Gávea Investimentos’ Arminio Fraga: ‘We Are Still in Crisis Mode’

Arminio Fraga was president of the Central Bank of Brazil from 1999 to 2002. He has sometimes been called the Alan Greenspan of Latin America, though that comparison may not sit well these days as Greenspan comes in for his share of the blame for the global financial crisis. Fraga is also a former associate of George Soros and his Quantum Fund. Since 2001, he has been a member of the influential Washington-based Group of Thirty, a consulting group on international economic and monetary affairs.

In 2001, Fraga founded the Rio de Janeiro-based Gávea Investimentos, an independent asset management company. It operates principally in the areas of hedge funds, wealth management and illiquid investment strategies. In an interview with Knowledge@Wharton, Fraga draws upon his wide experience and understanding to talk about the financial crisis, its causes and future concerns.

An edited transcript of the discussion appears below:

Knowledge@Wharton: What are your views on what is happening with the world financial system? What caused the crisis, and what will be the impact on Brazil’s economy?

Arminio Fraga: The short version is that the world went through some very happy times. There was a lot of growth and prosperity. The five years that ended in 2007 were not stressful years in the world’s economic history. But, as often tends to be the case, people got carried away. There was quite a bit of borrowing, consumption-driven borrowing, to be more precise. There was also, as a result of all this, an impact on many asset prices, particularly on U.S. real estate.

As such things tend to go, this came to an end. What we are now going through is basically the unwinding of this great run. It is a process of deleveraging — often forced deleveraging — very unpleasant, very much like a hangover after a fantastic party.

Knowledge@Wharton: Is the hangover over, or are we still going to hit bottom sometime down the road?

Fraga: It may be that we have now been able to avoid the most extreme negative scenarios. But in my mind, we are still going to have to deal with a slowdown, a recession, and unemployment is likely to go up across these regions and other parts of the world as well. And some of the important prices in these economies have not yet adjusted. So the depression-type scenarios may be now much less likely than they were; we are, in many ways, acting according to the lessons learned from the Great Depression. But there is still plenty of work to do. There is still quite a bit of pain and, therefore, headaches down the road.

Knowledge@Wharton: What do you think of the remedies that have been prescribed for the headaches? What else could be done?

Fraga: The remedies have so far primarily targeted the functioning of the financial system. If we keep this analogy with a hangover and so on, the threat that we were facing was one of the financial system stopping, coming to a halt. In many ways, it is like the blood circulation in our bodies coming to a stop. The remedies have so far been geared towards fixing this.

It is a bit early to tell what else could be done. But so far, so good. It has been a long process, perhaps too long. Often one had the feeling along the way that the authorities all over the world were somewhat behind the curve. But the problem that is being managed is of amazingly large proportions.

Now, there are some things that have not been addressed. I do think as real estate prices in the U.S. go down towards, say, their historical trend — assuming that they do not overshoot and go below their historical trend, which is a possibility — there are other problems that are going to have to be managed. For instance, a large number of foreclosures that are very inefficient and so on.

Another way to think about this is while the lenders may be better capitalized than they were a few weeks ago, the borrowers are probably not in that great shape. So even if the lenders get back on their feet, and the money starts flowing a bit in the system, and this tremendous absence of confidence subsides, there will still be the issue of how the borrowers are going to look like with higher unemployment and lots of debt still on their balance sheets.

Knowledge@Wharton: What could be done about that part of the equation?

Fraga: That, I think, is a more complicated issue. It is not just going around, looking at financial institutions, auditing them, and coming up with the appropriate amount of capital with all the necessary features that have been discussed and now voted into law.

On the borrower side, you are dealing with the sanctity of contracts, incentives, across a diverse number of lenders, regions and so on. I am not a specialist. I am sure there are quite a few folk at work and they could come up with a good plan. I hope they are engaged in these discussions. It is a very important question.

Knowledge@Wharton: What kind of structural changes do you think are required to prevent such a crisis happening again?

Fraga: This is an ongoing debate. At the moment, it is not on the forefront of the action largely because we are still in crisis mode. But this will be discussed soon, and we seem to be converging towards a world of very large financial institutions in most countries. They are all going to be too big to fail, and I believe they will be subject to quite a bit more regulation than what we have had so far.

The issues that come to mind are the following: I believe capital ratios are going to go up; more capital is going to be demanded of such institutions. I believe funding risks are going to be addressed and probably regulated as well.

In plain English, the reliance on short-term funding will be curbed. I also believe we have gone through a period of massive failures in risk management and governance in the financial sector. I am puzzled by this, and some of the things that were done, the amount of leverage that was used in some cases. It is surprising to me that this is something that has to be regulated but I am convinced we must. Many players in the system benefit from the implicit or explicit insurance mechanisms that are provided at a low cost, and the so-called moral hazard that comes out of this has to be dealt with through regulation.

I think there are also issues of infrastructure in the system, whether more contracts will have to move to exchange or clearing house environments, and quite a bit more. I do not have a full list in my head right now, but these are a few that I believe should be at the top of the list.

Knowledge@Wharton: Conventional wisdom is that when the market is this depressed, there are some buying opportunities. Are there any that you think are interesting these days?

Fraga: Yes, both in the equity universe and in the credit universe, I am sure there are. I am not a mortgage specialist, but I am told that in quite a few securities very high default rates that may not materialize are already priced in. Those are difficult for the typical investor or the non-specialist, but they are there.

The easier ones are in the world of stocks, and here one can do no better than repeat what Warren Buffett has been saying. You should buy good businesses with good management at a good price, businesses that have a good profit margin, and that do not have much leverage. If you do not use leverage to buy, this is probably a good moment to start looking around, although I would not expect instant gratification. This is for the long-term investor and one that can put up with some volatility.

Knowledge@Wharton: I wonder if we could speak about your background. You have been described as the Alan Greenspan of Latin America, for the way you managed monetary policy during your tenure as president of the Central Bank. What were economic conditions like in Brazil when you took office, and how did they influence the way you formulated policy?

Fraga: I took office in early 1999 after the real — the Brazilian currency — was forced to float. It was a managed exchange rate regime, and the currency peg could not be defended. That meant that Brazil had to look for some other way of stabilizing prices — some anchors, we like to call them in more formal circles. We decided at that point not to go back to an exchange rate anchor. These had been frustrating for us and many other countries in Latin America and Asia, and even in Europe.

As a result, we had to look for something else, and we decided to adopt inflation targeting in a formal way, much like the Bank of England, and in Sweden, New Zealand and quite a few others. That is what we did. It was done in stages, and it worked out well. It worked also because the government had been strengthening the fiscal regime, basically fixing the budget deficit and creating a more sustainable fiscal situation.

At that point, our banking system was in pretty good shape. Brazil had had a banking crisis some years before and it was now well-managed. All these [factors] together ended up working well for Brazil. That is the short version. The long version…

Knowledge@Wharton: With 20:20 hindsight, is there anything you would have done differently?

Fraga: Little things. But I think the big picture is one that is still there, the tripod of fiscal responsibility, floating exchange rate, and inflation targeting. This has worked well for us. I would not change that. Of course, I would be silly if I had a chance to go back and not change or tweak a few things here and there. But the big structure I would not change.

Knowledge@Wharton: You have now served under two administrations, the de Mello administration as well as the Cardoso administration.

Fraga: Yes.

Knowledge@Wharton: What did that teach you about the possibilities and limits of reform?

Fraga: When I first started, I was one of the governors at the Central Bank. Those were crazy times. Brazil was dealing, at that point, with hyperinflation. Brazil was in default on its foreign debt, and so on. There was quite a lot to do; those were difficult times. We set out with a reform agenda that was pretty ambitious and included stabilizing the currency, getting rid of inflation, fixing the budget, starting a privatization program and so on, and opening up the economy.

We were moving along when we were hit by a political crisis. You may recall there was an administration that ended up getting into deep trouble and the President ended up being impeached.

So, the second half of my time in government in those days was very frustrating. We were basically just making sure things did not blow up. All of us had to hang in there. Most of us, if not all of us, wanted to leave. It looked like things were pretty bad, and we all agreed to stay until the vote. We were then going to leave regardless of the outcome. We did.

That was more a playing-defense type of experience, but it helped me a lot when I came back as chairman of the bank some years later. The second time around, even though it was again under difficult circumstances, we had a strong government with strong leadership. We were able to do quite a lot. We had a couple of years of reasonable global economic conditions and we pursued a pretty good agenda of reforms.

Later on, the world kind of turned around and we were back in crisis mode. First, there was the NASDAQ crash, then Argentina’s troubles, and so on. Towards the end there was a confidence crisis that was also politically driven. That happened when the then opposition of [Luiz Inácio] Lula started to rise in the polls and the markets panicked completely.

Luckily, for Brazil, President Lula turned out to be very pragmatic and has since done a good job. Things have kind of gotten back on track. With the help of the global boom that I mentioned earlier, Brazil has had quite a good run.

Knowledge@Wharton: You wrote an influential article titled “A Fork in the Road” some time ago. Based on that, could you comment on how Latin American economies should manage the trade off between populism and reform?

Fraga: You know, the thing that has always surprised me about populism has not been the “supply of populism”, the seemingly abundant supply of populist politicians. We find them everywhere, and we are not any different from most countries in that respect. What has been surprising for us in Latin America, over the years, is that despite the terrible results that these sorts of policies have delivered for the people of the countries in our region, somehow they keep on getting elected. That has been the most puzzling thing.

I wrote that article a while back. The thinking then was: Are we going to make the right decision and do the right thing, and kind of toughen up and do some things that, in the short-term, are not exactly easy? Some reforms are tough but have sustained long-term benefits. I think this is what I was alluding to but, quite frankly, I do not remember. I wrote a couple of things along those lines.

But that has been the tendency. I think in South America now, we are again seeing countries facing a fork in the road. The region is very heterogeneous, very split. You see some countries where you have populist leaders — Venezuela, Ecuador, Bolivia, even to some extent Argentina. And then you have others like Brazil or Colombia or Chile where you see less populism. There are always traces of populism everywhere, a greater degree in some countries and a smaller degree in others. But we have not conquered that enemy of ours; it is still there.

Knowledge@Wharton: Yes, it is not easy. The economist and Nobel laureate Joseph Stiglitz is believed to have recommended you for the job of World Bank president. If you had that job today, what would you do?

Fraga: I find that the World Bank has done a very good job over the years. Stiglitz was a professor of mine, and I was flattered when he came up with my name. I never thought of that as a realistic situation. And I have to say, therefore, that I do not quite have in my mind a sort of agenda for the World Bank. But as a former customer of the World Bank, having been in the government here in Brazil, I got a lot out of working with them.

There are things people talk about, quite a few things. I am sure if you give me enough time, I could come up with some suggestions. But on the whole, I think the World Bank plays an important role and it is constantly reinventing itself as it should be, and the world is better off with it than without it.

Knowledge@Wharton: What is the biggest leadership challenge that you have ever faced? How did you overcome it and what did you learn from it?

Fraga: I have always thought of the times I spent in government as wonderful times — often tough times. But the situations were largely dealt with by a group of people. I was part of that group, one of the leaders in the group, but not the only one. There have been quite a few [tough times]. The toughest one probably was the last one, the transition from Cardoso to Lula. Being part of that effort, there were moments when it seemed we were getting a little too close to the edge. We often wondered how this was going to turn out.

That is a good example. The solution came more through politics than economics or finance. I am not a politician, but I was very involved in the discussions. Then Mr. Lula and his team upped the speed on what was going on, and they deserve most of the credit. But I was glad to play a role.

There have been other situations. But I do not see life as being one great drama; that is really not my style. I think you kind of wake up and try to do the best you can everyday and let the chips fall where they may.

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