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. Last Updated: 07/27/2016

Why Devaluation of Real Shook World

WASHINGTON -- If you're an average investor, you've probably never heard of Itamar Franco or the state government he heads in Brazil.

But thanks to this cantankerous governor of an ailing state in a troubled Latin American nation, world stock and bond markets from New York to Frankfurt to Mexico City quaked Wednesday at the specter of a new bout of global financial instability, just as the last one seemed to be fading.

Just last week, the tempestuous Franco declared that his once-wealthy industrial state, Minas Gerais, had been so hard-hit by the economic downturn in Brazil that it wouldn't honor its debts to Brazil's federal government. That triggered a crisis of global investor confidence in Brazil's financial stability, a new bout of capital flight from Brazil, and then Wednesday's effective devaluation of the Brazilian currency, the real.

The typical person probably views the real as something unreal. But for four months international bankers have described the defense of the real's value as a Maginot line in the battle to restore international financial stability.

That's because so many investors, companies and workers are tied to the fate of Brazil. And because Brazil accounts for 40 percent of Latin America's economic output, its problems are also Argentina's, Venezuela's, Chile's and Mexico's problems. And because 20 percent of U.S. exports go to Latin America, Latin America's problems are U.S. problems too. And because investors tend to tar all emerging market economies with the same brush, instability in Brazil can rock markets in Turkey, Russia, South Africa and Hong Kong.

"That's been the nature of this global crisis,'' said Edward Yardeni, New York-based chief economist of Deutsche Bank Securities. "It starts somewhere you never imagined should be that important, like Thailand or a small province in Brazil.''

"Historically people thought you could diversify risks between U.S. and developing markets. But there's been convergence and the links are getting closer,'' said Leila Heckman, managing director for global asset allocation at Salomon Smith Barney, a unit of Citigroup.

Economic analysts now forecast a deep recession for the entire South American continent. A Latin America expert at one major U.S. bank predicted that Brazil's interest rates would climb higher now that the government's credibility is shattered. That would strangle economic growth in Brazil, push up inflation and impoverish millions of Brazilians. The Brazilian budget deficit would grow as tax receipts fall, forcing more borrowing at ever higher rates, currently around 30 percent domestically. "It is a day to be marked down as a black day for Latin America,'' he said. "Brazil has just blinked.''

For the U.S. economy overall, a downturn in Latin America this year could knock a few tenths of a percentage point off U.S. growth, estimated Jeffrey Sachs, an economist and director of the Harvard Institute for International Development. "The consequences are not large,'' he said, "but they're not insignificant.''

More importantly, many analysts worried that Wednesday's devaluation by Brazil would be the opening shot of a new round of global financial tremors by putting pressure on the Hong Kong dollar, the Argentine economy, and emerging markets in general. That could make Brazil's move another step toward a dangerous worldwide cycle of falling prices, incomes and demand for goods - including those produced by U.S. companies.