Jerome Powell ignores Brazil at his peril

Last month, in a speech in Switzerland, Federal Reserve Chairman Jerome Powell asserted that the emerging market economies should be able to manage the move to tighter monetary policy in the advanced economies. Since that statement, it appears that Brazil, the world’s eighth largest economy, has joined the ranks of Argentina, Indonesia, and Turkey as countries experiencing acute exchange rate pressure as a result of higher US interest rates and a stronger dollar.

Chair of the US Federal Reserve Jerome Powell stands for the official photo of delegates during the G7 Finance Ministers Summit in Whistler, British Columbia, Canada, June 1, 2018. REUTERS/Ben Nelms

Hopefully, when the Fed meets next week, Mr. Powell will not be as sanguine as he has been to date about the effects of US monetary policy on the emerging market economies. With Brazil now in play, the deteriorating economic outlook in the emerging market economies could have a significant bearing on the US economic outlook. This is especially the case considering that a Brazilian economic crisis would be playing out at a time of heightened Italian political instability.

Since Mr. Powell took office, the Brazilian real has depreciated by around 15 percent. Among the factors triggering the currency’s most recent weakness has been a crippling 10-day truckers’ strike that has raised serious questions about the Brazilian economic outlook and the government’s ability to persevere with a much needed economic reform program.

The strike also contributed to a heightened sense of political uncertainty ahead of Brazil’s contentious scheduled general election in October. This has been especially the case considering the collapse of support for Brazil’s centrist parties and the likely victory of a populist candidate for the presidency.

A particular reason for concern about Brazil is its unsustainable public finances. The country has been running budget deficits of around 8 percent of GDP, which has taken its public debt to GDP ratio to 75 percent of GDP. In nominal terms the Brazilian public debt is of the order of US $1.5 trillion of which around 20 percent is held by non-residents. The last thing that the country now needs is to slip into recession and to have its interest cost rise as a result of further Federal Reserve tightening and a strengthening US dollar.

There would seem to be at least two reasons why the Fed should be concerned about Brazil. First, as Latin America’s largest economy, economic developments in Brazil can have an important bearing on the economic outlook for the region as a whole and particularly for Argentina.

The second is that Brazil is very indebted both at the government and the corporate levels. In addition, a significant part of that debt is held by US financial institutions. Should Brazil have need to restructure its government or corporate debt, there could be a meaningful impact on US financial institutions’ balance sheets.