korean debate. Brazil’s case did not lend itself nearly so easily to a bail-in as Korea’s did, Treasury officials contended. In the first place, much of its foreign debt was owed to bondholders who couldn’t be organized into collective action. Furthermore, Brazil wasn’t on the brink of default as Korea was, so scaring the banks into a bail-in with dire admonitions about a global cataclysm wouldn’t work. Even talking about a Korean-style standstill was counterproductive, the Treasury team added, because it was prompting some banks to pull their money out of Brazil in advance of one.
So the Brazilians got their way, and the Europeans weren’t the only ones rankled. “This is a double standard!” Japan’s Sakakibara complained to his fellow G-7 deputies. The IMF and the Clinton administration had crammed reforms down the throats of Asian governments seeking international assistance. So why, Sakakibara asked, should Brazil be given so much discretion over important aspects of its IMF program, such as maintaining the value of the real? It was desirable, to be sure, for countries to “own” their programs; countries that are force-fed IMF remedies often go off track for lack of proper implementation. “Ownership” was a buzzword, much mouthed by both IMF and World Bank officials, to emphasize their belief that the most successful loans they make go to nations that cook up their own reform agendas. But having shown little concern about ownership in Asia, Sakakibara griped, the Fund and the Treasury were suddenly acting as if it were crucial in Brazil’s case. European policymakers sympathized; some of them fumed that Brazil was getting special treatment because of its proximity to the United States.
Still, the Europeans and Japanese found themselves hog-tied. They couldn’t be sure that a loan package for Brazil would fail. And they feared that if they blocked one, they would be blamed for the resulting chaos in global markets.
Within the G-7, the American position “was a pretty lone voice but a pretty determined one,” recalled one G-7 deputy. “At the end of the day, it was made quite clear to everybody that we were not going to supplant our political Judgment in the place of the Judgment the Brazilians had brought to the table, even though it was a Judgment one could easily disagree with. Nobody was willing to tell Pedro Malan, ‘Tough luck. You’re not getting the money.’”
Giving speeches off-the-cuff was not Alan Greenspan’s style, especially when he knew that TV cameras would be rolling and markets could be hanging on his every word. The Federal Reserve chairman preferred to draft his public remarks carefully, and he usually stuck religiously to his prepared text. But on Wednesday, October 7, 1998, the next-to-last day of the IMF-World Bank meetings, Greenspan had no time to write the speech he was scheduled to deliver that morning to the National Association for Business Economics. He had spent long hours the previous few days going to one appointment, meeting, and social function after another, and that had deprived him of the opportunity to prepare anything more than a sketchy outline. He had originally planned to speak to the economists about statistical issues, but he knew he couldn’t get away with droning on about such an irrelevant subject at a time when market confidence was disintegrating. So he winged it, and in one of the most important speeches of his chairmanship, he laid the foundations for more interest rate cuts. “I have been looking at the American economy on a day-by-day basis for almost a half century, but I have never seen anything like this,” Greenspan said, using some of the same language that had impressed European officials during the G-7 meeting. “The Russian experience has created a major shift toward risk aversion pretty much throughout the world.”
It wasn’t only the flight from risky securities that disturbed him, he continued; it was also the mad scramble among investors to protect themselves by holding only the most liquid, easily salable assets. The market participants who were unloading off-the-run Treasuries to buy the more liquid on-the-run issues, according to Greenspan, “are basically saying, ‘I want out. I don’t want to know anything about whether a particular investment is risky or not. I Just want to disengage.’” Financial markets “cannot effectively function in an efficient manner in that environment,” the Fed chairman said, and he concluded: “To date, the economy has remained in reasonable shape, with good growth and low if not declining inflation.... But we are clearly facing a set of forces that should be dampening demand going forward to an unknown extent.... We do not know how far it will go or how much it will affect consumer and business spending here at home. This is a time for monetary policy to be especially alert.”
Recession forecasts for the U.S. economy were beginning to surface; on the same day as Greenspan’s speech, economists at J. P. Morgan Securities Inc. predicted a downturn in 1999, citing the strains in financial markets. Much of what Greenspan and his Fed colleagues were hearing privately pointed to a similar conclusion. Shortly after Greenspan’s speech, for example, the seven-member Fed board met with a group of academic and private-sector consultants. Among the attendees was Jeffrey Shafer, a former Treasury undersecretary and Fed economist, now an executive at Salomon Smith Barney—where he had been told by the firm’s traders that no new corporate bond issues were likely for the remainder of the year. In corporate boardrooms across America, Shafer said, business executives were undoubtedly looking at the prospect of the bond market being closed for some time, and adjusting their capital spending plans accordingly—the likely upshot, in the absence of preventive measures, being a recession.
At the Fed, few disagreed with the need for another rate cut. The question was when. Within the FOMC, two of the most influential members, McDonough and Rivlin, were quietly lobbying for a dramatic step—an “intermeeting” cut, in which Greenspan would use the authority he had to ease rates downward before the committee’s next scheduled meeting on November 17. During a visit to Washington on October 12, McDonough Joined Rivlin in the chairman’s office, where they suggested that an intermeeting move would be Just the right sort of signal to send the markets, because it would convey the Fed’s willingness to do whatever it took to restore confidence. In fact, Greenspan changed rates often between meetings during the late 1980s and early 1990s; the FOMC frequently approved directives that gave the chairman the right to ease or tighten as he saw fit. But the practice had not been employed since 1994, in part because it delegated so much power to the chairman, so taking the step now would make a big splash. Although Greenspan had the right, under the directive of September 29, to order a rate cut, he was noncommittal about the idea when he met with McDonough and Rivlin.
Very shortly thereafter, however, Greenspan passed the word that he would convene a conference call of the FOMC, as was the custom before taking intermeeting moves, and in the early afternoon of October 15, the board members gathered in the boardroom with the reserve bank presidents piped in on speaker phones.
Greenspan let it be known that he was considering another 25-basis-point reduction in the federal funds rate, but before doing so he wanted to know the committee members’ sentiments. Some members fretted that taking action so soon after the late September rate cut would unsettle the markets, but the general reaction was positive. Even Laurence Meyer, one of the most resolute anti-inflation hawks, supported the cut. Meyer disliked intermeeting rate changes; like a number of other FOMC members, he generally saw no advantage, given the long lagged effect of monetary policy, in moving a few weeks earlier or later than a scheduled committee meeting. But when the rate cut was primarily for psychological purposes, that was another matter—and Meyer, the former head of a St. Louis-based economic forecasting firm, could easily see the need to change market psychology. “I had gotten a call from a former client of mine [in the bond markets],” he recalled, “who said, ‘I’ve never called you before, and I wouldn’t do it, but I owe it to you to let you know, it’s never been like this before out here.’”
Greenspan didn’t take a vote in the FOMC—he wasn’t required to—but immediately after the conference call, the board voted unanimously to cut the benchmark discount rate as well by 25 basis points. A few minutes after 3 P.M., the wires transmitted the Fed’s announcement of a reduction in both the federal funds rate and the discount rate.
This time, the markets got the right message. The Dow staged a 330-point rally, its third-largest point gain in history. Within three weeks, the index was up another 8 percent, to nearly 9,000. The bond market gradually began to return to normal, in part because the lower federal funds rate made it cheaper for portfolio managers to borrow the money they needed to buy bonds. Yields on the riskiest issues moved back toward their historical relationships with Treasuries.
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