Global Economic Environment of the Firm
Macro Economics
The questions should be answered using Macro Economic arguments using graduate level thinking. Please pay attention to the questions asked. More detail, the better.
Question: Crisis of Confidence in Government Finances
Fixing the finances
Feb 20th 2003
From The Economist print edition
FOR the past year the pundits have been arguing over whether Brazil is bound to follow Argentina into default. Even after the IMF stepped in with a $30 billion loan last August, some remained convinced that Brazil's public-debt burden, which almost doubled during Mr Cardoso's presidency, to 56% of GDP, had become unsustainable, and that sooner or later the country would have to “restructure”, willingly or otherwise. Others maintained that the country's twin deficits were well under control, with the government consistently running primary surpluses (before interest payments) and the current-account gap shrinking, thanks to a plunge in the real, all of which made a default seem a lot less likely.
John Williamson of the Institute for International Economics in Washington, DC, was one of several economists to crunch the numbers and conclude that a default by Brazil is neither inevitable nor impossible, but will depend largely on investors' expectations. Since most public debt is linked either to short-term interest rates or to the real's exchange rate, Mr Williamson reckoned that, unless these recovered, the debt burden would continue to rise. Investors would take fright and the real would plunge further. Attempts to shore it up by pushing interest rates even higher would merely hasten the end.
The no-default camp says there is a way out of this. Most of the public debt is denominated in reals (including some that is dollar-indexed but pays out in local currency), so in a tight spot the government could just print more reals to repay any debt it could not roll over. The trouble is that this would crank up inflation, which disproportionately hurts the poorest. Would Brazil's first left-wing president really rather default on the poor than on the rich investors in government bonds?
Even if he did, printing money to keep repaying the domestic debt might not avoid financial collapse. The government's foreign-currency-denominated debt, although a minority of the total, is significant, amounting to about $82 billion of the public debt of $250 billion, and Brazilian firms have foreign-currency debts of about $96 billion. Brazil as a whole is already using 91% of its export earnings to service its foreign debt. If foreign banks called in their credit lines, Brazil would soon run out of foreign currency to keep servicing its overseas debt and thus go bust by another means. That is why, when Antônio Palocci was chosen as Lula's finance minister, he went straight off to America to beg the big banks to keep their credit lines open.
However, if investors become convinced that the government has got its finances under control, the real will recover and interest rates will fall, making the cost of servicing the debt more bearable. Lower interest rates, and an increased willingness by both foreign and domestic banks to lend, would boost the economy. An improved domestic outlook would encourage multinationals to restart their stalled investment programmes in Brazil, further boosting growth. Since the debt-GDP ratio depends on the trajectory of GDP as well as that of the debt, any boost to growth would bring a further improvement in Brazil's debt ratio which would reassure investors. All the government has to do is persuade investors that everything is going to be fine, and it will be. Lula, literally, has to pull off a confidence trick.
Questions:
I: Read the last paragraph in the above article. Explain why if the “government has got it finances under control,” the real will recover and interest rates will fall?
II: The article says, “Even if he did, printing money to keep repaying the domestic debt might not avoid financial collapse. The government's foreign-currency-denominated debt…is significant, amounting to about $82 billion of the public debt of $250 billion…”
a. Explain why printing money to keep repaying the domestic debt may not avoid a financial collapse?
b. How are the investors in Brazil likely to react if they come to expect that the Brazilian Government may not be able to pay its foreign-currency-denominated debt?