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The Man Who Saved Brazil

Mar 1, 2002

Armínio Fraga has saved Brazil from calamity twice since he took over as central bank governor early in 1999. When Argentina's financial crisis began intensifying last year, he and his team at the central bank were ready. By May 2001, Brazil had already raised three-quarters of the $6.68 billion in financing it would get from the international markets in 2001. The central bank's official reserves were well stocked at $37.23 billion. Under Fraga, the central bank moved interest rates up 375 basis points at the beginning of the year.
Brazil had a rough ride last year as the Argentine crisis deepened. The economy sputtered but did not stop growing, in spite of power shortages and a weakening global economy. The September 11th attacks in the US further pummeled the Brazilian economy and 10 days later, the real hit an historic low of R$2.80 per dollar. Yet, by the end of 2001, the real had recovered by 21% and the price of Brazilian bonds was rising even as Argentina's economy staggered and fell. It was clear that Brazil would escape the effects of Argentina's troubles, confounding fears in the international markets that it would be contaminated. giving rise to a region-wide crisis of confidence.
Much of the credit for this goes to Fraga. Market participants recognize that Brazil made it through a particularly turbulent year thanks his remarkable abilities as a central banker. Roberto Setúbal, president of Banco Itaú, one of Brazil's largest banks, comments, "Armínio stands out for having plenty of common sense, for always being very calm in moments of tension. His positions are thought out in cold, unemotional, very technical terms. His strengths are consistency and tranquility. He does not contradict himself."
Fraga's achievement in 2001 was no fluke. The previous year he had steered Brazil through a period of steeply rising oil prices and even dared to cut interest rates aggressively, without allowing inflation to rise out of control. Fraga made his reputation in 1999, when he averted a disaster that could have simultaneously set Brazil back years and sparked yet another emerging market financial crisis.
In early 1999, the country's deficit-ridden finances were close to collapse after international confidence withered and the government had cut the real loose from its peg to the dollar. The political authority of recently reelected President Fernando Henrique Cardoso was hanging by a thread. It was he who had created the real and pegged it to the dollar in 1994 to help stamp out inflation.
Economists forecast serious trouble. Joseph Petry, then Latin America economist at Salomon Smith Barney (SSB), warned,"There is an enormous fiscal deficit and the economy is moving toward a deep recession. SSB maintains its [forecast] of a 6% GDP contraction for 1999, inflation of 35% and a double-digit fiscal deficit."
Yet the crisis was short-lived. By early March 1999, Fraga had calmed the market's nerves. He pushed interest rates up to nearly 45%, intervened in the currency and bond markets and announced that the central bank would focus on controlling inflation and would no longer defend the real. The currency soon recovered and Fraga cut interest rates. He gave a masterful speech at the March 1999 annual meeting of the Inter-American Development Bank in Paris that exuded confidence. He drew a line under the crisis in April when Brazil issued a $2 billion, five-year bond led by Salomon Smith Barney and Morgan Stanley. The economy held up well in 1999 and was all set for a burst of growth in 2000.
All Eyes On Him
It is natural that Fraga should be celebrated for these achievements. Brazil and the outside world are looking to him as a guarantor of stability in Brazil as the country prepares for presidential elections in October and change of government in January 2003, ending Cardoso's eight-year rule.
Fraga, 44, makes an implausible hero. He is balding, slightly paunchy and of medium stature. He is a terrible fidgeter, barely capable of keeping still for long. His favorite pastimes are playing golf and reading academic economics texts. Although he is personally wealthy, Fraga is modest and lacks any of the arrogance or love of ostentation of many who have preceded him in high office. But his personal authority is beyond question. He has a mind like a steel trap. He is respected in the markets for his ability to predict trends early and play tough when necessary.
Bill Rhodes, senior vice chairman of Citigroup, says, "Armínio is a very quick study. He grasps problems very quickly. He is willing to act with decisiveness and when he gives you his word, he keeps it." Rhodes adds, "He's open-minded. He's a listener but so many times, central bank governors and finance ministers like to preach and not listen."
Yet Fraga has few illusions about his calling. "One of our tasks [as economists] is to bring coherence, logic and rationality to situations which are sometimes emotional and fed by sentiment and not reason. This makes it hard [for people] to accept our work," he said last year. "Often we have to take an unpleasant position and say that there is a budget or warn about the unforeseen consequences of some decision or policy and this is not always very pleasant. The economist is often a messenger and the messenger runs the risk of being shot by someone who didn't like the message."
Fraga has plenty of critics who say he has helped drive up the national debt unnecessarily and kept interest rates at excessively high levels. Although this strangled growth, the central bank missed its 2001 inflation target.
Hometown Hero
Yet Fraga is popular at home. His candor, modesty and personal integrity count for a lot. His outstanding record at the central bank has given him considerable political stature, making his arguments and views all the more compelling. Fraga is a brilliant academic economist with a doctorate from Princeton, and is used to winning policy arguments. He is that rare animal: a Brazilian central banker who is an accomplished academic, with personal experience of life in the markets and an extensive international career. Fraga is politically adroit, and it is an unwise politician who crosses him.
It was a different story three years ago. During his confirmation hearings before the Senate, hostile questioners grilled him over his previous job as a managing director at Soros Fund Management in New York between 1993-1999. Denounced in the press as a speculator and poacher-turned-gamekeeper, Fraga also had to face down charges that George Soros and his funds had used prior knowledge of Fraga's appointment to make money in the markets.
In hearings broadcast on national television, Fraga impressed many with his quiet, dignified defense. He convinced his critics - who included Paul Krugman, the Princeton economist and New York Times columnist - to retract their accusations of insider trading. Krugman remains mortified to this day for his lapse of judgment. Fraga's political connections - he had previously served as international director at the central bank - and the collapse of the real made moot any further discussion of his suitability for the job.
Fraga is now widely considered one of the most gifted central bankers of his generation. Mohamed El-Erian, managing director at Pimco, the US fund manager that is the largest investor in emerging market bonds, comments that, "He has done what all brilliant central bankers do. He focused on the destination, which is to have a monetary policy anchored on inflation targeting."
Fraga explained to the markets that this was the only sensible policy for a volatile economy with a floating exchange rate. He proceeded to implement the policy methodically, hiring the right people, making the right statements at the right time and reorganizing the central bank, strengthening its research department that is currently led by Ilan Goldfajn. Brazil had no recent experience of a truly free currency market. There was little understanding of how a volatile exchange rate can affect both prices and the voluminous federal debt. Yet by June 1999, Fraga had formally presented Brazil's new inflation-targeting policy, which has remained in effect since then.
El-Erian, who has known Fraga for years, says, "Very early on he clarified to everyone that this is the destination, that these are the guiding policies. When the shocks happened these policies were not derailed as they are often are in other countries, because the destination was clear." Fraga, he says, "institutionalized the game by creating a central bank process, publishing an inflation report, having a monetary policy committee, having superb directors and never losing sight of institutionalizing the rules."
Although the real does indeed float freely, Fraga manages the exchange rate by ensuring that shifts in the market are not disorderly or do not trigger excessive spillover effects in the real economy. Last year, the central bank announced it would "irrigate" the market with dollars from its reserves to ensure liquidity. At first traders were scornful, betting that the trickle of dollars would not affect the market. Yet this, combined with well-timed open market operations and the provision of hedging instruments to the market, ensured that volatility in the financial markets did not threaten the country's economic stability.
Added to a broad program of macroeconomic reform, Fraga says, this ensured that "the real depreciation of the exchange rate in 1999 and 2001 [took place] without losing control of inflation."
While Fraga was busy domesticating the local markets, he also began patching up Brazil's awkward relations with the international markets. Speaking back in 1999, a Wall Street investment banker said scathingly, "Brazil has never been much of a player in the debt market because the central bank's attitude has always been that it doesn't care about the international capital markets."
Fraga and Daniel Gleizer, his recently departed international director, began building an international reputation for keen judgment, sophistication and stinginess. They quickly set about building an international yield curve. The central bank is responsible for managing the government's foreign debt and is the government's agent on the local bond market. Fraga and Gleizer impressed the bond market with the timing, audacity and complexity of many bond issues. In January, Brazil successfully launched a $1.25 billion bond the first Monday after Argentina had devalued its currency. The bond, which was richly priced, sold in four hours.
Fraga says, "We act proactively, looking at the curve to keep it smooth without any concentrations on a date or specific year, diversifying the investor base and currency."
El-Erian says Fraga and Gleizer drive a hard bargain. "Nothing is ever left on the table for the markets," he says, "There is no easy money to be made in Brazil." Yet El-Erian says investors "view [Fraga] with tremendous respect as someone who has enhanced the credibility of the central bank and put Brazil's external borrowing program on a very professional [footing]. The focus on transparency and communication, and signaling on policies are something that investors are looking for."
Fraga says he is lucky to have been able to work under a government that has maintained its commitment to free-market policies and fiscal rigor through thick and thin. He and Finance Minster Pedro Malan think alike. In fact, Fraga once studied under Malan at the Catholic University in Rio de Janeiro. "The central bank and finance ministry teams are separate," says Fraga. "They worry about long-term fiscal sustainability and we worry about prices and financial stability." Fraga says an expansionary fiscal policy "would have made my job impossible." Just as well, because the central bank has no legal independence. It is answerable to the finance minister, who has the power to summarily fire the governor.
Yet Malan says, "Armínio Fraga has led the central bank with extraordinary competence in these difficult times. He has a solid academic training, enviable professional experience in both the public sector and the private sector. He is public spirited, has an international reputation and is committed to Brazil and its future."
Joyce Chang, JP Morgan's head of emerging market fixed income research, says, "Brazil has the best working relationship between the executive and the economic team and the best coordination, probably better than investment-grade countries like Mexico, and that's critical to the way Brazil has been able to meet a number of challenges."
Naturally, Fraga's tenure at the central bank is not free of controversy. He has presided over a substantial increase in the national debt, has kept interest rates at very high levels and last year missed his inflation target by a wide margin.
It is true that the central bank is not directly responsible for the magnitude of the government's debts. However, critics say Fraga has caved in to market demands for bonds linked to the exchange rate and the overnight interest rate. Attempts to increase issuance of fixed-rate debt have fizzled out. At the end of last year, only R$48.8 billion ($20 billion) or 8% of the government's local currency debt, paid fixed interest rates. A year earlier, 15% of the debt was fixed interest. As a result, the debt swells every time the real slides or the central bank raises short-term interest rates.
Instead, say critics, Fraga has fueled the debt by linking half the $255 billion domestic debt to the overnight Selic interest rate and about one-third of the debt to the exchange rate. Some economists say Fraga should issue more inflation-linked debt to reduce the overall debt burden. Consumer price inflation last year was only 7.7%, whereas the Selic was at 19% for most of 2001. Fraga says that, "I favor using the CPI, but this will take time. People must realize that using the CPI link is for the long term. You cannot take any risks with indexation. You do not want that to come back."
Even the International Monetary Fund has grown worried about Brazil's penchant for exchange rate-linked debt. The Fund commented in its annual review of the Brazilian economy that, "the large share of the public debt that is linked to the exchange rate makes the overall fiscal balance and the debt-to-GDP ratio highly sensitive to exchange rate movements." While praising Fraga's overall prudent debt management policies, the Fund "encouraged the authorities to reduce the share of exchange rate-indexed debt as market conditions allow."
Weight of History
That is just the problem, says Itaú's Setúbal. "Floating rates are instruments the market developed to extend maturities [because] the country has lived through moments of great volatility and this requires more flexible instruments and the market has difficulty in accepting [floating rates] without a reduction in volatility. This is not Armínio's fault. It is beyond the control of anyone."
Furthermore, the central bank has issued short-dated dollar debt to provide liquidity and hedging instruments for companies struggling to manage their risk profiles. Issuance of dollar-linked debt rose sharply in September, which the central bank is now refinancing with two- and three-year debt.
Fraga and his team are responsible for setting short-term interest rates. They have erred on the side of caution for the last year, holding the Selic at 19%. This is a punishingly high rate, equivalent to 12% in real terms, and many say it has choked off growth. "These high interest rates are a crime," thunders Walter Appel, a partner in São Paulo's Banco Fator investment bank. Companies must pay interest rates of 25% a year or more while consumer credit loans to individuals can reach almost 100% a year. Mark Mobius, president of Templeton Emerging Markets, comments that, "Real interest rates are much too high in Brazil, where inflation is low. Interest rates should come crashing down. I'm not saying it's going to happen, but it should." Otherwise, he says, "This economy is not going to be as dynamic as it should be.''
Fraga replies patiently that, "Stability is essential for growth, because without thinking long term nobody can save or invest, which is very difficult to do if you are [artificially] stimulating short-term demand."
Too Soft?
Inflation hawks moan that Fraga was too soft last year, letting prices rise by 7.7%, missing his target for the first time. Back in 1999, he had aimed to lower inflation to 4% in 2001. Yet most economists and people in the markets agree that Fraga did well in an extraordinarily difficult year. He says he was prepared to give ground on inflation to avoid pushing the economy into recession, confident that the pressures driving inflation in 2001 - the effects of power rationing on utility prices and a weak real - would diminish in 2002.
Economists expect growth of 1% to 2% this year, with inflation falling to meet the central bank's 3% target which would allow it to cut interest rates. Yet Fraga is not letting his guard down. "The underlying currents are positive, but the wind is still against us so nobody should get too excited," he says. "We have got the departure of President Cardoso and it will be an important test for us. I am cautiously optimistic, but there is no complacency in the government."
Fraga has said he will probably stay on next year to help with the transition to a new government before moving on. He could be Brazil's next finance minister, or he could go back to academic life or the financial markets. There is little chance that the government will win approval in Congress for a bill granting the central bank independence with a mandate to ensure price stability.
Brazil under Cardoso, Malan and Fraga has fared infinitely better than Argentina, wracked by debt default, devaluation and economic depression. Cardoso sent Fraga to Buenos Aires in January to advise the incoming government of Eduardo Duhalde on how to manage the transition to a floating exchange rate, but little has come of his suggestions. Fraga is too diplomatic to say so, but there is little a central banker can do for a country that is tearing itself apart.
The tragedy in Argentina should serve as a warning of the dangers of abandoning economic rationality. Brazil's large public debt of over 50% of GDP, sluggish growth and reliance on imported capital are serious weaknesses that make it vulnerable to further shocks. Fraga has helped Brazil through many a tight scrape in the last three years, but he may not be at the central bank for much longer. Can Brazil cope without him? LF

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