Effects of the Brazilian Devaluation.

Government Drops Defense of the Real

Faced with growing capital flight caused by a loss of investor confidence in its fiscal reforms, the Brazilian government on January 15 abandoned efforts to defend the Real allowing the currency to float freely against the dollar. As of January 19, the devaluation of the currency had reached 28 percent with most analysts predicting it would peak at 30 percent before stabilizing.

The collapse of the Real Plan's exchange anchor has placed Brazil's entire economic program in jeopardy and has forced the government to scramble for alternative policies.

On January 18, the government outlined the exchange and monetary policies it will now adopt. The Central Bank will continue to allow the Real to float freely without setting a new upper and lower limit. Officials also said they will raise interest rates if necessary to combat inflationary pressures resulting from the devaluation.

With interest rates now separated from exchange policy, the Central Bank moved to give itself the means to apply an orthodox monetary policy. The Central Bank Monetary Policy Committee (COPOM) widened the interest rate band, lowering the floor of the band, the TBC rate, from 29 to 25 percent per year, while raising the band's ceiling, the TBan, from 36 to 41 percent. Interest rates will now float within a band of 16 percentage points rather than seven as before.

The wider interest rate band increases the flexibility of policymakers and permits short-term rate hikes to fight off inflation. If the Real devalues too quickly, interest rates will be raised. On January 19, the financial market benchmark Overnight rate was raised from 29.8 percent to 32 percent a year. President Cardoso said that he would also not hesitate to lower import duties if necessary to guarantee low inflation.

In addition to setting exchange and monetary policies, the government team again stressed the need to implement its promised fiscal reforms. Without such reforms, analysts have warned Brazil will quickly find itself in trouble again.

Events Leading to Devaluation

Investor confidence in Brazil began to …