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Braudel
Papers - Nº 15, 1996
As
Brazil’s latest surge of inflation was peaking in
early 1994, on the eve of the launching of the Real Plan,
street urchins were playing in gusts of paper money
floating in the air at a traffic light along the Avenida
Marquês de São Vicente, threading its way in the windy,
reddish São Paulo twilight past decaying factories and warehouses, beside the river that is now the great
city’s main sewage channel. At intersections
throughout São Paulo, droves of children beg for money
from motorists, converging on cars waiting for traffic
lights to change. One driver, in a cynical joke, got out
of his car to toss into the air a bagful of bills that
the boys chased, briefly examined and then tossed into
the air again as if to join in the game. One boy, an 11
year-old with a plastic pacifier in his mouth, was
leaping to grab at the bank notes, each with a face value
of 1,000 cruzeiros, equal to roughly US$15 when issued in
1990 but by now rendered worthless by the relentless
pressures of chronic inflation. A few years ago this bag
of cruzeiros would have fed their families for several weeks.
With the Real Plan, Brazil’s government changed
the name of its money on July 1, 1994 for the fifth time
in eight years. By the magic of decree, in previous
plans, it had erased three zeros from all monetary and
accounting denominations. Since 1985, 13 Finance
Ministers succeeded each other as the money changed
names: the cruzeiro novo became the cruzado, the cruzado
became the cruzado novo, the cruzado novo became the
cruzeiro and the cruzeiro became the cruzeiro real. The
cruzeiro real, which preceded the real, lasted only 11
months. Gustavo Franco, a Central Bank director with a
Harvard doctorate in economics, explained that the
succession of currencies has become routine:
“It’s like changing a baby’s
diapers.” For two years now, the change of diapers
has worked. The real was introduced after a surge of
prices in the old currency, so the government could
launch the Real Plan from a plateau of high prices.
Driven down by tight money, high interest rates and
promises of fiscal austerity, monthly inflation fell from
48% in June 1994 to below 1.5% in recent months.
Inflation now is low but the institutions of chronic
inflation are alive and making enormous claims on
government resources. Since the Real Plan was launched,
massive federal support has gone into sustaining
operations of five of the 10 biggest banks that were
since merged into other institutions or are still in deep
trouble, in one of the most complex banking crises in
financial history. Brazil’s big trouble now is a
spreading cancer of bank failures and state bankruptcy.
The main focus of this cancer is Banespa, the State Bank
of São Paulo, until recently Brazil’s
second-largest bank, which the Central Bank of Brazil
reluctantly took over on the last business day of 1994, a
few days after world financial markets were shaken by
devaluation of Mexico’s peso. Banespa has become the
biggest failure, in terms of lost assets, so far in the
annals of world banking. Shortly thereafter, a diabolical
front-page cartoon by Paulo Caruso appeared in the
newspaper O Estado de São Paulo, showing São
Paulo’s outgoing Governor, Luiz Antônio Fleury
(1991-95), as the giant gorilla King Kong, seated atop
the monumental office tower of Banespa in the old
financial district of the world’s third-largest
city, making obscene gestures at the population. The
obscene gestures on the Banespa tower, once Latin
America’s tallest building, display the incest
between bankers and politicians that threatens to wreck
Brazil’s financial system. If unchecked, these
obscenities will persuade leaders that the only escape
from economic collapse lies in a revival of chronic
inflation. A society organized for decades to accommodate
and propagate chronic inflation cannot move smoothly or
painlessly into a stable regime of low inflation.
Temporary reduction of monthly inflation may come
quickly. Voters and foreign bankers may applaud. But
economic stabilization is an act of popular sovereignty,
rooted in the very purpose of democracy, that activates a
long and lasting regeneration of public institutions to
strengthen the values of equity and stability. Ending
inflation is always and everywhere an act of courage.
“Society always is ahead of the politicians in
demanding stabilization,” Central Bank President
Gustavo Loyola said at a seminar at the Fernand Braudel
Institute of World Economics. “The gains from
stabilization are spread widely, but the costs are
specific to certain privileged groups. In 1994-95 we
crushed inflation but not the institutional mechanisms of
inflation.” Banespa’s aging tower is as
conspicuous on the decaying downtown skyline as was
Brazil’s economic growth, the fastest among big
countries in the century before 1980. Brazil then entered
a phase of economic stagnation, crippling fiscal
commitments and escalating chronic inflation from which
it is still struggling to emerge. The tower rises beside
a spider-web steel bridge, teeming with pedestrians, that
spans the concrete panorama of the Valley of Anhangabaú
at the core of this metropolis of 17 million people. São
Paulo led Brazil’s modernization because the
state’s interior is one of the world’s richest
farming regions and because its big-city economy is
driven by sophisticated communications and financial
enterprises and by Latin America’s strongest
industrial base, catered to by world-class shops and
restaurants. Yet some of its poor migrants dwell in caves
dug into the foundations of thruway overpasses. The vast
periphery of the metropolis, sprawled over 3,100 square
miles, is the scene of surging violence and adult
mortality thanks to the collapse of public health and
protection under the impact of state bankruptcy. Many of
these people hope that the Real Plan has given Brazil a
new start with in a process of political reorganization
to save them from the sins of the past. But King Kong
appears as a monster of self-destruction, heeding no
warning and wearing the clothing of political
convenience. Fearing financial and political crisis
arising from Banespa’s liquidation, Brazil’s
federal authorities so far have committed huge sums to
keep Banespa afloat. The $24 billion hole in
Banespa’s balance sheet far exceeds the recorded
losses of the second and third-largest failures in
banking history: the $10 billion looting that caused the
collapse in 1991 of the Bank of Credit and Commerce
International (BCCI), owned by Pakistani financiers and
the ruler of Abu Dhabi, and the $14 billion in losses on
bad loans and investments that by 1995 wiped out the
capital of Crédit Lyonnais, the biggest bank outside
Japan, owned by the French government, with assets 13
times greater than Banespa’s. History’s biggest
bailout yet may be the roughly $25 billion, roughly one
fourth of Brazil’s federal revenues, committed but
not yet spent by Brazil’s federal authorities, to
keep Banespa afloat, twice what the United States spent
($12.5 billion) in last year’s rescue of Mexico. The
current banking crisis is the kind of stabilization
hangover that countries experience when emerging from
long periods of high inflation. Since Banespa’s
collapse, the Bank of Brazil, one of the country’s
oldest and most pervasive official institutions, declared
the biggest one-year loss ($4.3 billion) in the annals of
world banking for 1995, and lost another $7.8 billion in
the first half of 1996. In August 1995 the press revealed
that Banco Nacional, Brazil‘s sixth-largest bank,
padded its loan book with $6.7 billion in phony assets,
the biggest bank fraud in world financial history. The
King Kong that wrecked Banespa and bankrupted the state
government was compound interest. The inflation tax, from
which governments profited, has been replaced by a
stabilization tax: high interest. Governments rob the
public by printing too much money, thus reducing the
purchasing power of their nominal obligations. Banks reap
the same advantage by using sight deposits, price-shaving
on retail money market investments and delays in payments
and check clearances under high inflation as a source of
cheap funding, which they lend to the government at high
interest. The government pays high interest, much of it
to foreign investors, to sustain its deficits and keep
the financial system going under high inflation. When
inflation stops suddenly, as in the Real Plan, high
interest becomes a stabilization tax to attract foreign
funds to back the local currency, while the government
forgoes the inflation tax by running a tight money
policy. Old habits and institutions, geared to high
inflation, no longer are viable, which is why Banespa and
other banks have collapsed and state governments have
gone bankrupt. Since the collapse of Banespa, the search
for a scapegoat, and avoidance of the consequences, has
engaged leading politicians involved in this disaster. In
the quagmire of accusations, tortuous negotiations and
paralyzing lawsuits among politicians and central
bankers, everybody’s fallback position is to
transfer Banespa to federal ownership, adding to
political and inflationary pressures on an overburdened
government and further endangering Brazil’s program
of economic stabilization. A decision on Banes-pa’s
future may come before December 30, 1996, when the
Central Bank’s legal authority to run the bank
expires. The controversies surrounding Banespa’s
collapse focus mainly on $650 million borrowed by
Governor Orestes Quércia (1987-91) from Banespa in late
1990 against future tax receipts, known as an ARO (antecipação de receita
orçamentaria), at the end of
his four-year term to finance the election of Fleury, his
protégé. Since reelection of a President, governors and
mayors is banned by Brazil’s Constitution, arranging
the election of a politician’s successor is a symbol
of his power and prestige and helps to mobilize support
in future campaigns. For Quércia, planning to run for
President in 1994, this support was crucial, as it is for
the current mayor of São Paulo, Paulo Maluf, a former
Governor and perennial Presidential candidate, who is
running up big municipal debts to boost the election
campaign of his Finance Secretary, Celso Pitta, to
strengthen Maluf’s next run for President or
Governor in 1998. “The situation reminds me of what
happened at the end of Quércia’s term, when the
state became a theater of public works projects, some of
them still incomplete,” observes Roberto Macedo,
former dean of the University of São Paulo Economics
Faculty. “The goal was to elect his candidate, Fleury, little-known at the time, just as Pitta was a few
weeks ago. So the state went bankrupt, the public works
stopped and the problem was passed on to the new
Governor, Mário Covas.”
Shortly after his inauguration in January 1995, Covas
accused his two predecessors, Quércia and Fleury, of
“scorched earth tactics” in bankrupting the
state and making it “ungovernable” as a result
of systematic plundering of its revenues and borrowing capacity. At the end of 1993, all the state’s assets
were worth only one-fifth of its obligations. Most of
these assets are in 28 state enterprises, including two
banks and related financial companies, four power
companies with huge dams and the biggest electricity
distribution network in Latin America, five transport
companies (including a railroad), a water-sewage utility
and a housing corporation.
A year later, the recovery value of these assets fell
to one-tenth of state debts under the explosive impact of
compound interest. When he took office on January 1,
1995, Covas discovered that the state had only $400,000
in its bank accounts to meet a payroll of $800 million
within five days. In his final weeks in office, in the
custom of outgoing Brazilian officeholders, Fleury
inflated the state payroll for the new governor by
granting 118% salary increases to police, judges and
state attorneys. Overdue debts with contractors and
suppliers totaled $4.2 billion. All over the state, 3,800
public works projects were paralyzed for lack of funds,
only 439 of which had reached 80% completion. Indignation
at the incapacity of public institutions to meet the
needs of the population suffused the new governor’s
inaugural speech, evoking images of “workers who
walk to work in the dark because they lack money for a
bus fare; hands of prisoners reaching out from behind
bars of overcrowded and violence-ridden police station
cells; anguished mothers, carrying small children, unable
to get attention at public clinics;....the sick abandoned
in corridors of public hospitals; children alienated by
impoverishment of schools in crisis.” However,
instead of addressing these problems, Governor Covas, a
close political ally of President Fernando Henrique Cardoso, became obsessed with recovering control of
Banespa for the state government. After a year of
tortuous negotiations, a $15 billion bargain was struck
to enable the state to pay its debt to Banespa. The
federal Treasury would lend $7.5 billion to São Paulo
and the National Bank for Economic and Social Development (BNDES) would “advance” another $7.5 billion
toward privatization of the state’s railroad and
three airports. However, approval by Brazil’s Senate
was required, which took another six months. By then,
compound interest had raised the debt by another $3
billion to $18 billion. Then Covas, a skillful
negotiator, said the deal was off because São Paulo had
no way to pay the extra $3 billion. A source close to the
negotiations reports that “a consensus is developing
among Covas and his associates against reassuming control
of Banespa,” which would involve firing thousands of
people and closing scores of branches, now seen by them
as being politically inconvenient. Brazilian politicians
find a million ways to say that all practical solutions
are politically impossible. Confirming this folk wisdom
is the failure of Cardoso and the resistance of Congress
in efforts to end privileges of public stakeholders
—civil servants, pensioners, state banks and
governments, municipalities, huge federal financial
institutions such as the Bank of Brazil and the Caixa
Econômica Federal (CEF)— that parasitically bleed
government of the resources needed to operate a complex
society and to invest in long-term processes of
modernization. The economic benefits of liquidation
—freeing public resources tied up in unviable claims
and bankrupt positions to be invested more
productively— are politically dangerous and never
discussed. So monetary pressures bred by escalating
domestic public debt, by bank rescues and by the tangled
web of exaggerated government guarantees threaten the
hopes invested in economic stabilization. Brazilian
politicians, including Cardoso’s reformist
government, have trouble perceiving limits to creating
money and credit to fudge problems of moral and fiscal
cohesion. Twice in the past decade, in the Cruzado Plan
(1986-87) and the Collor Plan (1990-91), monthly
inflation approached zero, but then rebounded to near
hyperinflation levels after the government failed to make
needed adjustments in fiscal policy and structure. The
trouble with the Real Plan is that cutting monthly
inflation was such an easy victory, at little cost
compared with stabilization efforts in other countries,
that political leaders neglected to create the
psychological climate of a stabilization plan in which a
nation fights desperately for its survival as an
organized society. When Fernando Henrique Cardoso was
Finance Minister (1993-94), Professor Thomas Sargent of
the University of Chicago, a historian of hyperinflations, wrote him an open letter in which
Sargent argued:
Persistent high inflation is always and everywhere a
fiscal phenomenon, in which the Central Bank is a
monetary accomplice....A Central Bank cannot by itself
stop an ongoing inflation against the will of a fiscal
policy authority determined to run persistent budget
deficits. Indeed, a Central Bank determined to ‘go
it alone’ and to fight inflation with tight money in
the face of persistent deficits can achieve only
temporary gains in the battle against inflation, and at
the cost of making inflation worse in the future. This
outcome results because, in the face of a persistent
fiscal deficit, a Central Bank can achieve go-it-alone
tight money only by forcing the fiscal authority to issue
increasing amounts of interest-bearing debt: without a
fiscal adjustment down the road, the monetary authority
will eventually be forced to generate more inflation down
the road in order to raise the inflation
tax....Credibility is not something that a small number
of people, even Presidents and Ministers, can manipulate.
In a democracy, a fiscal policy credible for supporting a
stable currency must be arranged so that ‘the votes
are there’ for levying enough explicit taxes to
cover whatever expenditures have been voted.
Cardoso and Covas have steadfastly avoided the hard
choices posed by state bankruptcy and the collapse of Banespa. Meanwhile, Quércia and
Fleury, in political
disgrace because of the aura of corruption enveloping
their administrations, mounted a campaign in the press
and the courts to save their reputations and to discredit
the Central Bank’s handling of Banespa.
Banks are prime sources of election finance in Brazil.
Their survival and continuing liquidity become a tragic
obsession for politicians, involving colossal waste of
resources. Along with Banespa, the Central Bank took over
four smaller state banks and, months later, two big
private banks, Econômico and Nacional, amid revelations
of fraud and political scandal. Brazil now toils in a
political and financial quagmire engulfing much of its
public and private banking system. Inflation is low now,
but Brazil’s oversized banking system, concentrated
in the public sector and engineered to profit from
chronic inflation, is in deep trouble. Until now, Brazil
has sailed along on a crest of expanding world liquidity
while avoiding institutional changes demanded by stable
prices. Failure to deal effectively with the overhang of
fiscal and banking problems will breed inflation in the
future.
São Paulo’s state government now owes roughly $72
billion, 16% more than Brazil’s entire debt to
foreign banks ($62 billion) before it got relief under
the Brady Plan of the U.S. Treasury. Central Bank
auditors, poring over the giant carcass of Banespa in
early 1995, found $13 .5 billion of bad debts on its
books, dwarfing its nominal capital of $1.9 billion. Of
these bad debts, $9.5 billion was owed by Banespa’s
owner, the state government. Brazilian banking laws bar
concentration of loans in a single borrower and
self-dealing by controlling interests, but state banks
were freed from these limits from 1975 to 1990, subject
to approval of each loan by the Central Bank. In December
1990, as Senator from São Paulo, Cardoso proposed a
special resolution enabling Quércia to borrow the $650
million ARO from Banespa, which was rolled over
repeatedly in the 1990s as it ballooneda into a debt of
$3 billion as high interest was capitalized. With the
Central Bank running Banespa, the $9.5 billion state debt
to its own bank grew to $20 billion. Capitalized interest
is accruing at a rate of $700 million monthly. Another $4
billion in bad debts is owed by the private sector,
mainly from insider loans originally funded by
Banespa’s foreign borrowing. Of $57 billion in loans
outstanding, the state government owes $24 billion to its
two banks, Banespa and Nossa Caixa, Nosso Banco [Our
Fund, Our Bank], an old savings institution that recently
became a universal bank, with 12,000 employees and 550
branches, currently is ranked 10th in assets among
Brazilian banks. The state pays $20 million monthly on
its $5 billion debt to Nossa Caixa under a previous renegotiation, while capitalized interest grows this debt
by $100 million each month. Negotiations with the Central
Bank on how to merge Banespa and Nossa Caixa into a
single state bank have begun, but no viable formula is in
sight on how to deal with the state debts. Of $20 billion
in state debts to Banespa, two-thirds are from the
bank’s guarantees of old loans to defaulting state
agencies and corporations that were rolled over
continuously for more than a decade at what became
astronomical real interest rates in the 1990s. The final
blow, dramatizing the political and financial
vulnerability of Banespa, was Quércia’s $650
million ARO, now amounting, because of compound interest,
to one-third of these debts. São Paulo owes another $10
billion in unpaid judicial awards. Creditors are suing
for a federal takeover of the state government to secure
payment of these awards under a rarely used
constitutional provision.
Top Central Bank officials were divided over whether or
not to liquidate Banespa. The Central Bank interventors
appointed to run Banespa never received a reply to their
requests for authorization to cut back the scale of
operations. In the 20 months since the Central Bank took
over Banespa, political pressures —from mayors,
unions and legislators— prevented the new management
from reducing significantly the number of employees and
branches. Of its two million accounts, 1.7 million are of
state employees. Four-fifths of Banespa’s funding
consists of deposits of the state government.
“Banespa basically has been bust since 1980,”
said one former director. “By then it had lent more
than its entire capital to a single customer, the state
government, which also was its owner and which
didn’t repay its loans. At the end of 1990, the
Central Bank banned all further AROs, which dealt with
flow of new loans but not the existing stock that was
being rolled over continuously. Private banks made huge
profits by funding Banespa’s unpaid state loans on
the overnight interbank market as the state debt rose
from $4 billion to $20 billion since December 1990.”
Banespa stayed alive for so long because, like other
banks, it enlarged its branch network in long periods of
high inflation to benefit from the “float” of
delays in payment and clearance while lending the funds
to the federal government at high interest. In capturing
this inflation tax, Banespa had extra privileges as the
State of São Paulo’s paymaster. Of its three
million personal and corporate accounts, 60% were held,
as legally required, by state employees, contractors and
suppliers in order to get paid. Another $1.4 billion in
judicial escrow accounts was deposited by law at Banespa.
Also, accounts of state and municipal governments and
public corporations were freed from Central Bank reserve
requirements. With $28 billion in assets at the end of
1994, 611 branches and 53,000 people on its payroll
(including pensioners), Banespa’s physical network
is roughly the size of Citibank’s domestic U.S.
operations with less than one-tenth of Citibank’s
assets and capital.
All the options are painful. The Central Bank’s
ideological choice is privatization, which is not viable.
Privatization would drain Banespa’s privileged
source of cheap deposits as a public bank. A
privatization proposal was rejected by leading private
bankers, who face a shakeout in Brazil’s oversized
banking industry and have no incentive to take on the
grim task, avoided by politicians, of firing thousands of
employees and closing hundreds of branches. The remaining
options are liquidating the bank, seen by the main actors
as politically impossible, and federalization, a recipe
for more bailouts and an unending source of printing
money to pay bad debts.
The problem will not go away. Banespa is the leading
example of Brazil’s fiscal problems that must be
solved before inflation is beaten. In early 1995 the
World Bank estimated at $140 billion the total debts of
Brazil’s 27 state governments, which together now
run $24 billion in deficits annually. Most are desperate
for new loans. A new federal loan program has been
announced to bail out state governments from their debts
to state banks on the condition that they close,
privatize or recapitalize their banks. Finance Ministry
officials say the program reschedule the $24 billion in
state bank debts over 30 years.Calculations of the fiscal
cost of these bailouts are scratches in the sand, with no
provision for defaults on rescheduled loans.
Brazil’s federal system is under great strain. Other
Brazilian states, bred in the same political and
financial culture, reproduce São Paulo’s bankruptcy
on a smaller scale. Debts are rolled over perennially and
payments almost never made. A soft budget constraint
becomes no budget constraint. The stock of debt swells
and the rate of interest no longer matters because debts
are not paid. But when inflation stops, then money really
matters. A nervous breakdown forced the Governor of Mato
Grosso into seclusion for two months earlier this year
after as the state government fell five months behind in
paying salaries, which absorb more than 80% of revenues
of many states. New federal loans were granted only after
Mato Grosso’s legislature agreed to privatize the
state bank and power company, but the state quickly
became one of 12 states asking for 90-day debt relief
during the current municipal election campaign. The 19
states that were bailed out with $2.1 billion in new
federal loans at the end of 1995 have paid only $268
million in debt service as capitalized interest
accumulates. Also five months behind in paying salaries
is the Northeastern state of Alagoas. Its payroll
consumes 117% of its $20 million monthly revenues,
leaving nothing to service a $1.1 billion state debt at
8% monthly interest. The division of Alagoas’s
payroll mirrors the distortions of income distribution in
Brazil. The 3,500 highest-paid state employees together
get as much as the 51,000 poorest paid; some retired
police colonels receive pensions of $20,000 monthly,
which are not uncommon among state governments. The state
legislature and judiciary set their own salaries and
staffing levels. Alagoas’s legislature has 3,000
employees, though only 500 can fit in its building. The
federal government is lending US$65 million to Alagoas,
which also is trying to borrow US$ 160 million abroad on
the Euromarkets.
Brazil is a continental archipelago of communities
speaking the same language and flying the same flag, with
big differences in achievement and shifting centers of
power. The regression of modern institutions is
concentrated in big cities like Rio de Janeiro and São
Paulo. Vast swaths of the country have the trappings but
not the effective substance of modern institutions, even
though they are linked to the outside world by modern
systems of communications and transport. Some states and
municipalities are solving their problems, mainly excess
employment and debts. Some, like Ceará and Paraná,
began to deal with these problems a decade ago. The state
governments of Minas Gerais, Bahia and Rio Grande do Sul
have taken big steps to reduce their fiscal burden. Even
São Paulo increased revenues by 27% in 1995 and balanced
its non-debt budget for the first time in several years.
“We had 210,000 employees when I took office and now
we have 180,000,” says Rio Grande do Sul Governor
Antônio Britto. “We have closed 10 state
corporations. But our debts have grown from $1.3 billion
in 1991 to $5.5 billion today. I’ve been telling the
federal government that we’ve built an atomic bomb,
made not of principal but of compound interest, that will
blow up not only my government but all of Brazil. The
federal government finally seems to understand the
seriousness of this because it now faces the same problem
itself.”
The dilemma between economic collapse and revival of
chronic inflation arises from an expanded concept of
looting as developed after the U.S. savings and loan
banking crisis by two economists at the University of
California at Berkeley, George Akerlof and Paul Romer,
who argue:
Bankruptcy for profit will occur if poor accounting,
lax regulation or low penalties for abuse give owners an
incentive to pay themselves more than their firms are
worth and then default on their debt obligations.
Bankruptcy for profit occurs most commonly when a
government guarantees a firm’s debt obligations. The
most obvious such guarantee is deposit insurance, but
governments also explicitly or implicitly guarantee the
policies of insurance companies, the pension obligations
of private firms, virtually all the obligations of large
banks, student loans, mortgage finance of subsidized
housing and the general obligations of large and
influential firms....As a result, bankruptcy for profit
can cause social losses that dwarf the transfers from
creditors that the shareholders can induce. Because of
this disparity between what the owners can capture and
the losses that they create, we refer to bankruptcy for
profit as looting....If net worth is inflated by an
artificial accounting entry for goodwill, incentives for
looting will be created.
The concept of bankruptcy for profit applies to Brazilian
politics. What happened to Banespa shows how this kind of
political looting works. This looting has been widely
practiced in Brazil, in both the private and public
sectors. In Brazil, the capital value of “good
will” is a political concept that enhances the
capacity of firms, especially public banks,
municipalities, state governments and other franchised
stakeholders, to extract resources from the political
system, generating widespread parasitism and escalating
claims against government that cannot be met within a
clear framework of public accounting. The game can only
be kept in motion through the deceptive accounting of
chronic inflation. The obscenity of this escape lies in
the continuing degradation of modern public
infrastructure and institutions —schools, hospitals,
public security, roads, water, sewage and electric power
systems— that lay in waste because of previous waves
of looting. At both the federal and local levels, state
bankruptcy drains the will and capacity of government to
absorb liquidations, among bothofficial and private
financial institutions, which is the cost of moving from
a regime of chronic inflation to market-oriented economic behavior. This may be a transitional
problem, but the
price of transition cannot be escaped and the price of
delay continuously rises. At all levels of government and
in its banking system, Brazil now faces cruel choices
between liquidation and resurgence of inflation.
Liquidation of failing public institutions is alien to
Brazilian political culture. Closing state banks and
firing their employees only has begun to be discussed recently. Awareness may be growing that monetary
pressures bred by escalating domestic public debt, by
bank rescues and by the tangled web of exaggerated
government guarantees are undoing the hopes invested in
economic stabilization.
Too Big to Fail
"Most
countries faced with bank failures delay recognition of
the failures and eventually assume responsibility to the
depositors and socialize the loan losses," observes
Allan Meltzer of the Carnegie Mellon University.
"The main economic rationale for financial
regulation and supervision is to prevent failure of the
payments system. Some would broaden the statement of
purpose to include the entire financial system. The
emphasis in either case is on the system, not individual
firms or institutions. The reason for this emphasis is
that, in principle, well-designed regulation can reduce
the risks that society must bear."
Like Crédit Lyonnais, Banespa was seen as being too big
to be allowed to fail. Fear of financial and political
turmoil, known as systemic risk, endows survival of big
banks all over the world with an aura of high public
interest, breeding large and growing claims on government
resources. These claims are magnified by negligence in
bank supervision and by political pressures on central
banks. The "systemic risk" rationale focuses on
the web of loans among banks on the interbank market in
support of the argument that failure of one big bank
would cause a chain reaction of panic among creditors,
who in turn would be unable to meet their commitments,
thus inflicting damage to the payments system. The
historical cases cited most often in support of the
"too big to fail" doctrine are the collapse in
1931 of Austria’s Creditanstalt, deepening the Great
Depression, and the Federal takeover in 1984 of
Chicago’s Continental Illinois, both of them big
short-term international interbank borrowers. The
difference between Brazil’s current banking crisis
and historical "too big to fail" experiences is
that the interbank exposure of failing Brazilian banks is
almost entirely with government institutions. Over the
past year, the number of Brazilian banks with access to
private interbank lending has been halved because of
increasing risk. For example, Banespa’s
non-performing state loans were funded on the interbank
market at shocking interest rates, reaching 16% monthly,
before private banks withdrew their credit in September
1994 and the Bank of Brazil stepped in as an
intermediary, guaranteeing Banespa’s overnight
loans. Thus no risk to the payments system is posed if
Banespa were to be liquidated.
In June 1996 Standard & Poor’s reported:
"Brazilian bank industry risk is high because
government regulations are in some cases distortive and
in some cases lax." One of the distortions leading
to the current wave of Brazilian bank failures is the
Central Bank’s exacting compulsory reserve
requirements, which tighten bank liquidity and drive up
interest rates, which in turn enable Brazil to attract
foreign funds to support an overvalued currency that is
one of the main props of the Real Plan. High interest
rates, needed at first in most stabilization efforts,
quickly outlive the usefulness and must be replaced by
credible fiscal policies. Using three different indices,
the Fundação Getúlio Vargas (FGV) calculates that the
real effective value of Brazil’s currency increased
between 29% and 47% since the Real Plan was launched,
urging the government to "accelerate mini-devaluations of the real to avoid a devaluation
shock later and to halt a fall in exporters’ profit
margins that is "bad news for a country running a
deficit in its external accounts and with urgent need to
invest in order to export." This view follows a
consensus among economists now cautioning against
prolonged use of overvalued currencies as an anchor to
stop chronic inflation. The Bank for International
Settlements (BIS) in Basle, the central bank for central
banks, warns: "Exchange rate-based stabilization
programs, which have often resulted in sharp reduction in
inflation, are frequently maintained for too long and the
exchange rate becomes overvalued. The longer an
unrealistic exchange rate is maintained, the greater will
be the chance that finance flows to the wrong sectors and
the higher will be the subsequent costs of dislocation.
This will be especially true if a reversal of short-term
capital flows forces a large and sudden adjustment.
Indeed, several financial crises in Latin America have
been triggered by very abrupt exchange rate
changes," adding that poor economic performance also
has been caused by "an uneven institutional fabric,
bad banking practices, weak prudential oversight and the
inevitable problems encountered in the transition to a
more liberal system."
The initial success of the Real Plan, creating political
and price stability in Brazil for the first time in many
years, launched foreign investors into a euphoria only
briefly dampened by the "tequila effect"
hangover from the 1994-95 Mexico debacle. Punters buying
Brazilian financial assets in early 1995 got a 30% annual
real return in dollars, reduced to roughly 20% in 1996 as
the Central Bank eased local interest rates. In the first
five months of 1996, Brazil received gross long-term
capital flows (at least 360 days) of $28 billion, double
the 1995 investments in the same months. Direct foreign
investment ($3.3 billion) grew at triple the 1995 pace,
spurred by hopes of accelerated pri-vatization and
increases in popular consumption that tempted
international companies to seek a bigger share of a huge
potential market.
Many blame Brazil’s current epidemic of loan
defaults on real annual interest rates of up to 30%, the
magnet that enabled Brazil to multiply its foreign
exchange reserves tenfold since 1991 to $60 billion,
fourth-largest in the world after Japan, China and
Taiwan. Government officials proudly point to these huge
reserves, four times the size of the monetary base, as a
kind of Maginot Line, defending an overvalued exchange
rate and the Real Plan itself. But admirers of this
Maginot Line may not recall how fast Mexico’s
reserves fell from a peak of $29 billion in February 1994
to only $4.4 billion in January 1995. What sank Mexico in
1993-94 was a big credit expansion in an overvalued
currency. The same happened in the first 18 months of the
Real Plan, but in 1996 the stock of private domestic
credit has leveled while public debt has kept growing.
Concern is spreading that events in the world economy
outside Brazil’s control, such as a rise in U.S.
interest rates or failure by Argentina to finance its
1996 deficits, may drain foreign funds from Brazil.
"The resources will stop coming and will start to
go," says Francisco Gros, twice Central Bank
President who now works for Morgan Stanley on Wall
Street.
Some broad purchasing power gains from lower inflation
are being eroded in a consumer credit boom. Bankers
estimate that 70% of personal cheks issued in Brazil now
are predated, a conventional form of consumer credit
invented during high inflation. Poor people also have
been paying monthly interest rates of 14%-18% in 1995,
falling to 4%-7% this year, to buy consumer durables
ranging from electric fans to cooking stoves to used
cars. For purchases at monthly interest of 7.5% in six
installments, lenders would break even with a 29% default
rate. If defaults are only 3%, the historical average for
big São Paulo stores, profits reach 37%. The lending
boom is financed by Brazilian and foreign banks.
"Many banks are trying to buy finance companies
because of the spread between foreign borrowing at low
interest and domestic lending at high rates, which is
very profitable because of the interest distortions
imposed by the government’s economic policy,"
says Affonso Celso Pastore, a former Central Bank
President. "Today whoever buys a finance company
recovers his investment very fast. For this stabilization
program to run its course, re-storing economic growth, we
must have interest rates near international levels. Then
the consumer credit market will be much bigger."
The problems of transition have led to complicated flows
of support between Brazil’s federal banks, the
Treasury and weakened financial institutions, hard to
measure because of opaqueness, secrecy, omissions and
delays of published accounts. A piecing together of these
rescue operations, both promised and already realized,
suggests enormous displacement of resources. Official
financial commitments for bailouts, mergers, recapitalization, debt swaps, advances toward purchases
of state government assets, Central Bank losses and other
forms of support of the banking system and the currency
since the launching of the Real Plan may exceed $100
billion. This displacement of $100 billion is perplexing
not only because much of it escapes conventional monetary
and fiscal accounting and because it amounts to nearly
twice foreign currency reserves and the whole banking
system’s capital ($52 billion), over one-fifth of
all its assets ($464 billion) and one-third of the broad
money supply (M4). It also animates a culture of deranged
economic transfers at the core of long-term processes of
chronic inflation. This culture led the World Bank to
report in 1983 that the volume of transfers "is such
a unique feature of the Brazilian economy that one may
refer to it as a transfer economy to distinguish it from
the market and centrally planned economies." The
Bank of Brazil used to record huge profits from its Conta Movimento, a massive rediscount facility of virtually
interest-free funding from the Central Bank that by the
early 1980s approached the size of the monetary base. In
1978 the flow of credit subsidy amounted to 54% of total
federal revenue, with over one-third of all loans to the
private sector highly subsidized. Intelligent, dedicated
officials have struggled hard over the years to reduce
and modify these distortions. Progress has been made in
reducing subsidies and clarifying public accounts. Since
passage of the 1988 Constitution, government lending was
cut steeply. Yet new gimmicks are always appearing and
their distortions can have more impact in a climate of
lower inflation. The displacement of resources in
Brazilian currency support and bailout of banks and state
governments, now roughly 17% of GDP, falls within the
scope of fiscal cost of recent bank rescues in other
Latin American countries, ranging from 12-13% in Mexico,
Argentina and Venezuela to 20% in Chile in the early
1980s. No economy can sustain such a huge drain on its
resources on a continuing basis. The main Brazilian
support operations, already disbursed or announced, come
through a jumble of fiscal channels:
•$28 billion in Central Bank swaps with state banks
of unmarketable state government debt paper for
negotiable federal notes.
•$15 billion to recapitalize the Bank of Brazil, of
which $8.7 billion already has been disbursed for a new
stock issue. After declaring its huge loss for 1994, the
Bank of Brazil’s financial position was weakened
further by a political deal in Congress as the
government, seeking passage of a gutted constitutional
amendment for social security reform, agreed not to
collect $7.6 billion in defaulted debts by big landowners
in exchange for votes in Congress.
• $13 billion in published Central Bank losses
accumulated from June 1994 to December 1995. Most of
these losses came from mismatches between interest
received on foreign exchange reserves and interest paid
on internal public debt floated to prevent the inflow of
foreign funds from swelling the domestic money supply.
Also contributing to these losses is the mismatch between
the market interest rates paid by the Central Bank on
Treasury deposits and the low interest received by the
Central Bank on its Treasury bond holdings.
• $13 billion in new federal loans to state
governments to enable them to sell or liquidate state
banks, or to recapitalize the banks if a state can pay
half the cost of restructuring.
•$15 billion in emergency loans under PROER, the
Central Bank’s Program of Incentives to the
Restructuring of the Financial System, funded by
compulsory reserve deposits of other banks, to
restructure the balance sheets of failed private banks
for merger with other banks.
•$13 billion in Treasury loans to state governments
to pay loans from state banks, including $7.5 billion to
São Paulo State to pay part of the state
government’s debt to Banespa.
•$7.5 billion from BNDES (National Bank for Economic
and Social Development) as advance against purchase of
São Paulo airports and railroad for privatization later;
the advance is to be used to repay Banespa loans to the
state government. The reported $3.6 sale price to be paid
by BNDES for Fepasa, the São Paulo railroad, is several
times its appraised value.
•$12 billion in revolving overnight loans and the
interbank market borrowed from private banks by Bank of
Brazil and CEF relent to state banks, mainly Banespa, for
daily funding of their balance sheets.
•Apart from these specifically announced
commitments, a large share of the $12 billion in
revolving overnight loans on the interbank market is
borrowed from private banks by Bank of Brazil and CEF
relent to troubled banks for daily funding of their
balance sheets. Another large share of the $6 billion in
revolving Central Bank rediscount window loans is funding
troubled banks.
Recent financial crises in Scandinavia, Japan and U.S.
savings and loan institutions show that the final cost of
a banking system bailout are often greater than original
estimates. While these bailouts are absent from most
fiscal accounts, they can be seen in a broader
perspective. Over the past year, bitter public protest
arose in Japan against the use of $6.3 billion in
taxpayers’ money to rescue seven failing jusen
(mortgage lenders), to which politically-powerful farm
cooperatives had lent heavily and which criminal gangs
had looted. But this $6.3 billion jusen rescue was the
only government bailout so far in Japan during its
present banking crisis, involving just 0.14% of the
banking system’s $4.5 trillion in outstanding loans.
Of these, 10%-20% are now seen as unrecoverable thanks to
collapse of real estate and stock market prices in the
early 1990s. Brazil’s public opinion and
politicians, meanwhile, have been more passive in dealing
with bailouts involving 16 times more money than the
jusen rescue in a banking system with only one-tenth of
the assets of Japan’s, but with interest rates
several times higher. Brazilians have been more passive
because of enormous pressures to save bank and government
jobs and to roll over unpayable public and private debts
far into the future.
The profits from inflation that kept banks and
governments afloat, facilitating political arrangements,
have nearly vanished since launching of the new currency
in July 1994. The inflation tax transferred to banks from
the population fell from $9.8 billion in 1993 to just
$460 million in 1995. Brazil’s poorest families
gained hugely in purchasing power as inflation fell,
improving income distribution. Their gratitude gave
Cardoso a landslide victory in the 1994 Presidential
election because, as Finance Minister, he presided over
drafting of the Real Plan in 1993-94. Incentives for
ending chronic inflation remain high for the Brazilian
people as a whole, less so for bankers and politicians as
well as for bank and public employees, whose ranks grew
over the past decade of high inflation and could lose
jobs in a tighter fiscal regime.
Key parts of Brazil’s patronage system are
Brazil’s state and federal banks, such as Banespa,
making 55% of all loans and now forming a huge financial
garbage dump, littered with wasted resources and
unrecoverable assets, often created for political
reasons. After reporting $12.1 billion in losses for
1995-96, purging huge accumulations of bad debts from its
balance sheet, the Bank of Brazil’s new managers
were praised for their courage, given the difficulties
they faced in downsizing and restructuring the
bank’s operations. As a result of these losses, the
Bank of Brazil, which was the monetary authority before
the 1960s and fiercely resisted creation of a new Central
Bank in 1964, lost its place as the country’s
biggest financial institution to the CEF, which has
massive problems of its own. With an overhead of 115,000
employees and 3,000 domestic branches, the Bank of
Brazil’s new reform administration, headed by a
former Central Bank President, was blocked by political
and labor union resistance in its plans to cut staffing
levels and close money-losing branches. According to
Mailson da Nobrega, a former Finance Minister who began
his career as a Bank of Brazil officer: "The Bank of
Brazil still has not recovered from the loss a decade ago
of its Conta Movimento". The Bank of Brazil
responded to its loss of free funding by trying to become
a financial conglomerate, starting new leasing,
brokerage, insurance and credit card businesses. But it
was forced to adopt outdated computer technology from a
failing government corporation, Cobra, and was burdened
further by a bureaucratic culture and acquired rights of
its highly-paid employees who resisted change. However,
the institutional credibility of the Bank of Brazil is
such that, despite these problems, it gained deposits in
a "flight to quality" when other banks got into
trouble.
At the core of a highly concentrated system, five
government banks hold 45% of all assets and the Big Six
private banks (Bradesco, Unibanco, Itaú, Bamerindus,
Real and BCN) another 22%. Operating costs (8.3% of total
assets) are among the highest in the world, compared with
3.2% of assets for banks in the United States, 2.3% in
India and 1% in Germany and Japan. Earlier this year,
Central Bank accounts showed that 16% of all bank loans
to the private sector are overdue or unrecoverable,
despite two-thirds growth of the loan portfolio since
January 1994. While weaker banks keep rolling over bad
loans, stronger ones shrink their balance sheets in real
terms and make provisions for bad loans. "It’s
a bad sign when banks expand their balance sheets under
these conditions," said one Central Bank official.
"It means that many banks are helplessly rolling
over bad loans and making new ones to desperate firms
with no prospect of paying today’s punishing
interest rates."A new study by the FGV shows that,
between the last full year of high inflation (1993) and
the first full year of low inflation (1995), provisions
for bad loans by the Big Six rose from $273 million to
$3.7 billion, or 27% of their net worth. Personnel and
administrative costs kept escalating and rents from the
payments float collapsed from $5.1 billion in 1993 to
only $344 million in 1995. This performance would have
been much worse if Banespa and two of 1994’s private
Big Six, Banco Nacional and Banco Econômico, were not
excluded from the 1995 rankings after collapsing into the
arms of the Central Bank, which absorbed their bad loans
and poured another $14 billion into their carcasses to
merge them into other banks amid scandals of fraud and
diversion of assets. In addition, Bamerindus,
Brazil’s sixth-largest bank, has been struggling to
survive with Central Bank support despite a $1.9 billion
liquidity shortfall.
Such debate has focused on the $15 billion in rescue
loans of PROER to support merger of failed banks, mainly
Nacional and Economico, into stronger institutions. As in
Argentina in the early 1980s, banks with stronger loan
portfolios thus were forced to finance the bailout of
troubled banks by holding high reserves so that the
Central Bank could make emergency loans. Of 271 Brazilian
banks, 58 suffered Central Bank intervention or
liquidation or changed ownership in the past two years.
Of these, five state banks, including Banespa, and 26
private banks came under Central Bank management. Another
22 changed owners without Central Bank PROER loans, which
go to the new owners to clean up the balance sheets of
failing banks during mergers. Under a formula developed
in previous banking crises in Chile, Japan and the United
States savings and loan industry, bad assets of the
failing bank are taken over by the government as a
"bad bank", like the U.S. Resolution Trust
Corporation, while the failing bank’s viable assets,
deposits and branch network are taken over by the new
owner, who can return additional loans to the "bad
bank" if they produce no income. They demanded
collateral with face value of 120% for PROER loans, but
then accepted as guarantees value-impaired government
obligations, known as moedas podres [rotten money], of
which $75 billion are outstanding, bought at 40%-60% of
face value on secondary markets. This financial
engineering enabled the "bad bank" of the Nacional, which failed with a $5.4 billion hole in its
balance sheet, to claim a profit after revaluing
inflation-eroded housing mortgages, purchased at a 58%
discount for $3.2 billion, at their face value of $7.8
billion, according to lawyers for the former owners. It
also gave windfall profits to banks that had written off
these government debts that never were paid or whose
value was eroded by inflation. Financial results of the
biggest banks for the first half of 1996 would have been
worse without sale of some $5 billion in moedas podres
sold to "bad banks" under Central Bank
management, led by the $2 billion sold by Bradesco, and
from risk-free interbank lending to fund Banespa, with
the Bank of Brazil acting as intermediary. PROER gives
the Central Bank new powers to intervene in banks and to
hold auditors responsible for failing to report financial
irregularities. Time will tell whether the Central Bank
can improve bank supervision with these new powers.
The Central Bank as
Scarecrow
Roberto
Campos, Planning Minister in the 1960s, called the
Central Bank of Brazil "The Monster That I Created.
" The Central Bank now is struggling to rise above
its historic role as a monetary accomplice to high inflation. In his brilliant memoir of public life over
the past half-century, Lanterna na Popa [Lantern on the Stern] (1994), Campos argued that the Central Bank
"strayed from its intended role as intransigent
defender of the currency to finance Treasury deficits and
to aggravate uncertainty in the financial market with a
torrent of regulatory instructions and norms."
According to Campos, the Central Bank’s
"normative diarrhea" produced 4,692 regulatory
changes from March 1985 to November 1992.
Managing a banking crisis on the scale of Brazil’s
present difficulties would be a daunting task for much
stronger central banks, such as the Federal Reserve, the
Bank of England or the Bundesbank. That Brazil’s
banking crisis so far has not led to a general financial
panic or collapse is due to the courage and creativity of
a small group of Central Bank officials who made mistakes
but who managed to keep the system intact. The price of
temporary salvation has been waste, injustice and
problems for the future, but things could have been
worse. The crisis of the big private banks may be
reaching an end, but more failures of smaller ones are
expected while the problems of the federal and state
government banks remain unsolved and will demand firm and
continuous policy over successive Presidential
administrations.
The institutional problems of the Central Bank are key
issues in efforts to stabilize the Brazilian economy.
They are only beginning to be discussed in public debate.
They are (1) political weakness; (2) excessive functions;
(3) crippling distortions in its personnel structure, and
(4) laxity in bank supervision.
1. Political weakness. In the rough and tumble of failed
stabilization plans since 1985, the 14 Central Bank
Presidents at the helm of Brazil’s financial system
have stood like scarecrows in a stripped field whom the
crows learn to ignore. They take political orders and
always can be overruled by Brazil’s Presidents
making deals with state governors and leaders of
Congress. Under protest, Central Bank Presidents hand out
money under threats of a general financial crisis and of
the loss of jobs protected by leading politicians.
2. Excessive functions. The Central Bank generally has
been able to meet short-term goals of monetary policy.
When the government wants inflation in order to pay its
bills, the Central Bank produces inflation. When the
government wants tight money, the Central Bank produces
tight money, even with suicidal interest rates. Its
failure as a guardian of price stability and the
integrity of the financial system is due both to
political weakness and too many responsibilities in too
many areas. Until the late 1980s, 32 development
programs, such as lending to agriculture and small
business, were operated by the Central Bank, financed
almost entirely by printing money. Even today, its
traditional Central Bank functions of managing currency
emissions, buying and selling public debt and controlling
foreign exchange operations compete with vast and
neglected responsibilities for supervising 4,875 banks,
funds, brokers and other financial firms, public and
private.
3. Personnel structure. The Central Bank employs 6,200
people, 4,000 of them working in Brasília and the rest
in branch offices in other large cities. According to
Ibrahim Eris, who as Central Bank President in 1990-91
froze 40% of the financial system’s assets in one of
the more spectacular stabilization efforts of recent
years, "We had too many employees. A few were doing
too much work. Too many were not doing enough. Our
research department was weak. Pay was low. A director
could earn four times as much in the private sector as at
the Central Bank." No competitive examinations to
recruit new staff were held from 1979 to 1993. Now the
Central Bank’s pool of qualified people is shrinking
as its aging staff retires in ever-greater numbers.
However, many young recruits also are leaving the bank
because entry pay is very low. During Eris’s
Presidency, the number of bank inspectors was cut by 15%.
Now only 632 inspectors in Brasília and the branch
offices are directly involved in supervision of a complex
and volatile financial system. Moreover, the time spent
on different kinds of supervision is badly distributed.
Only 0.5% of inspectors’ time is devoted to the CEF,
holding 17% of the banking system’s assets. The huge
problems of the Bank of Brazil absorb only 9% of their
time, barely half the scrutiny given consórcios
[privately owned pools for installment-buying of consumer durables, mainly cars], accounting for only 0.3% of the
financial system’s assets.
4. Bank supervision. "Bank supervision is subject to
as much political pressure as monetary policy,"
Central Bank President Gustavo Loyola recently said.
"If the Central Bank loses its supervision
responsibilities, oversight of banks might become even
worse if an even weaker regulatory agency is created in
the present institutional environment." Yet the
scarecrow role of the Central Bank lost whatever
credibility it previously enjoyed in the scandals of the
Econômico and Nacional.
A "secret" report of the Federal Accounts
Tribunal (TCU) on operations of Nacional and Econômico,
leaked to the press, found that "the Central Bank
for several years observed recurring irregular practices
without taking effective steps to safeguard the investing
public, capital markets, public banks and the Treasury
from false accounting and massaged balance sheets."
Internal documents examined by the TCU show that Central
Bank inspectors repeatedly had reported to their
superiors in Brasília that both banks were close to
failure as far back as 1987. Instead of taking corrective
measures, Central Bank officials chose to overlook or
cover up these irregularities.
At the Econômico, "not once was anything done to
regularize credits [in arrears] and accounting for unduly
registered income," quoting Central Bank inspectors
who in 1989 reported: "This picture is not new and
is being painted with ever-darker colors over the years
in the absence of corrective measures." According to
the TCU: "More timely action by the Central Bank
possibly would have avoided the extreme of lending the
enormous sum of $6 billion to the Econômico after the
bank failed." Central Bank officials taking over the
Banco Econômico in August 1995 found in the personal
safe of its boss and principal stockholder, Angelo Calmon
de Sá —former Minister of Industry and President of
the Bank of Brazil— a handwritten spread sheet
listing $2.4 million in campaign contributions to 25
candidates in state and federal elections, $1.1 million
of which went to Senator and former Governor Antônio
Carlos Magalhães, the political boss of Bahia.
Banco Nacional was ranked sixth in size and second in
profitability among the big banks in 1994. It listed
profits of $140 million on assets of $11 billion, before
Veja magazine revealed that the failing bank added $6.7
billion in fake assets to its loan book, the biggest bank
fraud in world financial history. Red-faced Central Bank
officials still are trying to explain how a big bank
continuously could invent phony loans since 1986, spread
among 652 false accounts in hundreds of branches. A
former executive of KPMG-Peat Marwick, the accounting
firm that audited Nacional’s accounts over the past
two decades, explained that "most big frauds are
done by top management. Computer access to these accounts
were blocked by special codes. Brazilian banking laws
were adopted in 1964, before computers were widely used.
Central Bank supervision concentrates on whether the bank
does its regulatory paperwork correctly, not on what is
really happening inside the bank." After 107
inspections of the Nacional since 1987, Central Bank
auditors reported in 1992: "It is ascertained
[Pedro: Constáta-se] that, despite the country’s
grave crisis, the Nacional manages to main the posture of
a traditional commercial bank." In 1995, months
after the Central Bank gave the Nacional a $5 billion
emergency loan, its technicians reported: "The Banco
Nacional is not a source of risk to the market."
In recent years, intense debate has taken place, both in
Brazil and elsewhere, over whether central banking should
be independent of government, so that the goal of
monetary stability can be pursued without political
interference, and whether bank supervision should be a
central bank function or be given to an independent
agency. However, the experience of many countries shows
is these structural formalities are less important, in
terms of growth and inflation, than the political will to
achieve fiscal and institutional stability. Given
continuing instability, it is hard to quarrel with the
argument of Gustavo Loyola, the current Central Bank
President, that "Central Bank independence only can
be achieved when government accounts are organized.
Otherwise any independent action by us would be crushed
by a fiscal crisis. The Central Bank now is financing the
Treasury with its own capital, which is one reason why we
face the problem of decapitalization."
The Central Bank’s balance sheet is roughly $130
billion, against $80 billion each for CEF and the Bank of
Brazil, the two biggest public banks, and $29 billion for Bradesco, the largest private bank. But the quality of
the Central Bank’s assets are deteriorating rapidly.
Its balance sheet is now loaded with bad loans absorbed
to refloat failing private banks in exchange for
marketable federal notes. Even excluding these bad
assets, its net worth is now negative (-$2.5 billion)
after losses of $13 billion from July 1994 to December
1995, thanks to mismatch of assets and liabilities.
Central Bank officials voice concern over mounting losses
and accelerating decapitalization. Chile’s Central
Bank also ran big losses from its rescue operations in
the banking crisis of the early 1980s, making it harder
to reduce interest rates and inflation, but was saved
from greater difficulties by a tight fiscal policy and
higher savings generated by private pension funds.
Brazil’s political system refuses so far to provide
this safety net.
What does Central Bank decapitalization mean? If decapitalized, a Central Bank will lack the credibility
needed to carry out monetary policy and, specifically,
will lack enough marketable assets to absorb excess money
from the economy in order to contain inflation and to
provide emergency liquidity to the financial system. To
rescue banks and to avoid inflationary swelling of the
money supply by the inflow of foreign exchange reserves,
Brazil’s Central Bank borrowed local currency equal
to roughly $53 billion on domestic financial markets
since the Real Plan was launched, in addition to another
$46 billion raised by the federal Treasury to finance its
deficits. In other words, federal authorities have
leveraged more than a year of their tax revenues ($90
billion) in short-term borrowings, accelerating in early
1996. At real interest rates of 15%-20% yearly, these
borrowings become a powerful engine of monetary expansion
to service maturing debt, a Ponzi game driven by
ballooning interest. The game is made more dicey by
mismatch between low interest earned on Brazil’s
hard currency reserves and high interest paid on domestic
public debt contracted to sterilize capital inflows. One
critical difference with Mexico is that Brazil, in
effect, has not one but three central banks. The Central
Bank of Brazil is an outgrowth of the Bank of Brazil,
which continues to carry out some central bank functions.
The third central bank is the Caixa Econômica, which
besides its banking activities runs six national
lotteries and 11 special forced savings and social
welfare funds with little transparency or supervision,
all together moving volumes of money equal to two times
the federal budget. The current banking crisis has bred
division of labor between the three central banks. The
Central Bank mainly rescues and merges private financial
institutions and the Bank of Brazil and the CEF bail out
state banks and governments. The three central banks are
more like government agencies, disguised as banks, to
distribute financial transfers. The weight of transfers
in the Brazilian economy has become more focused under
provisions of the 1988 Constitution, which Cardoso and
Covas played leading roles in shaping as Senators from
São Paulo. Transfer payments to states and
municipalities have nearly doubled, although government
lending was cut steeply. More than 1,000 new
municipalities have been created to make localities
eligible for these earmarked transfers, even though local
taxes raise less than 10% of revenues of many local
governments. Provisions for job stability and salary
escalation, written into the new Constitution, doubled
federal personnel expenses since 1988, driving efforts by
Cardoso and Covas to rewrite the Constitution as
President and Governor. Intelligent, dedicated officials
have struggled hard over the years to reduce and modify
these distortions. Progress has been made in reducing
subsidies and clarifying public accounts. Yet new
gimmicks are always appearing and their distortions have
greater impact in a climate of lower inflation. In view
of these institutional difficulties, there seems to be a
need to return to simpler forms of central banking in
which the Central Bank becomes an independent,
specialized agency dedicated to managing the money supply
and foreign exchange. Bank supervision should be assigned
to another independent agency, as it is in many other
countries. Institutional safeguards should be designed to
protect the independence and integrity of these agencies.
This is not an easy job, but there seems to be no other
alternative.
The Real Plan Needs
Deepening
The gain to
society from the present banking crisis is to reveal the
full measure of these institutional difficulties, bred by
decades of chronic inflation, giving us a deeper
understanding of the time and courage needed to achieve
the goal of political and economic stability. A resolute
effort to deal with these problems has its own rewards.
It strengthens a government’s credibility. It also
can buy time and develop a momentum of its own. Deals are
being cut with state governments for new federal loans in
exchange for shares in state banks and corporations that
could be sold or liquidated later. In these deals there
always is a danger that state governors again will
default on their debts, leading to another cycle of
renegotiation by their successors, and that employees of
public corporations will be able to block privatization
by mounting political mobilizations. More failures of
this kind would be an enormous setback for Brazil.
Credibility is gained by persistence. This test of an
anti-inflation consensus is still to be met.
The Real Plan has not failed. What it needs now is a
coherent and courageous deepening. The immediate issue is
the survival of state capitalism with its costly and
entrenched privileges. The challenge gains immediacy from
the electoral cycle, the impact of compound interest,
weakening trade figures, inflationary pressures on an
overvalued currency and President Fernando Henrique
Cardoso’s confused priorities, especially his
attempt to secure reelection. So far he has won respect
and affection because of his decency of character,
because of his eloquence in favor of market-oriented
modernization and social justice and because he has given
Brazil an honest government which is a hopeful change
from the scandal-ridden gangs of the recent past. Cardoso
repeatedly has reminded Brazilians that he is no savior
and that the changes needed to consolidate democracy and
stability can only be achieved over several years by
successive administrations. In seeking these changes,
however, he so far has relied too much on sweet talk and
personal charm and has been timid in dealing with the
politicians from whom he must win concessions to
consolidate the regime of low inflation needed to sustain
economic growth, to rebuild public institutions and
revive public investment, which Brazil needs to
strengthen its capacity to operate a complex society on a
continental scale.
The first phase of the Real Plan was relatively easy
because decisions were made by a small group of
technicians who freed prices and imports, supported an
overvalued new currency with big reserves and high
interest rates and promised fiscal reform. We now face
the second phase of the Real Plan. Hard choices must be
made by thousands of people and backed by the whole
society and promises must be kept to stop fiscal leakage
and sustain credibility. Brazilians still need convincing
that these goals must and can be achieved. But
Cardoso’s efforts to win support from the political
community to achieve fiscal balance and abolish chronic
inflation have been undermined by five big mistakes made
in his first 18 months in office:
1. Even though he served as Finance Minister for a year
before launching the Real Plan, he failed to use the
three months between his election and inauguration to
prepare specific proposals to Congress for fiscal balance
and consolidation. When these proposals finally were
presented, months later, they were weaker than needed and
the political momentum gained from his landslide election
victory was receding.
2. Further political initiative was lost by intensive
Presidential travel abroad during Cardoso’s first 15
months in office, distracting his own and public
attention from his legislative program and leaving more
room for maneuver to its opponents in Congress.
3. Instead of creating new opportunities for
federalization of state banks and continuous rollover of
state debts, Cardoso should have consolidated the fiscal
and financial framework of Brazilian federalism by
offering to help to state governors only if they first
privatize or liquidate state banks. The World Bank is
lending money to regional governments in Argentina and
Brazil for these purposes.
4. Cardoso’s premature maneuvers to change the
Constitution so he can seek reelection in 1998, which
started shortly after his inauguration in January 1995,
have generated an extra focus of disturbance in Brazilian
politics and harmed chances for reform in his first term.
Presidents Carlos Menem of Argentina and Alberto Fujimori
of Peru won constitutional changes of this kind in recent
years only after carrying out painful stabilization
programs that continue today, each based on an
anti-inflation consensus much stronger than
Brazil’s. Cardoso has not passed this test yet and
has far to go.
5. In democracies throughout the world, national
governments tend to lose mid-term elections, especially
municipal elections in which local issues and
personalities predominate. Instead of standing aside from
Brazil’s October 1996 municipal elections and
focusing on national priorities, Cardoso belatedly
plunged into the campaign for mayor of São Paulo,
already contested by three strong candidates, to stake
the prestige of his government and his party in the
candidacy of his Planning Minister, José Serra, who for
several months had disclaimed interest in running. Serra
now stands fourth in the polls with only 9% of intended
votes. The outcome of this election is likely to weaken
Cardoso politically for the rest of his four-year term
and may lead to a loss of support from other parties.
The Real Plan, if it is to progress and ultimately
succeed, cannot remain the electoral property of a single
politician. The opportunity and the responsibility for
achieving political and economic stability must be
shared. Brazil’s politics is being further confused
and agitated by the prospect of Cardoso bargaining away
the fiscal austerity demanded by the Real Plan to gain
the support of state governors and Congress to change the
1988 Constitution to make him eligible for reelection.
This kind of bargaining would evoke memories of the
concessions made by President José Sarney (1985-90)
during the Constituent Assembly to secure a fifth year
for his term of office. Instead, Cardoso could bargain
away his fading reelection option for firm and broad
support for a deepening of the Real Plan that would
guarantee him a revered place in Brazilian history and
heighten prospects for an acceleration of economic growth
and political development. In effect, Cardoso could say:
"I will seek reelection only if Congress fails to
pass measures to secure the viability and continuity of
the Real Plan. If Congress passes these measures and
other candidates agree to a binding consensus on future
reforms, my candidacy for a second term will not be
necessary."
In the recent experience of the few democracies allowing
Presidential reelection, the second term is almost always
a disappointment. This is as true in the United States in
the second terms of Eisenhower, Reagan and Nixon as in
Venezuela after the return to power of Carlos Andrés
Perez and Rafael Caldera. A more lasting triumph would be
a broader consolidation of responsible government which
the Brazilian people have sought, and only partially
achieved, in the elections of 1989, 1994 and 1996.
Responsible government will come to stay only if people
keep demanding it and if they do not lose hope.
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BRAZIL