(FORTUNE Magazine) – The salvation of the world economy is a heavy burden to lay on a country beset by yawning government deficits, ghastly poverty, anemic economic growth, and a long history of hyperinflation and debt problems, not to mention a soccer team that lost the World Cup--to the French. But to hear the talk from Wall Street, that's what things have come to. "Brazil is the next line of defense," says Robert Barbera, chief economist at brokerage house Hoenig & Co. "It's probably the last line of defense."

The world's ninth-largest economy has been struggling since summer to fend off the kind of currency collapse that devastated Asia and Russia. The International Monetary Fund is on the case, along with the U.S. Treasury and European authorities, preparing a credit line estimated at around $35 billion. Brazil's central bank, meanwhile, has spent more than $20 billion of its foreign currency reserves since August to prop up the real. That's a lot of money, but it may not be enough.

The problem is that the economics of the Brazilian rescue scenario are extremely shaky. Brazil's currency is overvalued by about 20%, and everyone knows it. The alternatives to propping it up, however, are too scary to contemplate.

Unlike the Asian meltdown of last year, a Brazilian collapse wouldn't exactly be a surprise, but it would still probably send global financial markets reeling. The profits of U.S. multinationals, which make more money in Brazil than in any other emerging market, would take a hit (see table). Other Latin American countries would come under pressure to devalue. In the worst case, that could bring on an Asia-style regional economic collapse, and then the world's big banks, already wounded by bad loans in Asia, hedge-fund collapses, and wild interest rate swings, might totter if their $111 billion in loans to Brazil (and $210 billion to the rest of Latin America) start to go bad.

What led Brazil to this precipice was a series of decisions that, when they were made, appeared perfectly rational. Until five years ago the country was a mess. Inflation had gotten out of hand, hitting 47% a month in early 1994. The country's currency had no credibility; its economy was stagnant and inwardly focused. In mid-1994, then-finance minister Fernando Henrique Cardoso introduced a new currency, the real, and tough inflation-fighting measures. Prices stopped rising, the economy grew, Brazilians started feeling richer, and investment capital poured in from abroad. Cardoso became a national hero and was elected president later that year (he was reelected in October).

Cardoso's reforms did bring on two problems. First, the inflow of capital from abroad boosted the value of the real, which helped lower inflation but led to a growing trade deficit. Second, government officials could no longer play the hyperinflationary accounting games that had kept budgets largely balanced. Deficits ballooned. In response, Brazil linked the real to the dollar with a "crawling peg" that allowed the real to devalue, but slowly and steadily enough to ward off inflation and reassure investors. Also, Cardoso tried to clamp down on government spending increases until the economy, and tax revenues, could catch up.

For a while it worked, because investors at home and abroad were willing to fund the deficits by buying long-term government securities denominated in real. But last year's Asian currency crises alarmed investors everywhere, and since then Brazil has had to issue short-term securities, many of them linked to the dollar, to keep people buying. In addition, the country's central bank had to raise short-term interest rates above 40% last fall to fend off a run on the real. That squeezed the economy. It also meant the government had to pay a lot more interest on its debt, which in turn made the deficit even bigger. (It's now more than 7% of GDP.)

The real didn't crash, and interest rates went down last spring. But when investors started looking suspiciously at Brazil after Russia's collapse in August, they saw a country with a weakening economy, a growing budget deficit, and tons of debt coming due soon--$92 billion in the last three months of 1998. Interest rates nearing 50%, coupled with rumors of IMF help and the happy coincidence that many of the world's hedge-fund jackals were too busy licking their wounds to bother Brazil, have kept the increasingly unreal real from collapsing. But who knows how long it can hold up?

The hope is that with a credit line from the IMF and some nice, sharp budget cuts, Brazil can restore investor confidence enough to lower interest rates and issue longer-term government debt. After six months or so, when everybody has settled down, it might even quietly bring the real down to a more reasonable level. But sharp budget cuts on top of today's high interest rates are a recipe for a deep recession, one that the government can't do much about for fear of scaring investors. (Those investors might bail out anyway, because who wants to put money in a shrinking economy with an overvalued currency?)

There are alternatives to this IMF-standard approach, but all involve a sudden currency devaluation that could send investors scurrying and inflation rocketing--and would make paying off dollar-linked government debt a big problem. So the world crosses its fingers and hopes the bad economics of Brazil and the IMF somehow turn out all right.