Market Advisory Features

THE financial markets' euphoria over Brazil's $30 billion rescue by the International Monetary Fund, announced last week, was short-lived. The real soon fell back below three to the dollar, and the risk premium on Brazil's government bonds rose. President Fernando Henrique Cardoso called meetings, for August 19th, with the four main candidates to succeed him in October's election, to plead with them to commit themselves to the Fund's conditions and thus calm the markets. Though the two leftish contenders who lead the polls, Luiz Inacio Lula da Silva and Ciro Gomes, no longer talk of “renegotiating” Brazil's debts, investors worry that the country may be unable to repay them, even with the Fund's help.

The IMF package aims to boost Brazil's reserves sufficiently to ward off any further speculative attacks against the real, and to finance its big current-account deficits for this year and next. The point is to reassure lenders sufficiently for them to want to resume lending to Brazil's government and companies at reasonable rates, dissipating any talk of default. The optimists, led by Pedro Malan, the finance minister, point out that the package is bigger than the markets had hoped for, and thus bound to succeed. There are also doubters. Moody's, a credit-rating agency, this week downgraded Brazil to five notches below “investment grade”, fearing that the next president—whoever wins—may be unable to meet the Fund's demands, such as raising the current target of a 3.75% surplus on the primary budget (that is, before interest payments) if this is needed to stabilise the public debt.

Both the upbeat and the downbeat point to precedents. Brazil last defaulted on its debts only 15 years ago; Argentina did so eight months ago, despite lashings of IMF cash. On the other hand, Brazil defied predictions of default after its forced devaluation in 1999. This week's wobbles do not prove that the new bail-out is doomed: J.P. Morgan Chase, an investment bank, notes that turbulence continued for weeks after the announcement of other rescues that in the end succeeded, such as Mexico's in 1995 and South Korea's in 1997.

So who is right? A new paper* on Brazil's debt sustainability, by John Williamson of the Institute for International Economics in Washington, DC, concludes that, even with the new bail-out, things could go either way. Until the 1980s, he explains, economists took the deterministic view that any set of starting conditions had but one probable outcome. More recently, a theory of “multiple equilibria” has gained support, in which there is more than one probable outcome, with market expectations usually the deciding factor. Brazil's total public debt, or its foreign debt, both public and private, could either be sustainable or could become unmanageably large, depending on what the markets henceforth expect.

Mr Williamson starts by asking: how much debt? This is no simple matter. For instance, it is hard to know which government assets and liabilities (eg, those of state-owned banks) should be counted towards its net indebtedness. And the oscillations of the real make it hard to put a value on the chunk of debt tied to the dollar. Mr Williamson reckons that Brazil's net public debt on August 8th, the day after the IMF announced its rescue, was 841 billion reais, or $288 billion at that day's exchange rate—that is, equivalent to two-thirds of Brazilian GDP, up from 30% in 1994.

As for the foreign debt, the government has $56 billion, net of its reserves, while Brazilian firms' gross external debts are estimated at $120 billion. Though Brazilian companies and individuals have big foreign assets (estimates range from $70 billion to $170 billion), many of these are illiquid (eg, factories) and those that are liquid (eg, offshore bank accounts) would not be repatriated in an emergency: on the contrary, more Brazilians have been sending money offshore. So Mr Williamson puts the effective foreign debt at an alarming $176 billion. Brazil is already having to commit nine-tenths of its currency earnings from exports to servicing foreign debt and to financing the remittances of foreign firms' Brazilian operations.

Nevertheless, if the markets now become convinced that a default can be avoided, the real should recover some of its recent losses, lenders should resume offering money at reasonable rates of interest, and Brazil should resume reasonable growth, of around 4%, say. This would be enough, Mr Williamson reckons, for the public debt-GDP ratio to start falling, and for fears to be eased that Brazil is running out of dollars to pay its foreign debt. But if current market conditions continue, disaster looms: if the real does not recover, and Brazil has to roll over its expiring debt at current market rates, then the debt-GDP ratio could rise by another nine points this year. That, says Mr Williamson, is scary. Three-quarters of the government's debt is with local investors, who can be leaned on to keep funding it. Yet the debt ratio could reach a point where it becomes politically impossible to cut spending and raise taxes any further to try to stabilise it.

Nervous foreign banks are reeling in their credit lines to Brazilian firms, forcing these to buy dollars to repay their expiring loans, sending the real down further and so increasing the chances of an eventual default. In Brazil's crisis of 1998-99, Bill Clinton's administration leaned on American banks to roll over Brazilian debts and avoid a crunch. Mr Williamson suspects that George Bush may be less inclined to do this. Brazil's central bank has agreed with the IMF to use some of the country's reserves to lend to companies in difficulties. But a second default trigger, set off by a shortage of dollars, remains possible.

Other economists have reached conclusions similar to Mr Williamson's: investors themselves will decide whether Brazil will default on the money it owes them. They may be swayed either way by the responsibility, or otherwise, that Brazil's politicians now show, in the light of its grave situation. A few well-chosen words, or even—miraculously—some deeds, such as approving much-delayed tax reforms, might avert a disaster.

IN RETURN for staying neutral in the 1991 Gulf war, Iran persuaded Saddam Hussein to surrender some disputed territory and to start releasing the Iranian prisoners he had been holding since the two countries fought in the 1980s. More than a decade on, Iran’s leaders are hoping to exploit Mr Hussein’s renewed vulnerability. But neutrality may now be harder to maintain. Much as they hate the idea of American troops on their western border, helping George Bush in Iraq could be a last chance for the clerical regime to stay off the president’s list of condemned countries.

Ayatollah Baqer al-Hakim, a Tehran-based Iraqi dissident with followers among Iraq’s Shia majority, is deeply involved in the Iranian-Iraqi-American imbroglio. America now wants Mr Hakim’s co-operation in generating a popular uprising in Iraq, but he and his small army need Iran’s permission to do so.

The Americans are anxious to avoid a repeat of the fiasco after Mr Hussein’s defeat in 1991: an American-incited rebellion among Iraqi Shias came to a tragically bloody end when Mr Hakim’s men (and members of Iran’s Revolutionary Guard) crossed the border, and an alarmed America withdrew its support for the venture. When Mr Hakim’s brother returns later this week from talks with American officials and other Iraqi opposition leaders, he will no doubt tell the Iranians what America now expects of them.

Ever since Mr Bush included Iran in his “axis of evil”, America’s pronouncements have been menacing, but vague. Earlier this month, Zalmay Khalilzad, one of Mr Bush’s senior foreign-policy advisers, made it clear that America had despaired of Iran’s “ineffective” reformist president, Muhammad Khatami. He did not, however, as some senators and congressmen would have liked, call for a new regime in Iran. What is more, Mr Khalilzad said that America was open to discussions with Iran, notably on creating an Iraq that was no longer a threat to its neighbours.

But Mr Khatami’s distrust of Mr Bush has risen since the Americans, far from thanking the Iranian government for its help in unseating the Taliban in Afghanistan, have been accusing the president’s conservative opponents of helping al-Qaeda fighters to safety. On Tuesday, Donald Rumsfeld, the defence secretary, reacted to the “news” that Iran had handed over 16 suspected al-Qaeda fighters to Saudi Arabia by insisting that many more were still in Iran.

The Iranians responded by saying that they have over time arrested some 150 al-Qaeda suspects, nearly all of whom have already been handed over to various countries. The 16 Saudis were in fact repatriated in May. Hamid Karzai, the Afghan president, managed to sound equally friendly to Iran and to America, when Mr Khatami visited him in Kabul this week.

Iran’s government looks for rewards in a post-Hussein regime, such as the liquidation of the Iraq-based People’s Mujahedeen, which has spent the past two decades threatening Iran with bombs and bullets. But its ability to influence events in Iraq is hampered, not least by Arab countries' fear of the effects that Iran-sponsored Shia chauvinism might have on their own Shia minorities. And some influential conservative thinkers, like Amir Mohebbian, expect America to continue to threaten Iran in the hope that its internal fissures become irreparable. Despaired of by Mr Bush, Mr Khatami is in a quandary. Even if he co-operates with America, his conservative opponents could repeat the spoiling tactics they are said to have employed in Afghanistan.

For the moment, the Iranians are concentrating on short-term gains. Mr Hussein, fighting for his life, has quietly accelerated the repatriation of his remaining Iranian prisoners of war: fewer than 1,000 are thought to be still in Iraqi hands. Iraq is also keeping the Mujahedeen quiet. In return, Iran will continue to turn a blind eye to the cross-border smuggling that keeps Iraqis supplied with food and other goods.

But Iran’s co-operation has limits. At a recent meeting with Mr Hussein’s elder son, Iranian military officials are said to have refused to hand over the 100 or so war planes that Iraq misguidedly entrusted to Iran during the Gulf war.

WILL he, won’t he? Not for the first time, Alan Greenspan, the powerful chairman of the Federal Reserve—America’s central bank—has kept the pundits guessing. Few Wall Street economists had expected the Fed to cut interest rates at its regular meeting on August 13th, but a growing number, though not a majority, expect a further fall in borrowing costs at some time this year. The stockmarkets, though, reacted gloomily both to the decision not to cut and the Fed's warning about possible trouble ahead.

By shifting its economic assessment from neutral—where the risks to stability are evenly balanced between inflation and economic weakness—the Fed is, in effect, saying that it is concerned about a possible further weakening of the recovery under way since late last year. The message is clear to those familiar with the Fed’s opaque turn of phrase: if it is judged necessary, interest rates will be cut again.

The Fed’s dilemma is clear—unlike the state of the American economy. Figures released by the Department of Commerce as Mr Greenspan and his colleagues were meeting in Washington underlined the extent of uncertainty about the strength of the recovery and the outlook. Retail sales grew by 1.2% in July and year-on-year growth appears stronger than in recent months. But much of the increase was accounted for by sales of cars, which were buoyant because of widespread discounting and zero-interest loan deals by the manufacturers. Once cars are stripped out of the retail sales data, they look much weaker, and have encouraged doubts about the American consumer’s staying power over the coming months.

That would be worrisome, since shoppers have been the mainstay of the American economy over the past two years: personal consumption did much to mitigate the effects of the downturn. Should consumers decide to spend less time in the shopping malls, the prospects for recovery would look weaker than they already do.

Mr Greenspan has gone out of his way not to talk up the recovery, consistently warning that the upturn would be modest. Even after the economy’s spectacular rebound in the first quarter of this year, he warned against exaggerated expectations for growth over the year as a whole. He was right to do so. When new figures for GDP were published on July 31st, they showed that expansion in the first three months of 2002 had been slightly less impressive than first thought: though at an annualised 5%, America’s upturn comfortably outpaced that of Europe’s still-sluggish economies. More disappointing was the economy’s unexpectedly weak showing in the second quarter, a more European-style 1.1% at an annual rate.

Even President George Bush, who was holding an economic forum in Texas while the Fed was meeting, admitted that “things are kind of tough right now”, though he insisted he was optimistic about the future. Mr Bush had little but words to offer, which is why attention remained firmly on the debate at the Fed's headquarters.

The statement issued after the meeting of the Federal Open Market Committee (FOMC)—the Fed’s main policymaking body—acknowledged that financial market turbulence and a whole series of corporate accounting scandals had largely been responsible for prolonging what the Fed called the “softening in the growth of aggregate demand”. The FOMC members, who were unanimous in their verdict, took the view that the interest-rate cuts made last year—11 in all, between January and December—should be enough to deliver a continuing improvement in the business climate in the next few months.

The FOMC also took heart from productivity figures released on August 9th which, though revising down some of the spectacular numbers seen as the economic boom peaked, turned out to be better than some economists had feared. The so-called American productivity miracle has lost some of its lustre, but it has not—yet—vanished altogether (though some might quibble with the Fed’s description of underlying growth as “still robust”).

The Fed had good reason to be cautious about cutting interest rates further. In spite of some gloomy data recently, the economic picture remains quite mixed. Government figures issued on August 14th showed business inventories rose in July for the second month in a row. The modest rise was in line with expectations, however, and did not fundamentally alter the general assessment that the recovery is modest and still vulnerable.

But the housing market remains strong, with the lowest interest rates for 40 years encouraging many people to re-mortgage their homes and withdraw some of the equity to finance spending. Mr Greenspan has argued that house prices have more impact on consumers than share prices, and can point to the Fed’s own figures, which show that the average American household owns less than $20,000 worth of shares, to support his view.

The Fed clearly thinks that some of the effects of last year’s monetary loosening have yet to have their full effect—interest-rate cuts tend to work with long lags. Mr Greenspan and his colleagues are also aware that with rates already down to 1.75%, the risk that further cuts will be less effective must grow. With fewer shots in the locker, it is all the more important to save them for when they might be absolutely necessary. Mr Greenspan wants enough ammunition to respond to another severe economic shock, such as that which followed the events of September 11th, or a significant worsening of the general outlook.

Initial market reaction to the Fed statement was not heartening. But the Fed has been wary of being seen as bailing out the stockmarkets: many economists take the view that much of the fall in equity prices since the peak in 2000 is simply the correction which inevitably follows the bursting of an asset price bubble. Only if persistent stockmarket weakness threatened to undermine recovery would there be a case for action.

Few people are yet predicting the economy will slide back into a double-dip recession. Forecasts are being revised downwards—the International Monetary Fund announced it would be reassessing its forecast for American growth this year. But lower growth is not the same as recession, and The Economist’s latest poll of private forecasters shows only slight shading down of the average growth forecast for this year, to 2.7%.

In any case, a pre-emptive strike by the Fed could be counter-productive if the financial markets see it as motivated by panic among the policymakers. Mr Greenspan would not want to be seen as other than cool under pressure and he has kept his nerve. But he has also left himself with an escape route: the option of cutting interest rates should he need to. Right now, few people are willing to bet on the outcome of the Fed’s next meeting, in September.

WITH world stockmarkets—and political America—still reeling from a long list of corporate scandals which have destroyed some of the country’s biggest companies, there was at least one comfort: America’s economic recovery seemed strong. Until this week, that is. Now that reassurance, too, has been brushed aside. Figures released on August 1st showed an unexpectedly sharp rise in jobless claims for the previous week. A manufacturing survey from the Institute for Supply Management, also released on August 1st, was also disappointing: manufacturing activity, according to the survey is still rising, but only just. And labour market data published on August 2nd confirmed the impression of an economy struggling to pick up momentum. These figures seemed to confirm the most dramatic figures, which had been published by the American government a few days earlier. These showed that the economy had grown much more slowly than realised in the second quarter of this year—by only 1.1% at an annual rate. Separately, survey data published by the Federal Reserve on the same day supported the impression of a slowing, and even faltering recovery.

Compounding the gloom are the revisions made by government statisticians to earlier figures. It now turns out that last year’s recession was significantly worse than previously estimated, and growth in the first three months of 2002 a bit less impressive than earlier statistics had indicated. The backward changes will mean a downward revision to America's spectacular productivity figures and cast further doubt on the “miracle” of the new economy.

The new figures are a blow to hopes that America’s economic recovery is well established. Suddenly, the recovery looks weak and the economy looks vulnerable to further shocks. The determination of American consumers to keep spending has bolstered the economy for so long. If consumers should now lose heart, as some recent surveys suggest they might, all bets will be off. Another downturn—a so-called “double-dip” recession—would then be highly likely. With Europe and Japan still in the doldrums, the forecasts of steady global growth this year could soon look overly optimistic.

The latest figures, though gloomy, are not all bad. Business investment is still falling, but at a slower pace than before. The one, very modestly encouraging sign is a small upturn in investment in computer equipment and software, though this comes after nearly two years of decline. Consumer spending grew more slowly in the second quarter than the first, though fortunately it is still growing, at an annual rate of 1.9%. And despite recent surveys showing a decline in consumer confidence, there are plenty of signs that consumers are still spending on cars and houses, as well as on smaller items. Retail sales in May, the latest month for which figures are available, were up nearly 5% on the previous year, in volume terms. With car makers reviving low and zero-interest deals, some analysts now expect July to be the best month of the year so far for vehicle sales. And one of the technical reasons for the weakness of the latest GDP figure is a boom in imports, which were up by 23.5%, the largest rise since 1984 (exports rose at only half that pace). The weaker dollar should encourage more Americans to buy home-produced goods in future.

So the picture remains mixed, but the risks of another downturn seem greater than most economists thought they were just a few weeks ago. The latest figures are, of course, a record of what has already happened to the economy, up to the end of June. They cannot offer a clear guide to what is happening now; and significantly they exclude the last few weeks which have seen near-panic in the stockmarkets and big falls in share prices. That is where the Fed's latest survey, or “beige book” can help fill in the picture. It comprises anecdotal evidence from the twelve district Federal Reserve banks spread across America. And it makes dismal reading, providing a significantly gloomier assessment of what's happening to the economy than the previous survey published seven weeks ago. Barely half the district banks, for example, reported an unambiguous expansion in manufacturing.

There is, though, still no clear evidence about the impact on consumers of the latest market volatility, which has itself posed a challenge for the authorities. After the latest setback, few economists expect to see a rise this year. Though American interest rates are now at their lowest level for the past 40 years, some economists have speculated that the Federal Reserve, America’s central bank, would cut them still further to try to calm the markets and stabilise the economy. The latest GDP data is likely to revive such speculation in the short term.

The Fed’s next scheduled meeting to review interest rates takes place on August 13th. A further cut still seems unlikely, for two main reasons: first, it might smack of panic, and thus be counter-productive by fuelling fear and uncertainty; and second, with interest rates already so low, the Fed will probably want to retain what ammunition it still has, in case the economy is faced with a further unexpected shock, such as that on September 11th last year. But it is difficult to predict with much certainty what the Fed will do next. Alan Greenspan, the powerful Fed chairman, plays his cards close to his chest.

One man likely to be especially concerned by the latest figures is President George Bush. His approval ratings have already taken a knock after the revelations of corporate malpractice and accounting fiddles at companies like Enron and WorldCom. Mr Bush has been struggling to regain the initiative for action from a Congress determined to clamp down on such activities; some voters perceive the president as having closer ties to big business than is desirable.

A sluggish economy is therefore a huge headache for Mr Bush, and his Republican Party. Control of both the Senate and the House of Representatives now look up for grabs in the mid-term elections in November. If the Democrats gain clear control of either, Mr Bush will find his ability to get much done in the second half of his presidency drastically reduced. If on top of this, America’s economy is weak, or in recession, his own re-election in 2004 could be threatened. Everyone in the Bush administration, not least the president himself, is painfully aware of his father’s failure to get re-elected, for which most blame the recession of the early 1990s.

Mr Bush has already presided over the disappearance of the huge budget surpluses projected when he first took office. For a time it looked as if he might narrowly escape being politically damaged by the economy, with the mildest recession on record and a swift and steady recovery. At the very least, the latest figures suggest that he can no longer count on either of these.

WITH Paul O'Neill, there never seems to be a dull moment. In his eighteen months as America’s treasury secretary, Mr O’Neill, who struck many as a drab businessman on taking office, has provided governments and investors around the world with plenty of thrills. True to form, he preceded his visit to Latin America, which starts on Sunday August 4th, with yet another headline-grabbing example of the simple, or simple-minded, straight talking on which he seems to pride himself. Mr O’Neill said he was not going to Brazil, Argentina and Uruguay with offers of new financial help because there was too much chance that any new funds would immediately find their way into Swiss bank accounts. The remarks caused great offence. The Brazilian government, in particular, was outraged. The American ambassador in Brazil and the treasury in Washington have spent the run-up to the trip on the defensive, trying to soothe ruffled feathers.

As entertaining as the episode has been for fans of Mr O'Neill, it is a little unfortunate for Latin America, because the now-troubled continent, along with the international financial community, is counting on America to lead it out of economic crisis. The problems facing the three countries that Mr O’Neill will be visiting are all different, and all require different solutions. The one thing they have in common is that outside help is needed to resolve them; without America, that help is unlikely to be forthcoming. America has a veto in the ruling councils of the International Monetary Fund (IMF) and the World Bank. Without its agreement, there will be no new IMF cash for any of the three.

In the long term, Brazil’s problems are probably the most worrying, if for no other reason than its huge size. But the crisis in Uruguay looks most urgent, and that in Argentina most intractable. Uruguay’s problem is primarily one of contagion from its larger western neighbour. For months, it looked as if the economic and political collapse in Argentina would not spread to other countries in the way that previous emerging-market crises have enveloped a whole region. Investors, on the whole, continued to look at each country on its merits.

Uruguay, though, is a small economy. Its currency, the peso, has lost about half its value since March, pushing up the cost of its public debt to alarming levels—it is now roughly 100% of GDP. Most bank deposits are in dollars, and many of those are held by Argentines, whose bank accounts at home remain frozen. A run on the banks is therefore draining the country’s foreign-exchange reserves, by around $500m a month. On July 30th, with reserves down to $655m, the government closed the banks until August 5th, while officials tried to negotiate disbursement of the remainder of an IMF loan already agreed.

Even a deal with the IMF, though, can bring only a brief respite, unless confidence in the banks is restored. Without that, it is hard to see how Uruguay will be able to avoid a debt default. This would be nearly as large as the record $133 billion on which Argentina defaulted at the end of last year, but it would be the second Latin American default in a few months, and so would be bound to make investors even more anxious than they already are.

A Brazilian default would have far more serious consequences, though, and this too remains a possibility. Brazil’s crisis is home-grown. The presidential election in October, and the prospect of a victory by a candidate seen as less market friendly, has caused the upset. Since April, when investors started to fret about the prospect of a leftish victor, the Brazilian currency has weakened significantly. At one point last week, it had lost lost about a third of its value, though it subsequently recovered quite sharply. The currency’s weakness has pushed up the cost of servicing the country’s debt burden, which itself has risen to almost 60% of GDP, from 52.5% a year ago, according to the central bank. The risk premium on Brazilian bonds has soared, leading some analysts to fear that the debt will become unserviceable. Some think the government should start an orderly restructuring of its debt, to avoid a more chaotic default.

But the structure of Brazil’s public debt is fundamentally different than that of Uruguay. Brazil’s public foreign debt is both relatively small and long-term. Most of Brazil’s debt is held by local investors, who have in the past reaped high returns from government bonds. Only a few have so far switched to cash.

Meanwhile, Brazilian officials are in talks with the IMF about a new loan agreement. The IMF said on August 1st that these discussions are being pursued “intensively”. But it also said that no new agreement can be reached without what a spokesman called an “understanding” from the main presidential candidates that they will maintain basic economic policies. The two left-leaning candidates who are currently ahead in the opinion polls appear to have ruled out such a deal. Although front-runner Luiz Inacio Lula da Silva has tried to adopt a more politically moderate tone recently, he said on August 1st that he would “prefer to look for another remedy and not rely on the IMF”. The other left-wing candidate, Ciro Gomes, who is now in second place in the polls, also ruled out a commitment to an IMF programme. “No way”, he said. The two men could find themselves under intense pressure to modify their positions if that was the only obstacle to a new IMF deal.

The race may change when the government candidate, Jose Serra, who is currently trailing third, gets access to the dominant share of free television time from mid-August. If Mr Serra’s fortunes improve and if the IMF holds out the prospect of extra assistance, investors’ near-panic might start to subside. Soothing words of support for Brazil from Mr O’Neill might also help, but the government would be unwise to count on anything too concrete. Mr O’Neill is known not to favour bail-outs.

O'Neill's carrying no cheques

Argentina’s embattled caretaker government knows that only too well. After agreeing to a rescue package in August last year, America has steadfastly blocked further help until substantial economic reforms have been put in place. Most economists now acknowledge that the last bail-out simply postponed the crisis without helping to mitigate it. Hence the insistence of the IMF—and its paymasters—that reform must this time be delivered in advance. When negotiations reached an apparent stalemate on the nature of the reforms needed, an independent panel of advisers, known as the four wise men, went to Argentina in July: their report, though, seems to dodge some of the basic differences between Washington and Buenos Aires.

So the interim government of President Eduardo Duhalde will be seeking to persuade Mr O’Neill that its case is a deserving one. Mr Duhalde has brought forward the presidential elections to March next year, in the hope of giving Argentina a fresh political start and, he hopes, having secured a new deal with the IMF. He may be disapppointed. Mr O’Neill has said he wants to see Argentina return to a position of strength and stability. He has not said how he envisages that happening.