Financial markets conspire to make Brazil's economic crisis even worse

Another emerging markets crisis threatens as Brazil struggles to pay mounting debts

When the Brazilian World Cup football team takes to the field tomorrow, its supporters will be praying for a win to take their minds off their domestic economic woes.

The countrywide celebrations after Friday's elimination of England certainly took the edge off the collapse of its currency, the real, to an all-time low against the dollar.

But there is no hiding from the harsh reality. There are mounting fears the giant Latin American economy is about to follow its neighbour Argentina into default.

Not only would this bring misery to the Brazilian people. As the second national financial crisis this year, it could send shockwaves around a recession-hit global economy.

"If Brazil went into a major crisis, I don't think you could comfortably say it could be easily ring-fenced," said David Riley, managing director of sovereign ratings at the credit agency Fitch.

Last week Fitch cut its ratings on Brazil and slapped a negative outlook warning on its prospects. It was not alone; Moody's Investor Services cut its assessment to negative from stable.

Mr Riley said the first countries to feel the impact would be emerging markets, which have already suffered as investors took flight from any risky investments in the wake of the Argentina crisis.

Uruguay has already felt the impact. It was forced to abandon its exchange-rate peg last week, and saw its currency fall 10 per cent as a result.

One of the casualties could be Turkey, which has been hit by the six-week illness of its Prime Minister Bulent Ecevit. Ironically Turkey is Brazil's opponent in tomorrow's semi-final.

"How severe the impact would be on developed markets is difficult to say but it certainly won't help matters in the US," Mr Riley said.

For the world's largest economy, a Brazilian crisis would eliminate another potential purchaser of US goods on its doorstep. But more importantly it could further undermine investor confidence.

This could start a vicious spiral for the world economy, as it was the collective decision of the financial markets to turn against Brazil that triggered the crisis. Both Fitch and Moody's cited the downturn in investor sentiment in their warnings. "The change in outlook reflects the real and potentially lasting impact on the government debt dynamics that can result from a sharply negative change in investors' sentiment that has emerged in recent weeks," Moody's said.

But the curious factor in this change of outlook is that, as Moody's points out, it has taken place against a background of a "sound macroeconomic policy mix". In fact even a few months ago, a crisis in Brazil did not look likely.

The economy had withstood the impact of the Argentine collapse, mainly thanks to its decision to devalue its currency some four years before its neighbour was forced to do so.

But as investors' mood has shifted, Brazil's huge debt mountain has become more exposed. The nation has overall public debt of $230bn (£160bn), or 53 per cent of its annual GDP, although only 28 per cent of that is internationally traded.

However, Brazil has been forced to pay a higher and higher premium to gain or renegotiate loans. The risk spread on its bonds – how much more it has to pay in interest compared with US treasuries – has widened to 1,500 basis points from 750 last year.

In other words borrowers are paying a 15 per cent premium at a time when inflation is about 4.5 per cent.

In a sign of the important role the markets will play in Brazil's survival, the president of its central bank, Arminio Fraga, will arrive in London tomorrow and meet bankers to try to stem their recent sales of Brazilian bonds, stocks and currency.

At the heart of the markets' concern is the upcoming presidential election and the surge in popularity of the Workers' Party and its left-wing leader Luiz Inácio Lula da Silva.

But Fitch's Mr Riley said he was more concerned over medium-term issues including high levels of debt, a struggling economy that has grown 0.5 per cent in the past year and the risk that continued low growth would exacerbate poverty and lead to political instability.

"In the near term it would not take too much to put Brazil in a vicious cycle where the medium-term issues get crystallised into near-term problems," he said.

For pressure groups that are growing increasingly concerned about the fate of Latin American peoples, this would be a great injustice.

Ann Pettifor, director of Jubilee Research, said Brazil should serve as a reminder, just a few months after Argentina, of the role played by the financial markets and institutions such as the International Monetary Fund and the World Bank.

"This poor little country has been told by the IMF to expose itself to the global financial markets but when it fails they will blame this all on a workers' leader," she said.

Rather than be forced to borrow money at rapidly appreciating rates of interest, she said countries such as Brazil that face a potential crisis should be able to call a stand-still on its debts.

Jubilee advocates a system similar to Chapter 11 bankruptcy procedures that enable US companies to restructure while keeping creditors at bay.

For its part the IMF has already embarked on a major review of how countries at risk of default could be granted a temporary stay on their interest payments.

It has been highly supportive of the Brazilian administration, which last week drew about £7bn of reserves from the IMF at the same time as toughening up its target for the public finances.

"The fund is strongly supportive of the Brazilian authorities' efforts," a spokesman said. "They have taken bold moves quickly, not waiting for developments to force them to act – rather, that they have taken the initiative."

But the global authorities appeared complacent after their reassurances over Argentina turned out to be misplaced. For this reason, if no other, Brazil will be near the top of the agenda when the leaders of the Group of Eight nations meet in Canada tomorrow – and not just because of an interest in the outcome of its World Cup tie.