The Brazilian economic canary in the coal mine

Troubles come to the Brazilian economy not as single spies but in battalions. Especially at a time of rising U.S. interest rates, this hardly bodes well for the international economy. Brazil is Latin America’s largest economy, so a full-blown Brazilian economic crisis could have a domino effect on the rest of Latin America’s troubled economy. It could do so in much the same way as economic troubles in Thailand triggered the 1998 Asian economic crisis.

Even before the COVID-19 pandemic delivered Brazil the severest of public health and economic blows, the country had a troubled economy. The pandemic found a Brazil still struggling to kickstart its economy after the unusually deep 2015-2016 economic recession. It also found Brazil with an uncomfortably large budget deficit and a record-high public debt level. 

In no small measure due to Brazilian President Jair Bolsonaro’s incompetence and apparent indifference, the COVID-19 pandemic has exacted a high human toll on Brazil. To date, some 277,000 Brazilians have lost their lives due to COVID. With Brazil’s vaccination program still in first gear and infections still surging, there seems to be little sign of light at the end of the COVID-19 tunnel for Brazil. 

Thanks to a very generous public spending program, including very popular handouts to the poorest segments of the Brazilian population, Bolsonaro has succeeded in limiting the depth of the country’s COVID-induced economic recession. However, he has done so at a considerable cost to the country’s public finances. According to the International Monetary Fund (IMF), in 2020 Brazil’s budget deficit ballooned to almost 15 percent of the country’s Gross Domestic Product, while its public debt skyrocketed to a level approximately the size of its economy.

Adding to the country’s economic and political woes has been a Brazilian Supreme Court judge’s decision to overturn former far-left President Luiz Inacio Lula da Silva’s criminal conviction. That opens the way for Lula to challenge Bolsonaro in next year’s Brazilian presidential election. It also makes it all the more difficult for Bolsonaro to begin addressing the country’s highly precarious public finances or to begin reforming its sclerotic economy.

In an environment of ample global liquidity, markets have been very forgiving of Brazil’s public finance excesses. However, with the bold Biden budget stimulus now threatening to cause the U.S. economy to overheat by year-end, it is very unlikely that today’s ultra-easy global liquidity conditions will last very long. As if to underline this point, since the start of the year, the key U.S. 10-year Treasury bond yield has moved up sharply from less than 1 percent to its present level of over 1.5 percent.

The gathering clouds over the Brazilian economy have not gone unnoticed by the markets. Since the start of the year, the Brazilian currency has been among the world’s worst performing currencies and now stands at close to its all-time low. Meanwhile, the Brazilian government is running into increased difficulties in placing its debt as reflected in higher government bond yields and in the fact that almost 30 percent of the country’s debt comes due over the next year.

In 1998, as global liquidity conditions tightened, Thailand’s economic troubles triggered the Asian currency crisis. With Brazil being a much larger economy and having much worse public finances than Thailand in 1998, one has to wonder whether Brazil’s troubles might not trigger a more widespread emerging market debt crisis if U.S. interest rates do indeed continue to rise out of fear of U.S. economic overheating. 

All of this should be of particular concern to U.S. economic policymakers. With emerging market economies now constituting around half of the global economy, an emerging market debt crisis today would be much more serious than the 1998 Asian currency crisis. With U.S. interest rates likely to rise for the remainder of this year, it would not seem to be too early for the Biden administration to start thinking about how it would respond to an emerging market debt crisis.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.