Like soldiers emerging from foxholes after artillery shells have stopped pounding their positions, analysts began to venture predictions in late October that the worst of the crisis appeared to be over. “We are potentially turning the corner,” declared David Hale, global chief economist at the Zurich Group in Chicago.
The Fed’s intermeeting rate cut, which was followed by another quarter-point reduction in the federal funds rate at the FOMC meeting on November 17, Justifiably added to Greenspan’s aura as an economic virtuoso. It surely helped that U.S. inflation was quiescent; had the crisis come at a time when markets were hypersensitive to worries about a wage-price surge, perhaps the Fed would have been more reluctant to issue such a potent signal of monetary ease, and perhaps the outcome would have been less favorable. But in any event, the rate cut did the trick, and though it was the most important factor changing the market’s mood for the better, it was by no means the only one.
Japan’s ruling and opposition parties reached an agreement on October 12 that would provide several hundred billion dollars in government funds to shore up the financial condition of solvent but shaky banks. At the same time, the nation’s parliament approved landmark banking legislation that would allow the government to nationalize banks that were failing.
The moves came three days after the Nikkei index plummeted to 12,879, the lowest level since December 1985, and they appeared to mark a significant change in Tokyo’s attitude about the need to confront its banking problems. Japanese banks clearly required vast sums of money to boost their capital before they could resume lending, so the promise of a large amount of government funds (for which the government would receive shares of the banks’ stock) came as a welcome relief to the markets. So too did word that Japan appeared ready to deal with insolvent banks more aggressively. Under the legislation passed by the parliament, the government would nationalize such banks or liquidate them, and establish a public institution to resell the good assets and deal with the bad ones, a process similar (on the surface, at least) to the U.S. strategy during the savings and loan crisis.
The Nikkei responded with a rally that lifted it more than 10 percent in two weeks, and other Asian markets also roared back to life, as Hong Kong’s Hang Seng Index gained 24 percent from October 8 to 23 in tandem with similar upward moves in Thai and Korean stocks. Helping to improve sentiment in Asia was a sharp rise in the yen, which appreciated 17 percent against the dollar from October 5 to October 19, easing competitive pressure on the currencies of Japan’s neighbors.
Meanwhile, on October 15—the same day as the Fed’s rate cut—the Clinton administration reached agreement with Congress on a compromise IMF funding bill, adding to the general sense of relief in the markets. The deal cleared the way for Washington to make its contribution toward a $90 billion increase in Fund quotas, as well as its contribution toward an expanded credit line for the Fund. To obtain majority support in the House, the Treasury agreed to secure a number of reforms at the IMF, including a rise in the Fund’s lending rates to make it less attractive for governments to seek its aid.
Market-buoying news came from Europe as well, where policymakers who had once assumed their region was insulated from the crisis began waking up to the need for stimulative action. Central banks in five European capitals cut interest rates in early November, followed by an eleven-nation coordinated rate cut on December 3, with even Tietmeyer acknowledging that developments overseas posed a greater danger to the continent’s economy than he had expected.
Finally, on November 13, the IMF and the world’s major industrial countries unveiled a $41.5 billion package of loans for Brazil. Unlike the emergency rescues provided to Thailand, Korea, Indonesia, and Russia, this program came at a time of relative calm for the country and was billed as a prophylactic against any further outbreaks of turbulence.
The program contained several features hailed by the High Command as innovative responses to the dangers of contagion. The main idea was that if Brazil came under speculative attack, the government wouldn’t have to wait to have the bailout money doled out in dribs and drabs as is customary in IMF programs. The Brazilians could draw the first tranche of about $9 billion immediately if they wanted, and if it became necessary, they could draw a second $9 billion too—dubbed a “floating tranche”—without waiting for an arbitrary deadline. Within twelve months, they could have up to $37 billion, provided they abided by the conditions of the program. Moreover, the “headline” figure of $41.5 billion was much less questionable than in other packages, such as Korea’s and Indonesia’s, in which the contribution by the United States and other industrial countries came in the form of second lines of defense. In Brazil’s case, the $14 billion bilateral portion of the package was provided up-front, alongside IMF money, through loans granted by the Bank for International Settlements and guaranteed by individual governments. The Europeans, despite feeling buffaloed into backing a bailout they didn’t like, kicked in their share and declared their support.
Fischer struck a confident air at a press conference when he and Camdessus unveiled the program. He emphasized that “the most important element in making a financing package succeed is the actions that the Brazilian government is taking,” which included ambitious commitments by the Cardoso administration to cut spending and raise taxes by about 3 percent of GDP. In describing the package, Fischer presented the $41.5 billion in loans as a formidable manifestation of overwhelming force: “The international community is providing a very large, sufficiently front-loaded package to give confidence that Brazil has the resources to deal with any possible drawings on reserves that might become necessary in the next few months or during the course of the program.... You want to provide assurance to the markets that you’re not sort of slicing it very, very thin. You want the markets to know there’s a sufficient amount available comfortably.”
The global financial system gained a much healthier pallor in the final two months of 1998, thanks to the rate cuts in the United States and Europe, the Japanese bank reforms, the passage of the IMF bill, and the Fund’s package of loans for Brazil. But the crisis was not over. European skepticism about the IMF’s Brazil program would soon be vindicated.
The Brazilian economy initially emitted positive signals following the announcement of the country’s IMF program. The amount of money leaving the country dropped to $1.9 billion in November 1998, about one-tenth the rate it had been two months earlier. The government made steady progress, albeit with occasional setbacks, toward winning congressional approval of the Cardoso administration’s deficit-cutting program.
But even within the IMF, there were worries that maintaining Brazil’s fixed exchange rate was akin to an act of levitation. At a meeting with still-dubious European officials in Paris in early December, Mussa privately put the chances of the program’s success at fifty-fifty. That month, the capital outflow began to pick up again, totaling $5.2 billion. Fund staffers blamed interest rate cuts by the central bank, which trimmed the benchmark overnight lending rate from 42 percent on November 10 to 29 percent in late December. In phone calls, Fischer protested to central bank officials that their policy was undermining the program and reducing the incentive for people to keep their money invested in reais. But he was told that rates were still plenty high and inflicting much more damage on the economy than he seemed to understand. A recession appeared almost certain, with most indicators of production having fallen, and unemployment having risen by two percentage points, to 8 percent, since the beginning of the year.
Whatever the underlying reason Brazil’s rescue plan went up in flames, there is no dispute about the proximate cause—the moment at which, figuratively speaking, the cow kicked over the lantern in Mrs. O’Leary’s barn. The cow was Itamar Franco, the newly elected governor of Brazil’s second-largest state, Minas Gerais, and a bitter rival of Cardoso’s. He kicked over the lantern on January 6, 1999, with the announcement that his state would suspend payments on its $15.4 billion debt owed to the federal
government. A few other governors followed Franco’s lead in demanding relief on the debts they owed the federal government, and although the Cardoso administration vowed to beat Franco in court, the specter of debt moratoriums was enough to send investors bolting.
From January 6 to 12, the country lost another $2 billion in reserves. This meant that most of the $9 billion that Brazil had drawn from the first tranche of its international loan package was gone—into the pockets of banks, investors, and speculators who had changed reais into dollars at the high exchange rate, Just as the Europeans had predicted.
Ter-Minassian knew something nasty was brewing on Tuesday, January 12, a particularly tumultuous day in Brazilian markets, because she couldn’t reach any of the country’s economic policymakers on the phone. Figuring that Fischer could get his calls returned, she asked him to try—but before he could get around to it, a call came for him around 6 P.M. from Pedro Malan.
President Cardoso had appointed a new governor of the central bank, Malan informed Fischer. The new governor, whose nomination would be submitted to the Brazilian Senate for confirmation, was Francisco Lopes, the central bank’s director of monetary policy and son of a former finance minister, who went by the nickname “Chico.” In his first major move as acting governor, Lopes was changing the country’s exchange-rate policy, and he would call shortly to explain the new approach, Malan said.
On a speakerphone in his office, together with Ter-Minassian, Fischer listened with dismay as Lopes told him that the next morning, Brazil would drop the ironclad defense of its currency, in the hopes that a less-overvalued exchange rate would make it possible for Brazil to move quickly toward lower interest rates. The move, though, would not be a clean break from the Plano Real; the currency would be devalued by about 8 percent, and new, modestly lower target ranges would be set for it. Specifically, the central bank would change the trading range for the real, from a band that was adjusted slightly every few days—it stood at 1.12 to 1.21 reais per dollar on January 12—to a broader range of 1.20 to 1.32 reais per dollar.
Fischer and his colleagues were concerned about the devaluation, even though it had been anticipated for some time. But they were at least as worried about the way the new exchange-rate arrangement would work. They were certain that the markets would blast the new currency system to smithereens; the Brazilian stance resembled that of a boy with a bloody nose who, having been shoved backward a few steps, draws a line in the sand and dares his tormentors to step across it. The IMF deputy managing director, who recalled this moment as one of the most frightening of the entire crisis, could not imagine what would come next. “I thought, this is it,” he said. “We’re going to lose Latin America, and then it will go back to Asia.”
The “last line of defense” had been breached. The military metaphors invoked by the High Command about halting the crisis at Brazil now sounded like so much bravado. This was a mortifying setback for the IMF, especially after all the fanfare surrounding the announcement of its Brazil program on November 13.
What you’re proposing won’t work, Fischer told Lopes. “Controlled” devaluations like these had been tried amid crises in countries as diverse as Mexico and Russia, and the markets had quickly concluded—correctly—that the authorities wouldn’t be able to hold the line at Just one devaluation. The real will be blown through its bands, Fischer argued.
Lopes replied that he was aware the new policy might prove unsustainable, but its chances of success would be greater if the IMF endorsed it. If it didn’t work, Brazil could always abandon its defense of the real altogether and let the currency float. But the IMF thought Lopes’s approach risked causing the markets to lose so much faith in the real that the currency would go into free fall.
IMF officials weren’t sure what was going on. They found it inconceivable that Malan, the upholder of the Plano Real, was in accord with this move. It was well known that the finance minister’s rivals had been trying to persuade President Cardoso to take a step like this with the aim of Jump-starting the economy by depreciating the currency and lowering interest rates quickly. Fischer called Malan and implored him to persuade the president to change his mind. But Malan was playing the role of the loyal minister and wouldn’t reveal his reservations about the policy change.
This much the IMF hierarchy knew: Lopes, a fifty-three-year-old former economics professor, did not hold the Fund in high esteem. He had spoken disparagingly about the IMF in autumn 1998 when Malan was in Washington negotiating Brazil’s program. “The bureaucrats in Washington are all excited by the idea of creating a rescue package for Brazil so they can cover the tracks of their recent mistakes in Asia and Russia,” Lopes told O Estado de São Paulo, a leading Brazilian daily.
Fischer spent much of the night of January 12 on the phone, first at his office, and later at his home, with both Malan and Lopes. The next morning, at seven o’clock, the phone rang at Ter-Minassian’s home.
“Teresa, I failed,” Fischer said. “I wasn’t able to convince them.”
“What do we do now?” Ter-Minassian asked.
“Well, they’ll have to bear the consequences,” Fischer replied.
That day, as Fischer and his colleagues had feared, the new currency regime fared abysmally in its debut, despite Lopes’s assurances that it represented “an improvement in policy” rather than a departure from the past. Brazilian stocks fell more than 10 percent in the first few minutes of trading before recovering somewhat to end the day down 5 percent. The real popped through the bottom part of the new range, prompting the central bank to sell a significant amount of dollars to brake the currency’s descent. Markets went into paroxysms the world over, with the Dow plummeting as much as 261 points, Germany’s main stock index down 4 percent, and Argentina’s down 10 percent.
The markets showed every sign of bleeding the central bank’s reserves dry—the obvious assumption being that there might never be a better time to obtain dollars for reais. During January 13 and 14, the central bank’s reserves fell by another $4.8 billion.
A deluge of phone calls from top officials in Washington conveyed the message to Brasília: Stop this policy now, or you’re cut off from international support. Fischer told Malan that the international community would never countenance providing additional IMF loans to Brazil if the country’s reserves were going to be frittered away on an indefensible exchange-rate policy. The Brazilians agreed that on Friday, January 15, they would stop using reserves to defend the new band—allowing the real to float, at least for the day—and Malan and Lopes flew to Washington for a weekend of talks, with the stated intention of announcing a new currency plan on Monday. “When they came here, they had no clue what to do,” a senior IMF economist recalled. “We ourselves were somewhat, shall we say, unclear.”
Sandwiches, fruit, and soft drinks were provided for the top Brazilian officials and IMF staffers who gathered in Camdessus’s office on the twelfth floor of the IMF building on Saturday, January 16. But the atmosphere in the talks was often as frigid as the blustery weather outside. Fischer, who had gone far out on a limb for the Brazilian program, made it clear he was furious with the short notice the Fund had received of the change in exchange-rate policy. Malan, a friend of Fischer’s from his days on the World Bank board, was apologetic; Lopes, though civil, made little effort to disguise his disdain for Fund staffers whose grasp of economics he considered inferior to his own. He agreed to speak by phone with Fischer, whom he respected, on a daily basis—but decreed that other IMF personnel, including Ter-Minassian, would have to deal with his subordinates at the central bank.
The substantive discussions started off with an aggressive proposal by Camdessus: Brazil, he said, ought to adopt a currency board, with the real rigidly linked to the dollar at a somewhat lower level than the then-current 1.47 reais per dollar. “Why not?” the managing director demanded. A currency board, after all, would be even stronger anti-inflation medicine than the Plano Real had been, since the central bank would have no disc
retionary power whatsoever to increase the supply of reais. Moreover, Brazil was better equipped than Indonesia to establish a currency board, because it had a well-functioning banking system.
Malan, Lopes, and their aides wouldn’t hear of it. A currency board, they felt, might ideally suit the IMF’s purposes—namely, preventing a round of devaluations in Latin America. But they didn’t think it suited Brazil’s self-interest to handcuff the central bank so completely and irrevocably, and they offered compelling technical objections as well. (Brazil’s short-term government bonds were so liquid—so much like ordinary money—that establishing a credible currency board was impossible, they contended.)
Once convinced that a currency board wouldn’t fly, Camdessus said that Brazil would have to go to the opposite extreme—a free float of the real, with no bands or targets to defend. The Brazilians agreed; the markets had reacted enthusiastically on Friday when the real was floated for a day, since the danger had receded that the central bank would squander all its reserves propping up the currency’s value.
But the discussion turned fractious when the two sides got down to particulars. Camdessus argued that under a free float, Brazil would have to boost interest rates sharply—he mentioned levels of 60 percent and 70 percent—because with the death of the Plano Real, inflation fears would be rampant and investors would be leaving the country in droves unless given sufficient incentives to keep their money there. Once confidence was restored, rates could come down, Camdessus said, but the first thing the central bank should do is show its resolve on Monday morning by raising the overnight rate from 30 percent to 34 percent.
The Chastening Page 39