Sunday, March 2, 2014

Cardoso's Plano Real Does The Trick

In an earlier post, I wrote about the beginning of Brazil's hyperinflation. In this post, I turn to the policy reforms that led to its cessation.

Brazil’s hyperinflation was finally defeated in 1994 through the Plano Real (Real Plan), championed by Fernando Henrique Cardoso, who was appointed Finance Minister in 1993. This was a comprehensive agenda aimed at tackling both the underlying causes and symptoms of Brazilian hyperinflation.  The first step was the introduction of a new currency called the real. The central bank would act to maintain the value of real within a range of the dollar, which would constrain its ability to finance the government through base money production.  Exchange rate stabilization was designed to win credibility by setting a visible and easily monitored anchor of stability. (Singh)

Previous hard exchange targets had failed because they were not accompanied by explicit measures to limit fiscal deficits or increase central bank independence.  (Singh) Crucially for the Plano Real, the new currency was to be supplemented with steep budget cuts. The creation of the “Social Emergency Fund” effectively forced Congress to cede control of $15b of government spending to the Finance Ministry, roughly 1/6 of the total budget. Furthermore, to break the public’s inflationary expectations, the government requested shops to listed items with two prices, i.e. in the old currency (cruzeiro real) and in the theoretical value of new currency from March 1994 to July 1994. The stability of this non-monetary reference currency, known as the Unidade Real de Valor (URV, or Real Value Unit), was meant to showcase the stability that the real would bring. Despite the plan being heavily criticized on both right and left, the stability of the currency soon won popularity with ordinary Brazilians (though not before almost being derailed in an amusing episode). “We never expected inflation to fall so far, so fast. Following monthly rates of 45 percent in March and Apr, inflation slowed to only 2 percent in July, the month the real was launched.” (Cardoso) Inflation fell sharply and persistently, from a monthly rate of 47 percent in June 1994 to just over 1 percent eight months later. Equally importantly, private capital flowed into Brazil. Even with the tightening of macroeconomic policy that accompanied the Plano Real, real GDP grew strongly, by 5.7 percent for 1995 as a whole. The rebound in economic activity produced a primary fiscal surplus that exceeded what the government had thought possible. (Boughton)

While I, in my earlier post, criticized the notion of hyperinflation as inevitable, it is undeniable that the success of Plano Real benefited from the fulfilment of several preconditions. First, the time was ripe for broad institutional reform in Brazil.  President Collor was forced out of office in August 1992 after a corruption scandal, leading to political turmoil.  “In a strange way, however, the nation derived a certain amount of confidence out of the incident. Brazil’s institutions had proven to be stronger than any one man. We had handled a severe crisis by the book and without the intervention of the military.” (Cardoso)

A second factor that supported reform was increased urban migration. (Cardoso) A larger urban middle class was able to make its voice heard and express discontent with hyperinflation. Meanwhile, Israel and neighbouring Argentina had solved their hyperinflation problems, leading to belief that Brazil too could solve its problems with the right policies.

Finally, Brazil was able to negotiate a deal with external creditors and regain some of its standing in the international arena, which eventually led to a return of capital when the Plano Real was introduced. Early moves towards these negotiations benefited from the personal credibility of Marcilio Marques Moreira, who was appointed Finance Minister in May 1991. (Boughton) He negotiated with the IMF to secure a stand-by lending arrangement in Jan ’92. The Paris Club of official creditors agreed to reschedule Brazil’s debts in Feb.  In July, Brazil reached an agreement with international bank creditors on a comprehensive reduction in debt and debt service.  Collor’s impeachment and the government’s  failure to formulate a credible fiscal policy led to Brazil falling out of compliance with the IMF programme. Unable to secure a new IMF lending programme, Brazil circumvented the IMF by successfully rescheduling debt owed to international banks and collateralizing new debt with US treasuries bought in the open market with central bank reserves (not subscribing to the Brady programme, which required an IMF-supported programme).

It is worth noting that the end of hyperinflation brought its own problems. Greater macroeconomic stability expanded Brazil’s access to external finance and lowered borrowing costs, especially in foreign currencies, which, in turn, encouraged greater debt issuance along with a shift to riskier short-term external financing. A financial and economic crisis in Brazil in 1999 led to a forced exit from the hard exchange rate targeting regime. However, this did not result in a return to triple-digit inflation.  Despite a depreciation of the real of almost 60 percent in 1999, inflation averaged under 10 percent that year and remained in single digits until late 2002. (Singh et al) This showed that Brazilian monetary policy had won credibility at long last, which eventually allowed it to move to a flexible inflation targeting regime.

Here are some charts from the IMF (report by Anoop Singh et al) showing the Brazilian experience:

P.S. Marcus Nunes has some good posts on Brazil's hyperinflation here.

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