Brazil and South Africa: Could Turmoil Lead to Default?

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Franklin Allen on the risks facing Brazil and South Africa

The economic slowdown in China has taken an economic toll on supplier countries – particularly emerging markets – that provide raw materials and other inputs. Some analysts say it is a key reason why investors are now worried that Brazil and South Africa could default on loans. But Wharton finance professor Franklin Allen says he does not expect either country to default. And while the slowdown in China has certainly led to weaker demand for such commodity exporters, “I think particularly Brazil — but also to some extent South Africa — has many additional problems” – notably, corruption.

In this Knowledge in 5 interview – the second in a three-part series (see part one here) — Allen points out that currency and credit markets will continue to provide the best indicators of the economic health for the two countries. More generally, he also sees a “significant, [although] maybe not a major, probability” of a global financial crisis of some kind as a result the slowing global economy and adjustment problems that may crop up when the U.S. Federal reserve starts raising interest rates – most likely by year end.

Meanwhile, Christine Lagarde, head of the International Monetary Fund, noted this week that emerging market countries (and bond markets) expect rising corporate bankruptcies when the Fed finally starts to move up interests rates. The IMF has counseled the Fed to hold increases off until 2016. At the same time, the Institute of International Finance, a trade group, announced that emerging markets saw the largest divestment of assets since 2008 – some $40 billion worth – during the third quarter.

An edited transcript follows.

Knowledge@Wharton: Brazil might be exhibit “A” for how emerging markets are being affected by China and a general global economic slowdown. Its currency is down more than 30% this year against the dollar. Investors are increasingly betting that Brazil and also South Africa might default on their debts. The South African rand is down about 15%. It used to be thought that emerging markets would be the new economic locomotive, pulling other economies along, perhaps as the U.S. has for decades. What do you think is going on?

“I don’t think it is likely that [Brazil and South Africa] will default, but it is certainly now a possibility … [that] investors are worried about, so they are pulling the money out now.”

Franklin Allen: I think particularly Brazil — but also to some extent South Africa also — has many additional problems on top of those problems that we have been discussing [See: “The China Syndrome — How Volatility Is Affecting ASEAN”].

In Brazil, there is the issue of the corruption. There is the problem that the finance minister, who was expected to get the finances in order and be very tough, does not seem to have full support in the cabinet. The president [Dilma Rousseff] is very weak — her approval ratings are down to 8%, I believe, which is one of the lowest scores seen in any country.

They are supposed to have financial transactions taxed to plug a hole in the deficits, but she did not get that through, so now they are looking at a deficit of 8% to 10% — that kind of number. This is within a country with quite high debt levels, I believe 60% to 70% … in a year’s time if they do not plug the gap. And they are paying 7% real rates of interest on much of this debt. It is quite an unstable situation. I don’t think it is likely that they will default, but it is certainly now a possibility, and I think that is something that investors are worried about, so they are pulling the money out now, and things are not good there.

Hopefully, they will be able to pass some other kind of tax, and plug the deficit, and get the public finances in order, but they are still far away from doing that. And then on top of that they have got all of these global issues. So if you are an investor in Brazil currently — and it looks like the U.S. is going to put its rates up — now it seems as if it is time to get your money out before the exchange rate plummets even more, and get a high return in the U.S.

I think that is a lot of what is happening. In terms of the real economy, the slowdown in China is obviously not a good thing for them. It is an interesting question how much of that is driving the current problems, as opposed to their idiosyncratic factors, just in terms of the corruption scandals and the political scandals, and so on. South Africa has a bit of the same [situation].

We have not talked about India, but India is the bright point. They seem to be still growing at reasonable rates, but they are not that big of an economy. They have a big population, but they are not a huge economy in global terms. It is a big problem that so much of the growth was provided by emerging market countries, and now that is not going to happen nearly as much, at least for the next few years.

Knowledge@Wharton: If things were going to spin further out of control, say in Brazil or in South Africa, talking about these defaults and that sort of thing, what are the warning signs that we should be looking at? And if they did default, what would be the effects?

“It is a big problem that so much of the growth was provided by emerging market countries, and now that is not going to happen nearly as much, at least for the next few years.”

Allen: The currencies are probably the best indicator. Also the bond yield, the government bond yields, although those are probably a little bit less reliable because the government — if they have government controlled banks — can get the banks to buy them and so on. But I think [with the] exchange rate, that is what we are seeing: indications that there are problems in these places. If they were to default in Brazil or in South Africa, I think that would be serious problems for those economies. I am not so sure they would be a big problem globally. But you never know; it may be that people are not expecting that with quite the probability that they should. But let’s hope they are, so that if it happens, it will not be too disruptive in the global economy.

Knowledge@Wharton: Would you say that, in general, the global economy seems to be slowing, but most likely is going to be avoiding any big financial crises? How would you rate the potential for a major financial crisis right now?

Allen: I think there is a significant, [although] maybe not a major, probability of that. I think the other big issue is that as the U.S. unwinds its quantitative easing, what these flows are going to be, how big they are going to be, how they are going to adjust. I don’t think we have much of an idea about that yet. We will get a much better idea once we start seeing a few of these rises in the U.S. policy rate, and how quickly they are doing it.

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