IMF's $30bn bailout for Brazil 'sends lenders the wrong signal'

Washington changes tack to sanction rescue packages for Latin America

Last year Paul O'Neill, the US Treasury Secretary, sent out a clear message that the days of multibillion-dollar bailouts for failing countries were over. "The IMF, the World Bank and the regional development banks have spent hundreds of billions of dollars to reduce poverty and address financial crises around the globe," he said. "Visit some of the poorest nations in the world, and you will see that we have too little to show for it."

A year on – and in the wake of January's debt default by Argentina amid scenes of rioting and violent protests – the world seems to have changed.

Yesterday Mr O'Neill returned to Washington after a four-day tour of Latin American during which he had sanctioned a $1.5bn (£1bn) US loan for Uruguay and backed a record $30bn IMF bailout for Brazil. The package, announced after New York markets closed on Wednesday, outstripped the $20bn to $25bn anticipated by analysts and eased fears Brazil might be forced to default on its $250bn public debt mountain.

With Argentina facing renewed threats of default on its debts, most observers believe that another Latin American bailout is in the offing.

What has triggered such a turnaround in policy – dubbed by one analyst as "back to the future"? Conspiracy theorists are already at work, raising the idea that the US Treasury acted to avert of a repeat of the collapse of Long Term Capital Management, the hedge fund brought down by the 1998 Russian default.

"If that was the objective then one can say with certainty that it worked," one observer said.

Financial markets yesterday surged across the world as investors hailed the move as a sign that the international financial powers were determined to stamp out economic crisis at any cost. In New York the stock market continued its recovery on relief that Wall Street's largest banks would not be hit by default of their loans to Brazil, at least in the short term. Citicorp and JP Morgan, which have major exposures to the region, both rose strongly. In June Citicorp reported $9.3bn of outstanding claims on Brazil.

Charles Dallara, managing director of the Institute of International Finance, which represents 320 major financial houses, said the IMF had provided leadership. "This will help minimise the risk of contagion within Latin America," he told The Independent. "There was a real risk given the weak state of global markets and the problems that beset the G7 countries that it created potential for systemic deterioration."

Mr O'Neill's host nations during his trip were also happy. Brazil's currency soared more than 5 per cent as did its stock market, while government bonds leapt more than 7.5 per cent. The relief was felt across Latin America as JP Morgan's emerging market bond index – a guide to perceived risk for investors – gained 1.7 per cent.

Mr O'Neill said the US approved of the Brazilian bailout because the country had shown that it had "the right economic policies in place to maintain stability so that the economy can continue to grow". On Uruguay he went further, saying: "A government that puts in place and follows through on such strong economic policies merits the consistent support of the international financial institutions and the US."

However, emerging markets analysts said the details of the Brazilian deal asked more questions than they answered. Although the loan is worth $30bn, the IMF negotiated that only $6bn would be paid this year with the remaining 80 per cent disbursed next year. "By reducing vulnerabilities and uncertainties, a new programme provides a bridge to the new administration starting in 2003," said Horst Koehler, the IMF's managing director.

Sheetal Radia, emerging markets economist at Standard & Poor's MMS, said that in other words the IMF had agreed a bailout without knowing who would be running the country after October's elections. "We don't know what the new government will do until it gets in. Will the new government stick to the IMF's targets? There are loads of questions to be answered," he said.

The Workers' Party candidate for president, Luiz Inacio (Lula) da Silva, and the leftist ex-finance minister Ciro Gomes have a healthy lead in the polls over the financial markets' favoured candidate, the government-backed Jose Serra.

Access to the new IMF cash in 2003 is tied to Brazil maintaining its current fiscal policy, so the deal could potentially be derailed if either Mr Gomes or Lula refused to commit themselves to it. Yesterday Jose Alencar, Lula's running mate, appeared to back the plan, saying: "Any candidate will have to live up to the accord. We can't be against going to the IMF."

David Lubin, emerging markets economist at HSBC, said it was a "cheap deal" for both sides. "It is cheap for the IMF because it spends $6bn but gets the headline benefits of a $30bn package," he said.

It was cheap for Brazil because the IMF had not insisted on a tougher fiscal regime than it already faced. "Brazil gets a lot for not doing very much," he added.

Mr Radia said there were wider implications for emerging market governments and investors from yesterday's deal. "It sends a signal that every time Brazil gets in trouble the IMF will write a cheque. There's no incentive to tackle the problems," he said. "It reaffirms my view that if a country is considered important enough and if it is on the verge of a default then the IMF will come in and bail it out."

Economists call this "moral hazard" – where investors are happy to lend in the knowledge they will be bailed out. The IMF and the US's decision to allow Argentina to collapse under the weight of its debts, leaving Western banks with heavy losses, was seen as an example of the new regime. "We had been consistently led to believe that the Bush administration was taking a much less interventionist approach," Mr Lubin said. "But we have to look at things case by case. That's always the way the US has liked to play it."

The New Economics Foundation, a London think-tank at the forefront of calls for an insolvency process to help indebted countries, said yesterday's move resembled those for Asia and Russia. Andrew Simms, its policy director, said: "The IMF, through its commitment towards progressive capital liberalisation, goes around soaking the forest with petrol and then wonders why it needs bigger and bigger fire engines to deal with it."