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Lula's Problem
Subject Economic Growth
Topic International Finance and Economic Policy
Key Words Interest Rates, Economic Growth, Debt, Inflation
News Story

With the national currency, the real, slipping, public debt and the risk of default mounting, Luis Inacio Lula da Silva, a former left-wing labor leader, was elected president of Brazil on October 27. Lula, as Mr. da Silva is generally known, is being called upon to solve Brazil's serious economic problems. Although Lula is not a proponent of US-style capitalism, he has indicated that he accepts the need to pursue disciplined economic policies. He intends to honor the country's debts and to stick to IMF spending and inflation limits. Whether Lula's leadership and the $30 billion International Monetary Fund (IMF) loan will be sufficient to rescue Brazil is unknown at this time.

Whether anyone is capable of saving Brazil's economy is uncertain. Many economists believe that Brazil may soon experience "exploding debt dynamics," where monthly interest payments increase faster than the government's ability to pay, thereby causing total indebtedness to rise. Lack of confidence in Brazil's ability and willingness to repay its debt has depressed bond prices, resulting in increased interest rates. The collapse of the real has added to the government's debt, as many bonds are linked to the exchange rate, with payments rising automatically whenever the real falls. Brazil's net public debt, less than a third of its gross domestic product in 1994, jumped to 64 percent at the end of September. International financial markets may be betting that Brazil will follow Argentina, defaulting on its bonds and suffering a severe economic contraction. These markets may be betting against the real and their actions sometimes turn beliefs into truth.

In order to avoid dire economic consequences, interest rates must fall and the real must rise substantially. Since mid-October, the real has risen 11 percent, fueling hope that Lula will be able to rescue Brazil's economy. But if Lula is less than perfect, traditional policies and IMF prescriptions may be abandoned in favor of capital controls and debt restructuring. Such moves would wipe out the savings and pensions of the middle class and Lula, it is said, recognizes the need to avoid this.


(Updated January 2, 2003)

Questions
1.

The IMF's recommendation for fiscal austerity includes generating a budget surplus of 3.75 percent of GDP. How is a budget surplus defined? Assuming Brazil is currently running a budget deficit, how can it produce a surplus?

2. Lula is an advocate for eliminating hunger and homelessness. Given the current state of Brazil's economy why might he avoid expensive new aid programs?
3. What happens to Brazil's dollar-denominated debt when the real depreciates? What happens to Brazil's total interest payments?
Source Paul Blustein, "Lulu's Market Challenge," The Washington Post, November 6, 2002.

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