Gustavo Franco's bold use of power

Brazil's textbook response to last October's Asian crisis turned central bank governor Gustavo Franco into a figure of world renown. The doubling of interest rates together with fiscal cuts kept Brazil stable and gave credence to the current policy regime - fixed exchange rate with crawling devaluation and capital controls in an otherwise market-oriented environment - that Franco is associated with.

The Russian crisis is putting Brazil to the test again and the final outcome remains uncertain. While no-one is invincible, Brazilians can rest assured that in the current turmoil they have an experienced technician at the helm, who is cool in a crisis and not afraid to use the full weight of his powers to see off trouble.

"Gustavo Franco advised the president at the time of the Asian crisis that the government had to go for a very orthodox response," says an analyst with a Brazilian investment bank. "This earned him huge respect in the markets."

But Franco's resolute stance has not always made him popular. "Gustavo Franco believes deeply in what he stands for and is prepared to fight with all his strength for it. He doesn't mind making enemies," says a seasoned Brazil watcher.

Franco became central bank governor on August 20 1997 and had been in the job only three months when the Asia crisis hit. But his experience at the central bank goes back much further. He became the bank's director of international affairs in September 1993 after spending five months as deputy secretary of economic policy in the finance ministry. He was one of the architect's of the 1994 Real Plan which brought years of hyperinflation in Brazil to a close.

Not one to resort to dry technical jargon, Franco describes the unfolding drama of Brazil's reaction to the events in Asia in human terms. "Watching the storm coming, you have different levels of reaction," he says. "The crucial decision is to upgrade your alert status one notch further. The interest-rate increase was level one in which we had to react on the macroeconomic mode - selling reserves and the like. We had to do something macroeconomic that would affect the domestic economy. The second level of reaction was fiscal policy, to sit with the finance minister [Pedro Malan] and then with the president [Fernando Henrique Cardoso] saying that its one thing for the central bank to use its weapons to defend the currency, but the other thing needed is for the nation to use other means to defend itself from external financial shocks. Fortifying our macroeconomic fundamentals was a crucial thing to do. The decision was to build that fiscal package [of spending cuts] - that was an $18 billion effort, slightly over 2% of GDP - and then we had a complete response."

Franco recalls it as being a terrible week but laughs: "It was fast. These moments of financial uneasiness appear suddenly, but they go away very quickly."

And as Franco points out, this was not the first tense period he has lived through at the central bank. There was the Mexican peso crisis in 1995 and before that some nervous moments associated with the Real Plan.

The great achievement has been to have a coherent policy framework that acts as a reference even when markets are in turmoil. In Brazil the starting point for this was curing inflation and reducing the role of the state in the economy.

"Fighting inflation is not like reducing a fever with a cold bath," says Franco. "It's a serious disease and you need a long time to provide a definite cure. We knew that hyperinflation represented a crisis in our development model - to use big words - and we had to redefine the development process. Two major changes had to be made, one was changing the role of the state in the economy, that's another name for balancing the budget. The other thing was changing the relationship between Brazil and the rest of the world - that is, opening the economy for trade and foreign investment."

Brazil is still having difficulties with the first of these. The fiscal deficit between January and May was 6.5% of GDP made up of a primary surplus of 0.8% and interest payments of 7.4%. One Brazilian banker says: "The country is haemorrhaging money."

A recent report by ING Barings describes the seriousness of the situation: "As recent events in Russia are clearly demonstrating, a large government budget deficit financed through the issuance of short-term treasury bills can breed - given a pegged exchange rate regime - a genuine balance of payments crisis. Rising yields on treasury obligations do not always succeed in enticing debt holders to remain invested. Should there be a loss of investor confidence then, even if treasury bills are payable in domestic currency and the investor base is mostly local, the central bank could quickly find itself facing a wave of demand for foreign exchange that it may not be able to satisfy - at least not at a given, set price."

Franco, a former academic who has both an MA and a PhD from Harvard, and whose many books and articles include one entitled "Fiscal reforms and stabilization: four hyperinflation cases examined", agrees that the central bank cannot remain passive in the face of deficits. But he argues that the fiscal situation is not as serious as many observers have stated while current-account deficits are a result of openness and capital surges. He complains that the impact of global flows on the economy is making it harder for Brazilian politicians to sell the globalization concept to the people in an election year.

"Looking at our fundamentals - our fiscal numbers - they are not very much different from the average European case," he says. "Take away the spending by states and provinces from our fiscal numbers - which is a European practice - and we have a deficit of 3.5% of GDP which almost meets the Maastricht criteria. We know that we don't have a track record: that's something we have to build. But the other thing is that we have invested in the concept of being an open economy, in the concept that it is productive and useful to participate in the world economy in a more intense way. It's annoying to then receive from the world economy negative energies. For the man in the street who has heard so much about the good things of globalization, all of sudden globalization is bringing bad stuff, it doesn't help."