After flying high for several years, Brazil’s luck is quickly running out. Citing bad economic management and one-off accounting tricks that flattered its public finances, credit rating agency Standard & Poors has downgraded the country’s debt to BBB-, just one step above junk.
With this downgrade comes investor fears that the money they have lent the South American government will not be repaid. The reality of the situation is that this is not a new phenomenon.
There are always two ways to default: the explicit and implicit way. Credit rating agencies are concerned with explicit defaults. When a country doesn’t pay interest or principal it is evident that investors have lost. A bond rating informs investors what the perceived risk is that such an unfortunate event will occur.
Explicit defaults are rare compared to their implicit counterparts. Countries often run high inflation rates to reduce the payments on their debts. Money is borrowed at a set interest rate, and by inflating the currency (which the country controls through its central bank) the real cost of repaying this debt is reduced. The inflating country gets a free lunch of sorts, while investors are left with lower inflation-adjusted returns. Credit ratings are often meaningless for dealing with this type of default.
High price inflation has plagued the Brazilian economy throughout the past decade. Consumers most constantly grapple with increasing prices every year, but no less difficult is the life of an investor in Brazilian government bonds. Unsure of what the rate of inflation will be after they make their “investment”, these individuals are at the mercy of the central bank as it controls the money supply to suit its needs.
Many commentators will point to Brazil’s high economic growth as the reason for its price inflation. These people would do well to just consider some simple statistics from the central bank.
Money supply growth in Brazil has averaged nearly 20% per year for the past decade, and grew by as much as 40% as recently as 2009. That’s a lot of new money sloshing around looking for a place to be put to good use. As it is spent it has pushed prices up, and reduced the returns that investors in Brazil have earned.
The threat of a default by the Brazilian government might look dire, but it would really just be making explicit the policy the country has been pursuing for many years now. If it an explicit default meant price stability in the aftermath, maybe it would be a good idea to just get the pain over with in one fell swoop.
(Originally posted at Mises Canada.)