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The Great Recession and Developing Countries
government to increase interest rates to defend the exchange rate and interrupted the strong economic acceleration initiated with the successful price stabilization. The Asian and Russian crises in 1997 and 1998 also strongly affected the Brazilian economy. Speculative attacks against the real demanded firm monetary tightening, with widespread effects on economic activity and public debt dynamics. Additionally, the government used exchange rate–indexed bonds to avoid exchange rate depreciation pressures; the strategy appeared to be effective in the short run, but ultimately introduced additional risk into the composition of public debt. Deteriorating macroeconomic conditions led to economic stagnation in 1998, dragging down the average growth rate during 1995–98 to 2.4 percent, a rate only slightly higher than that experienced in the 1980s (considered the “lost decade”). Furthermore, a marked decrease in the capital accumulation rate, lower productivity, a weak labor market, and rising poverty interrupted the positive trends initiated with the launch of the Real Plan in 1994. In addition to low growth and high interest rates, the government’s failure to address the deteriorating fiscal accounts rendered public and external debts increasingly unsustainable. After the Brazilian authorities’ unsuccessful efforts to defend the currency following the Russian crisis—which included raising the headline interest rate to 30 percent, signing an additional Stand-By Arrangement with the International Monetary Fund (IMF) for US$43 billion, and international reserve losses of US$30 billion—the government in January 1999 had to abandon the crawling-peg exchange rate regime. This led to a rapid depreciation of the exchange rate and disruption of domestic financial markets. To avoid further depreciation, the government was forced to raise interest rates to 45 percent from 30 percent in December 1998. Given the large share of public bonds indexed to the exchange and interest rates, public debt jumped to 47 percent of GDP. Economic activity plummeted, with industrial production and capital accumulation falling sharply. Last but not least, inflation increased substantially because of the exchange rate depreciation, placing at risk the most important achievement of the Real Plan—price stability. In this context, the government adopted a new economic policy framework built on strong fiscal discipline, inflation targeting, and flexible exchange rate regime. The previous policy of fiscal laxity was replaced by a tight fiscal policy aimed at reducing indebtedness and restoring fiscal