Brazilian Real Crisis

In 1993 the Real Plan was introduced in Brazil as a stabilization package. The plan controlled existing hyper-inflation conditions, balanced the fiscal budget, and reduced federal expenditures. Most importantly, the plan introduced a new currency, the Real, which was pegged to the dollar.

Although the currency was successful in calming inflation, it was not enough to reconcile the discrepancy between Brazilian and U.S. Inflation rates. As a result the Real became overvalued, which made imports cheaper to buy and exports harder to sell abroad. In turn, the overvalued currency led to a current account deficit whereby the number of imports far exceeds exports. The huge deficit was more than offset by foreign investors' appetite for Brazilian assets, which attracted a huge inflow of foreign capital, and brought reserves in excess of 70 billion in the 1990s. Because the currency was so dependent on foreign investments to prop up its value, it was very vulnerable to a currency crisis if investors remove their funds at a rapid rate. Such conditions, which triggered a mass exodus of funds and led to the Real devaluation were:

• Financial Contagion: The Real was exposed to financial contagion. Contagion is a condition whereby a financial crisis in one country triggers widespread fear with investors, thus causing them to remove funds from other countries with comparable problems. The Asian Currency crisis, Russian crisis and the Mexican Peso Crisis were events that preceded the collapse of the Real. As investors liquidated their capital out of these countries, they also repatriated their funds from Brazil. One month before the crisis, funds were repatriated at an estimated $350 billion per day.
• Dollar-peg: In order to maintain the peg to the dollar, a central bank has the right to intervene in order to stabilize the value of the currency. Brazil's reserves fell from a high of 70 billion in the beginning of 1998 to half its value by year-end in order to maintain the value of the peg.
• Fiscal Problems: Interest rates were raised to almost 50% in order to try to prevent investors from removing their funds. However, this was not enough to mask the underlying structural problems of an overvalued currency. Raising interest rates only exacerbated the current account deficit numbers.

By 1999, Brazil decided to throw out its dollar-peg and let the Real devalue.

The real plunged 44% by January 29, 1999. The crisis showed that economic calamity in one country could easily spill over into other economies with similar problems.