Contagion from Argentina has led to a strong depreciation of the Real in the past months and has forced the Central Bank to tighten monetary policy in order to address potential inflationary pass-through.  Higher interest rates threaten to further undermine the economy already plagued by the slowdown induced by domestic energy rationing.  In order to shield Brazil from the deteriorating conditions in international capital markets, in the wake of the Argentina crisis, the IMF approved a new financing package. 

Argentina spill-over forces further interest rate hike.  The pace of the Real depreciation continued to quicken in July, with the currency losing another 5.2% of its value relative to the US$, following the 2.4% loss in June.  The Real has now depreciated 19.6% relative to the US$ since December 2000, well in excess of the 1.7% anticipated by the market at the beginning of this year.  In mid-July, the Real broke through the 2.50 to the US$ threshold and has since remained at that level to reach 2.48 Reais to the US$ on 10 August.  Concerned about the more accelerated depreciation and the potential pass-through on domestic prices, the Central Bank decided to raise the benchmark SELIC interest rate for the fifth time this year.  The Central Bank’s 75 basis point hike on 18 July, from 18.25% to 19.0% brought interest rates to a 22-month high and is likely to put additional downside pressure on the economy, already suffering from the slowdown prompted by energy rationing.

This month’s Consensus Forecast reflects the current exchange rate scenario.  Panellists expect the Real to recover some of the lost value in the coming months but to close the year at a higher level than in last month’s publication.  Monetary policy is likely to continue to be determined by developments in the exchange rate market.  While panellists expect interest rates to come down from their current levels, they have hiked last month’s forecast year-end SELIC rate.

Government moves to garner IMF support.  The pronounced weakening in the Real prompted the Central Bank to intervene in the foreign exchange market throughout most of July.  As a result, international reserves dropped by US$ 1.7 billion.  Growing concerns for a more protracted crisis in Argentina and the resulting slowdown in capital flows to the region impelled the Brazilian government to request additional funds from the International Monetary Fund (IMF).  On 3 August, the IMF gave an initial approval for a new US$ 15 billion stand-by credit through December 2002, of which US$ 4.6 billion may be made available as early as September.  Government officials hope that the IMF support will help minimize potential Argentina contagion by bolstering liquidity and aid in boosting investor confidence over policy continuity after the October elections.

Under the terms of the new IMF agreement the government agreed to apply more fiscal stringency by raising the primary fiscal surplus for this year to 3.35% of GDP (up from 3.0% established in an earlier agreement) and further to 3.5% of GDP in 2002.  Since the government has vowed not to raise taxes further, the adjustment will have to come from spending cuts.  The Central Bank will be enabled to lower the current minimum international reserve requirement (a minimum foreign reserve level that the Central Bank promises to maintain according to the IMF accord) from US$ 25 billion to US$ 20 billion and has committed to maintain the current inflation targets.  Following the Central Bank’s downward revision in June, the government has also lowered its economic growth projections for this year to 2.7% from 4.5%.  Additionally, the government also announced that growth is expected to expand more favourably at a 3.5% pace in 2002.

Growth strong in first half but to slow significantly.  GDP growth for the first quarter of the year has been revised upward by the National Statistics Institute (IBGE) to 4.1% from 3.8%, year on year.  But the Central Bank has cut its 2001 growth forecast as a result of energy rationing and rising interest rates.  Industrial production data indicate that economic activity is slowing.  IBGE reports that industrial output declined 1.4% in June over the same month last year, the first decline in 24 months, and that seasonally adjusted data show that monthly activity dropped 1.1% in June over the previous month.

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