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Document 2 of 2.

January 14, 1999, Thursday LONDON EDITION 3

SECTION: FRONT PAGE - FIRST SECTION; Pg. 01

LENGTH: 502 words

HEADLINE: Stormy waters as currency anchor is abandoned

BYLINE: By Geoff Dyer in Sao Paulo

DATELINE: Sao Paulo

BODY:
Brazil's slow-burning economic crisis erupted into political turmoil yesterday after the government abandoned the strong currency policy that has served as the anchor of its anti-inflation strategy.

The government acted by devaluing the Real following the fourth assault on its currency in 18 months and a steepening recession.

Francisco Lopes, who took over as head of the central bank after Gustavo Franco resigned, said the new policy would only work if capital outflows slowed and public spending was cut. At least $ 700m (Ł425m) left Brazil yesterday.

The new policy drops the narrow trading band, which permitted the Real to depreciate gradually against the dollar, in favour of a wider band. This allows for an immediate devaluation of up to 9 per cent and a further 3 per cent over the course of the year.

After the failed attempts by Mexico in 1994, Thailand in 1997 and Russia last year, Brazil is the latest emerging economy to walk the tightrope of trying to engineer a controlled and modest devaluation. The government said it would use its reserves and, if necessary, higher interest rates to prevent the sort of uncontrolled over-shooting that has characterised recent attempts by developing countries to devalue their currencies.

The political uproar was made worse by the resignation of Mr Franco, a former economics professor, who was the government official most closely associated with the previous strong currency policy.

"It was never my intention to act as a hindrance to the natural re-orientation of interest rate and foreign exchange policies," said Mr Franco, who had become the focus of attacks on the government's austerity strategy.

Mr Lopes, who was the bank's monetary policy director and effective deputy, said the main objective of the more "flexible" currency policy was to create conditions for reducing the high interest rates that have been suffocating economic activity.

Fernando Henrique Cardoso, Brazil's president, said the shift in currency policy would not detract from the primary objective main aim of reducing Brazil's crippling budget deficit - about 8 per cent of gross domestic product, and one of the main causes of the economy's vulnerability.

"Any reduction in interest rates will depend on progress on the fiscal adjustment," he said, in the sort of authoritative tone that critics have found lacking in his recent public pronouncements.

At the back of Mr Cardoso's mind must have been the knowledge that failure to control the devaluation could precipitate the return of inflation, robbing him of his main political achievement and dealing a death-blow to his second term, which only began 13 days ago.

In its favour, Brazil has $ 45bn (Ł27bn) of reserves to defend the new rate, and it has in place a $ 41.5bn package of emergency aid.

The government last night received welcome political support when the Congress approved tax increases totalling R$ 4bn. The success of the fiscal austerity programme is seen as vital.

LANGUAGE: ENGLISH

LOAD-DATE: January 14, 1999