MULTINATIONAL FINANCE

Case 2 : Brazil Fights a Real Battle

Group 2 :
ADHAM NURJATI
FATMA HAULIDA RAHMAH
MARIA FRANCISCA OKTAVIANI

MAGISTER MANAJEMEN
FAKULTAS EKONOMIKA DAN BISNIS
UNIVERSITAS GADJAH MADA
2017
Key Issues:
In 1994, Brazil inflation rate was high, nearly 50% per month, that condition made
Brazilian economy almost collapse, and investors did not interest to investing. Hyperinflation
made Brazil society more likely to import than export. Cardozo introduced the "Real Plan" in
1993 while he was a finance minister. Cardozo was elected as a president in 1994 and made a
real pan to stabillize the currency. Real plan managed to stop hyperinflation and attract
investors to invest. Real plan succeded reducing the inflation rate in Brazil, but the inflation
rate was very low. In October 1997 inflation rate of Brazil was 7% per year. President Cardozo
managed to raise BOLZA ( capital market in Brazil) by 158% since 1994. In the same year,
there was a crisis economic in Asia, that impact the economic in Brazil, investors assume that
government policies in Brazil about the currency made that over value in Brazil and investors
left Brazil which is reflected from the revocation of $ 10 billion in two weeks by investors. In
addition, Brazil's condition had a current account deficit whereby Brazil imports more than
exports. Seeing the phenomenon that the Brazilian government increased interest rates to 43%
to reduce imports.
Analysis:
Before Brazil led by president of Cardozo, inflation in brazil is very high and makes
Brazil State almost collapse where inflation occurs above 100%, which causes investors
reluctant to invest in Brazil because with the inflation is very high then the return from investors
will be very small and the investment becomes very risky. Economic conditions in Brazil are
illustrated in the table statistics of the Brazilian economy as follows:

In the same year, president of Cardozo who is Brazil's elected president made a new
policy of applying an open economy system that adopted free markets and stabilized the value
of Real Brazilian currency. This policy is known as Real Plan is a very tight economic system
by limiting the depreciation of the Brazil currency against the dollar by 0.6% per month. This
currency setting policy a crawling peg. This policy is taken because at that time the value of
the Brazil currency undervalue while the US currency overvalue. This is evidenced by
Purchasing Power Parity formula with data of 1992 and 1993 as follows:
Tahun Nilai nominal Nilai Riil Valuasi Nilai Valuasi Nilai
Exchange rate Exchange rate Real Brazil USD
(Real/USD) (Real/USD)
1992 0.005 2.27x10-3 undervalue Overvalue
1993 0.119 0.06 undervalue Overvalue

In addition, the undervalued of currency by Cardozo is considered to be a disadvantage

for the Brazilian economy and therefore president Cordoso imposed a crawling peg strategy to
make the currency value to be overvalue and to raise the economic competitiveness of Brazil.
And true after applied crawling peg which was Brazil currency undervalue become over value.
As illustrated in the following table:
Tahun Nilai nominal Nilai Riil Valuasi Nilai Valuasi Nilai
Exchange rate Exchange rate Real Brazil USD
(Real/USD) (Real/USD)
1994 0.846 3.383 Overvalue Undervalue
1995 0.973 9.004 Overvalue Undervalue
1996 1.039 1.19 Overvalue Undervalue
1997 1.116 1.122 Overvalue Undervalue

With the condition of overvalued currency makes the Brazilian society to prefer to
import goods from abroad that make Brazil’s current account deficit. This condition is actually
not a problem when a State increase the amount of investment will be, but the conditions of
Brazil's investment which is done very small and government spending from Brazil itself is
quite high this will certainly be a problem in the future. Nevertheless at that time can be said if
the value of currency exchange rate brazil stable, stable exchange rate makes inflation can be
pressed so that investor confidence began to wake up. Impact from inflation control can make
market interest rate in brazil decrease as shown in the picture below:

Reduced interest rate responded positively by investor because with decreasing of

interest rate make many projects have a positive Net Present Value because it will generate
high return for investors. The decline in interest rates due to inflation is also responded
positively by the capital market in Brazil where the Brazilian capital market BOLZA grew by
158% until 1997.
When the 1997 economic crisis struck in the Asian region, investors in Brazil were also
affected by this crisis where investors felt to be in the Brazilian real was overvalue with the
current economic conditions and indeed in fact overvalued, and investors responded with
investment in brazil with proven the existence of $ 10 billion out of brazil. This condition is
exacerbated by the current account deficit that causes the competitiveness of brazil reduced.
On the other hand investment in brazil is very small and government spanding is high. To
respond to this condition the Brazilian government raised interest rates by 43% or about 2 times
the original interest rate. This policy according to our group was not right because with the
increase of interest rate hence investor become reluctant to invest in brazil because will load
number of project which have positive Net Present Value will be less, with the decrease of
number of project which have positive Net Present Value this will impact on the number of
unemployed in brazil. If viewed from the purpose of this policy to reduce imports, with the
increase in interest rates this only makes the amount of imports fell only and no impact on
increasing exports. With this increase in interest rates make the Brazilian people prefer saving
rather than invest if in a crisis condition of course this will make the condition of banking in
brazil become worse because the burden of liability bang is higher, other effects that can arise
from high interest rates is economic growth which is slow. On the other hand this rate increase
can only be enjoyed by the rich people who have some money to save while the majority of
the Brazilian people are middle-class people down.
Recommendation
President Cardozo should not raise bank interest rate to 43% to face the crisis because
if the interest rate increase, besides its not having a significant impact on export growth in
Brazil can also be enjoyed only by some circles even this policy increases the number of
unemployed. From the political aspect of course this is also bad for president Cardozo Cardozo
considering the presidern still want to run for president in 1998 which would affect the chance
kemenagannya. Instead there are several other alternatives that is
1. Import quota
2. Increase tax
3. Export promotion
4. Reduced government spending