Executive Summary
Brazil is Latin Americas largest economy and since the 1990’s has shown steady economic reforms. These reforms were necessary as Brazil suffered years of hyperinflation as high as 1000% and deficit spending. The government decided to pursue economic policies that changed the Brazilian economy into a dynamic market based system.
Some of the key policy changes made were the privatization, of state owned enterprises, deregulation that allowed for greater domestic and foreign competition, perusing regional and multinational free trade agreements and the removal of red tape associated with foreign investment. The mainstay of all these reforms was the Plano Real (Real Plan).
This real plan involved the scrapping of the old currency, the cruzeiro and replacing it with a brand new currency the real. The plan was to drive out inflation by adhering to strict monetary policies. The government decided to peg the real to the United States (U.S.) dollar and not allow it to depreciate more than 7.5 % against the US dollar per year. The government also increased the interest rates repeatedly to maintain the value of the real against the dollar.
The economic reforms in Brazil were fairly successful, the country saw the inflation rate drop to 2% by 1998 and the economy grew by 3 to 4% annually as well as foreign investment soaring to $ 22 billion in 1998, but not all was well. Brazil was facing a huge trade deficit due to an overvalued real. There were also huge budget deficits which were structural in nature. These structural problems required that the Brazilian constitution be amended which was proving to be problematic for the government.
The real also faced challenges from the Asian financial crisis which triggered panic selling in all emerging markets. As the money began to flow out of Brazil the real was put under tremendous pressure and when the Russian government decided to default on some of its debt and devalue the ruble by a third, there was even more pressure on the real as confidence in Brazil and the emerging markets economies were in free fall.
The Brazilian government decided that they were going to defend the real and whether this policy was in the best interest of Brazil remains a debatable point. In the following analysis,

Introduction
Brazil was a slumbering giant in Latin America and years of hyperinflation and deficit spending was preventing Brazil from becoming a force in world markets. In the 1990’s the government decided to pursue economic reforms to make the Brazilian economy a dynamic market based economy.
The government based their reform policies on the Real Plan and other strict monetary and economic policies. The real plan was designed to drive down inflation and to encourage foreign investment. These economic reforms also saw the real pegged against the U.S. dollar and the government wanted the International Monetary Fund (IMF) to take notice of these reforms so that loans and funding could be obtained from the IMF to assist the Brazilian economy.
Although the real plan was successful and Brazil weathered the economic cries fairly well, sceptics and government oppositions were critical of the reform policies. The following questions that were answered by 4 STAR will evaluate whether this criticism is founded and if there were other options that the Brazilian government could have considered or if the policies that the government implemented were the correct ones.
The questions were answered by the following members:

Question 1
Explain the mechanism by which the Real plan helped to defeat hyperinflation in Brazil?

The mechanism by which the real plan defeated hyperinflation was the introduction of the real. In this, a tight monetary policy was enforced. To implement this policy, the value of the real was pegged to that of the US dollar and depreciated under 7.5 percent per year. Brazilian authorities had to raise interest rates repeatedly to keep the value of the real against the dollar, to keep depreciation under 7.5 percent. The high cost of credit helped reduce the expansion of the money supply. The Real Plan brought the economy under control and stabilized Brazil’s currency because Brazil was supplying money beyond the demand. When implemented in 1994, annual inflation rate was running at 1000%. This level discouraged economic activity and foreign direct investments (FDI). To fight inflation, the Brazilian government replaced its previous currency, the cruzeiro with the real. The real was pegged to that of the US dollar. Interest rates were repeatedly increased to maintain the value of the real to that of the US dollar. For Brazil, the high cost of credit helped reduce expansion of the monetary supply and brought inflation under control. This plan ignited economy growth and increased FDIs in Brazil. The study further explained, in the midst of all of the economic growth, the trade deficit continued to grow. Although the Real plan was effective the trade was affected, the trade deficit was due in part to an overvalued real, which hindered exports, while bringing imports into the country. Estimates showed the real was actually valued higher than the US dollar. It was also mentioned that the rigid structure of the government was to blame for the trade deficit. Taxes and constitutionally mandated budget items consumed 90% of the government revenues. With inflation now under control the government could no longer rely on it to reduce the value of public-sector commitments. Cardoso made several attempts to solve the structural deficit, but with limited progress. In the wake of all their troubles other countries also suffered financial crises that put further strain on the real. In response, Cardoso continued to raise taxes and interest rates, which helped stem the flow of capital and stabilize the real. This helped to slow the economy. Inevitably, the Brazilian bank entered the foreign exchange market and sought the support of the International Monetary Fund (IMF). Of course there were many critics to the IMF package, but the announcement alone helped stabilize the real. Brazil’s economic troubles didn’t end. The government employee pension tax proposals attached to the IMF package were defeated in Congress, while a Brazilian state declared moratorium on debt payments owed to the central government. This debt moratorium caused the Brazilian stock market to decrease. The Real Plan brought the economy under control and stabilized Brazil’s currency. In spite of its problems, Brazil continues to attract large amounts of foreign investment.
The launch of the Real plan was the first time Brazil showed economic discipline and was successful as it raised the standard of living by lowering inflation. I think it’s clear to see that Cardoso wanted to get the economy right and Brazil is a flourishing country and he wanted Brazil to be dynamic by: * Building the infrastructure necessary to support a diverse and fully developed economy. * Reducing poverty and inequality to ensure the citizens contribute to the economy. * Openness to the world. * Movement to reform domestic institutions to foster efficiency. Brazil has come a long way but in order to grow it must continue to diversify its economy, reduce regulatory and legal inhibitors to efficiency and fight poverty through social spending and education. They also need to find a way to balance the countries budget without slowing growth as Brazil is capable of becoming and advanced economy.

Question 2
What actions does the Brazilian government need to take to defend the peg of the Real against the United States dollar?

The reason for the Real been pegged to the dollar was because of the status an stability of the dollar in that point of time and it made sense to abandon your currency and join a more stronger currency to help your country grow. Government knew that the high cost of credit will help reduce the expansion of monetary supply and bring inflation under control. The Brazil government has to allow the central bank (Reserve Bank) to enter the foreign exchange market to turn to the people and setup a foreign exchange reserve for the public to purchase Real’s on the open market. The government also announced a $10.8 billion in budget cuts but they are going to have to follow though to keep the international market interested in the Real. Brazilian government raised interest rates repeatedly to discipline their people to stop spending and to give outside investor’s confidence to invest in their country, their interest rates stood at 39%, highest interest rates in the world. Despite doing all this they still ran into trouble so in order to maintain the peg they had to maintain the monetary and fiscal policies similar to those of the US so that the currencies will tend to move in unison against other countries and due to Cardoso’s negotiating with the IMF it helped bring calm to the exchange markets. In order for the IMF to assist and get Brazil out of the economic problem they also requested Brazil do the following: * Reduction in government spending. * Reforms in social security, civil service, pension and tax systems.
Their goal of action included a budget surplus before interest payments of around 2.5% of the GDP in 1999 and stabilization of the ratio of debt to GDP by 2000.
Government agreed and taxes increased by $11 billion and $12.5 billion in budget cuts and major structural reforms. Brazil government continued to raise interest rates and taxes. It is said that if the government allowed the Real to float it would help Brazil keep its exports competitive and boost the country’s economy and will reduce the country’s need to raise interest rates but critics said it will trigger panic. Brazil needed to strengthen its commitment to maintaining a stable Real by adopting a currency board system for managing the exchange rate and keep the Real locked to the Dollar. Brazil needs to now look attractive to bring investments into the country and boost economy and by doing this they could gain new Real as foreign investors will bring dollars into the country. By pegging the Real to the US dollar Brazil can succeed but only if they are disciplined as a country.

Question 3
Do you think the Brazilian government was correct to place a high value on defending the peg of the real against the US dollar? What were the costs to Brazil of this policy? What were the benefits?
3. (A). No the Brazilian government should not have placed such a high value in defending the peg of the real against the US dollar.
Although the real was not allowed to depreciate 7.5% against the US dollar, it was estimated that the real was overvalued by between 15 and 20% against the US dollar. The overvalued real caused a trade deficit which brought a high number of imports into the country, but stifled exports out of the country. This meant that it was cheaper to bring items into Brazil but the cost of Brazilian exports very expensive. The deficit was valued at 7% of Brazil’s gross domestic profit (GDP) which stymied the growth and undermined the reforms that the government was trying to implement.
3. (B) The cost to Brazil was firstly the loss of foreign exchange resources. The imports were high but exports were low or non-existent. This means that the world markets were not purchasing goods and services from Brazil resulting in very little foreign exchange. Although the real was pegged at 7.5% to the dollar the cost was between 15 and 20%, which was more than double the budget.
To protect the real, the Brazilian government decided to use its foreign exchange reserves to buy reals in the open market. This resulted in Brazil losing about 1/3 of its foreign exchange reserve. Brazil was spending about $ 1 billion a day in protecting the real.
The government planned $ 10.8 billion in budget cuts, but this did little to prevent traders from selling the real as the previous budget cuts were not followed through. The international markets were not convinced that the Brazilian government would carry out these budget cuts.
The Brazilian government also repeatedly increased the interest rate to hold the value of the real, but this also increased the cost of servicing the government’s debts and held back economic activity. This action reduced government’s tax receipts as companies were not submitting their returns timeously.
3 (C) In the long term one of the benefits of the above action by the Brazilian government was bringing to an end decades of hyperinflation. Although the inflation rate was at 39% during this time, the rate in previous years before the real plan was implemented was at times 1000%.
Pegging the real to the dollar also brought about stability in the Brazilian economy as well as the support of the International Monetary Fund (IMF). The IMF was now willing to loan money under strict conditions to Brazil, once it saw the change in Brazil’s economic policies and also the willingness of the Brazilian government to keep a strict control on these policies.

Question 4
What do you think might happen to the value of the real & the Brazilian economy in general, if the Brazilian government abandoned its defence of the real & decide to let it float against the dollar?

By letting the real float against the dollar by abandoning its defence of it, it could have led to the depreciation of the currency. With a weaker ‘Real’ .Imports would become more expensive and exports would become cheaper. Money would be leaving the country instead of coming in. Floating could have led to speculation and would not be attractive for foreign investment. Brazil needed money to come into the country, so that they would be able to pay off their debts and alleviate the poverty in their country. Floating would make current and future foreign investors more concerned about the safety of their investments.
Other countries would be uncertain in investing in Brazil, thus dampening their growth and foreign exchange.
This would have also led to the imbalance of the ‘real’ in the foreign exchange market and would lead to de-evaluation of the real even more than it already was.
This would not make Brazil attractive to foreign investment which means no money coming into the country and the deterioration of the economy. This would open the door to hyper-inflation and could put Brazil back to where they were or even in a worse situation.
If this were to happen the Brazilian economy would have suffered drastically , inflation which was reduced to about 2% by late 1998 from a whopping 1000% could have climbed back up at an alarming rate and create hardship for many in the region, which would be mainly the lower & middle income earners.
In conclusion the researchers would like to say that floating the real would have been the wrong strategy and the strategy that Brazil adopted by anchoring the real to the dollar and keeping the interests rates high worked in their favour and helped to reduce hyper-inflation. Pegging the ‘Real’ to the Dollar helped attract foreign capital and investment which propelled Brazil’s growth and was successful in raising the standard of living in the country by reducing inflation.

Question5
What would be the implications of allowing the real to float for the rest of Latin America and for the economy of the United States?

In the long run it might be good to let the Real float. This should probably only be done after confidence has been restored in the Brazilian economy (or for that matter, if all confidence has been lost already). At the present time, if the Real were to float, it would lead to a further lack of confidence in most Latin America economies, cause significant economic pain in Latin America, and reduce exports from the United States to this region. As the lead economy in the Americas, economic problems in Latin America will directly impact on the United States dollar causing the major investing companies to pull out due to the uncertainties caused by a floating real.
The floating exchange rate system was introduced in 1973 following the abolishment of the fixed rate system. The fixed rate system was considered as being advantageous only to the major economies of the world and did not allow the emerging currencies to grow at an acceptable rate. The floating exchange system made exchange rates more unpredictable than with the fixed rate system. This phase in the evolution of the IMS understandably gave rise to greater uncertainty in the foreign market. Companies and individuals involved in international business and finance had to contend with a rapidly changing international monetary scene and a highly unpredictable and volatile foreign market .During the period (Global Business A. Aregbeshola; et al 2011)
The floating of the real without first being stabilized first would have caused the whole region to have become destabilized ,the exports from the United States would have been affected by the devalued real. There would have been no investment from outside companies due to a lack of confidence and unsound economic policies. Floating the currency meant that the markets would have been unpredictable. There would have been pandemonium from all investors with current investments in Brazil. This would have led to further devaluation as these investors would have then been selling off their investments. The real would have brought down the dollar as the dollar relies heavily on the performance of its major trading partners.
While overcoming some of the inherent shortcomings of the fixed exchange system the floating exchange rate regime has undoubtedly contributed to the increased complexity, uncertainty and sophistication of the international financial markets.

The implications of floating the real could have been either good or bad for Latin America and the United States depending on the timing of the decision to float the real.
Conclusion
The decision by the Brazilian government to introduce the Real Plan and the privatization of state owned enterprises as well as encouraging foreign investment proved to be a success.
The governments strict monetary policies helped bring down the inflation rate from over 100% to 2% in late 1998 bears testament to this. Foreign investment soared to $22 billion in 1998 helped Brazil’s economy to grow and stabilize.
The Real Plan resulted in quick growth, reducing poverty and increased foreign investment, but the government should not have placed such a high value on defending the peg of the real against the U.S. dollar. The cost to Brazil for doing this far outweighs the benefits. This can be clearly seen in question 3.
The defending of the real by the Brazilian government helped the country survive the Asian and Russian crisis that threatened to derail all the good that was done. Although skeptics of the government would disagree Brazil emerged from the financial crisis better than most other emerging economies.
In spite of Brazil’s success, the government would need to diversify its economy and continue to encourage its growth, but needs urgent constitutional changes with regards to its civil servants to be able to balance its budgets. Education of the poor and social spending will assist the fight against poverty and make Brazil a first world economy rather than an emerging economy.

Reference List
Logistics Management Programme Case study. Page 26 to 39.
Aregbeshola, A. et al. (2011) Global Business Environments and Strategies. 4thed. Oxford University Press.