When the debt crisis erupted in Mexico in 1982, and shortly thereafter elsewhere in Latin America, observers were divided on its origins. Some blamed the depressed level of world economic activity, high interest rates and low commodity prices. Others argued that debtor countries had severely mismanaged their economies through overvalued exchange rates, pervasive budget deficits, unproductive spending and capital flight.


In Discussion Paper No. 243, Eliana Cardoso and Research Fellow Rudiger Dornbusch assess the roles played by the global macroeconomic environment and by domestic policies in shaping the Brazilian debt crisis and assess the prospects for Brazil's sovereign debt after five years of the `muddling-through' strategy. Dornbusch and Cardoso argue that this strategy has clearly failed: Brazil's debt/GDP ratio today is far higher than it was in 1982 and the period since has been highly undesirable from a longer-run perspective, even though it may have served the short-run interests of the creditors.

Brazil's experience in the 1980s does not conform to the common impression of domestic mismanagement, capital flight, overvaluation or massive inefficiency in the public sector. according to the authors. They estimate that between 1978 and 1982, $35 billion, or 75% of Brazil's total net debt accumulation, can be accounted for by reduced exports, increased real interest rates and higher real oil prices. This does not imply that Brazilian policy during this period was always correct. Relatively permanent shocks necessitate adjustment and the Brazilian policy mistake, if any, was failure to adjust to such shocks. But then in 1982, it should be remembered, everyone was convinced that the world economic shock was transitory.
Dornbusch and Cardoso do not attribute the failure of the muddling-through strategy to slow growth in industrialized countries: actual growth exceeded IMF forecasts between 1982 and 1986. The strategy failed for other reasons. Real commodity prices kept on falling even from their 1982 levels and by early 1987 the real price of non-oil commodities was at its lowest level since the 1930s.
Brazil also encountered the `transfer problem' in its attempt to transfer resources representing a significant share of GDP to its creditors. Its effort in the budget to service debts (including interest) led to inflationary money creation. In addition, the effort to transfer resources abroad required a depreciation of the real exchange rate, which is itself inflationary. The transfer of resources also required a Brazilian trade surplus: this might have come from reduced consumption (public or private) but in fact came from reduced investment damaging the prospects for sustainable growth in Brazil.
These difficulties highlight the domestic costs of bringing about, in the budget and in the external balance, a premature transfer of real resources towards the creditors, the authors argue. The costs take the form of depressed living standards, hyperinflation, sharply reduced investment, and hence the prospect of reduced long-term growth opportunities.
Dornbusch and Cardoso propose recycling a large part of the interest payments into Brazil, eliminating the need for trade surpluses and the resulting crowding-out of investment. The major part of the debt would be paid in `Baker certificates' cruzados which are in part automatically re-lent to the government to finance public sector investment and in part are freely disposable to acquire assets in Brazil but which cannot be transferred out of Brazil. In combination with a serious fiscal reform, this would restore normal growth and investment and so provide the best possible prospect for the ultimate transfer of resources to the creditors.

Brazilian Debt: A Requiem for Muddling Through Rudiger Dornbusch and Eliana A Cardoso

Discussion Paper, No. 243, June 1988 (IM)