Brazil the latest economy the US must monitor for global risk

In the run-up to this October’s Brazilian elections, the country’s presidential hopefuls would do well to heed the International Monetary Fund’s (IMF) latest and unusually explicit warning as to the urgent need for Brazil to address its very shaky public finances. 

Should the IMF’s advice fall on deaf ears and the country then experience a public debt and exchange rate crisis, its leaders should not turn around and blame the IMF for not having warned them in a timely manner.

{mosads}So too should U.S. policymakers in general and the Federal Reserve in particular pay close attention to the IMF’s warning about the very sorry state of Brazil’s public finances.

After all, Brazil is the world’s eighth-largest economy. With a public debt of more than $1.5 trillion, a Brazilian debt crisis has the potential to cause real waves in the global financial system.

The IMF underlines that in the best of circumstances, Brazil’s public debt is on a dangerous path.

It forecasts that even if Brazil was to experience a reasonable economic recovery and take timely measures to curb its outsized budget deficit, the country’s public debt would rise from its present level of 84 percent of GDP to a lofty 95 percent of GDP within the next three years.

Such a debt level in an emerging-market economy normally spells real trouble.

More alarming yet, the IMF warns that Brazil’s public debt could very well rise to a staggering 120 percent of GDP should the country experience another recession, should global liquidity conditions become more restrictive and should no action be taken to bring the country’s public finances under control.

It is for this reason that the IMF is imploring Brazil’s presidential hopefuls to be very responsible in what they say about the need for budget belt-tightening as well as about the urgent need for pension reform. The IMF explicitly warns that failure to do so could very well spook the markets and precipitate a Brazilian exchange rate crisis.

The timing of the IMF’s warnings to Brazil would seem to be all the more poignant in light of recent global financial market developments. Global liquidity is already drying up as the Federal Reserve, the European Central Bank and the Bank of England all signal their intentions to proceed with monetary policy normalization.

This is already leading to a reversal in the very large capital flows to the emerging markets that took place in recent years. It has also led to acute exchange market pressure in the emerging market economies like Argentina, Brazil, South Africa and Turkey that have all seen their currencies depreciate by 20 percent or more this year.

Hopefully, over the next few months in the run up to the Brazilian elections, the presidential candidates will be responsible and will not make expensive promises that the country can ill-afford to keep. However, this is far from the most likely scenario.

With a massive corruption scandal at Petrobras, the state oil company, having tarnished almost the entirety of Brazil’s political class, Brazilian populism is on the march, and political divisions have increased in the country.

This is likely to heighten political uncertainty and make for a hard-fought Brazilian election that will not be conducive to candidates being fiscally responsible.

Needless to add, the dismal Brazilian outlook is all the more troubling from a U.S. policymaker’s perspective in that Brazil is far from the only trouble spot in the global economy. Full-blown currency crises are already occurring in Argentina and Turkey.

Italy, the eurozone’s third-largest economy, seems to be sleepwalking to a debt crisis of its own; and China, the world’s second-largest economy, is showing clear signs of slowing down in part at least due to U.S.-China trade tensions. 

All of which has to make one hope that, in formulating both trade and monetary policy in the remainder of the year, both the Trump administration and the Federal Reserve have Brazil very much on their radar screens.

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.