NEW YORK (CNNfn) - Brazil stunned global financial markets Wednesday with a devaluation of its currency and the resignation of the currency's staunch defender Gustavo Franco.
Franco, president of Brazil's Central Bank, was one of the prime forces behind Brazil's four-year economic recovery, deftly guiding the world's eighth-largest economy back from its financial troubles. He was succeeded by Francisco Lopes, the bank's director of monetary policy.
At the same time, the Brazilian Central Bank announced it would effectively devalue its currency, known as the real, through more flexible currency and interest rate policy.
The moves, which ignited fears that an economic crisis in developing countries could hurt global prosperity, roiled markets around the world with the Dow Jones industrial average tumbling more than 260 points before rebounding to 9,350 -- down 125 points.
By the end of trading Brazil's currency, the real, weakened 9 percent to finish at 1.32 reals to the dollar after the central bank removed the tight mini-band in which the real had previously traded.
President Bill Clinton said he was in contact with key Brazilian government officials and the International Monetary Fund, and was carefully monitoring developments in world markets.
"We have a strong interest in seeing Brazil, with whom we have worked on so many important things around the world, carry forward with its economic reform plan and succeed, and we certainly hope that they will,'' Clinton said.
Devaluation had been feared
That the real has been overvalued is not a secret among the world economic community.
In fact, many economists saw its devaluation as inevitable at some point. Brazil's policy of propping up its currency forced the country to maintain high interest rates, which can hurt economic growth.
Nevertheless, experts say Brazil's decision to devalue the currency could have widespread effects around the world.
"Say you buy a factory in Brazil. When Brazil devalues its currency, that factory's value in dollars drops dramatically so your investment is worth a lot less. People are less likely to invest in a country that's prone to devaluations," said Greg Mastel with the Economic Strategy Institute.
Move could hurt U.S. firms, banks
An estimated 2,000 American businesses operate in Brazil, including such blue chips as Ford Motor Co. (F) and Coca-Cola Co. (KO).
U.S. banks, meanwhile have a $27 billion stake in the country.
"Many of our banks have lent money to Brazil, and some of those loans may not look so good today after the devaluation as they did before. So banks will be hurt, or some banks will be hurt and the stockholders in those banks will be hurt," said Gary Hufbauer Institute for International Economics.
Brazil's move is expected to eventually help its economy by making its exports cheaper and by lowering Brazilian interest rates. But currency devaluations can be tricky and often unpredictable.
"A good example is Mexico in the mid 90's," Mastel said."It tried to do a moderate devaluation, but the market didn't accept it. It lost control of the currency, there was a dramatic devaluation, and a subsequent recession -- even a depression in Mexico."
Pedro Malan, Brazil's finance minister, said the government chose to devalue the currency in order to give officials a flexibility which was not there before.
In an interview on CNNfn Wednesday, Malan said he did not think another move would be needed.
"The movement today means almost a 9 percent movement. It's hard to argue that there is a need for further movement. There is a tendency to overshoot in these things and we know this."
"The fiscal program is on track. There is no reason for fear about our ability to implement it as presented," he said.
However, Sherry Cooper, chief economist at Nesbitt Burns Securities, said Brazil continues to face challenges.
"There are also great concerns about the political instability within Brazil," said Cooper.
"There has obviously been quite a bit of dissension as to the governmental policies, the slashing in fiscal expenditure, potential tax increases, as well as the astronomical increases in interest rates."
State and municipal governments have chafed under some of the austerity measures. Last week, a state governor announced he would suspend debt payments to the central government for 90 days. While other states have yet to follow suit, it has created concerns about more panic within the country.
The new central bank president quickly tried to head off some of the uncertainty by denying Brazil had carried out a major devaluation and said the country still had "almost $45 billion" in reserve to defend the real.
As might be expected, the news from Brazil had its most immediate consequences on its closest neighbors.
When Thailand devalued its currency in 1997, it led to a string of devaluations among neighboring countries which shook the region's finances.
Similarly, Latin American countries worry their own region's finances will be hurt as overseas investors lose confidence in the region and send their investment money elsewhere.
For neighbors such as Argentina, which sends one-third of its exports to Brazil, the news couldn't have been worse and economists there predicted planned sales of state-run businesses, such as the Banco Hipotecario mortgage bank and stakes in oil firm YPF would have to be postponed.
Rubin tries to calm markets
While U.S. markets struggled all day Wednesday with Brazil's problems, as did European markets, the U.S. government tried to take a muted approach to the situation.
"We are in close touch with the Brazilian authorities, the IMF, the G-7, and the financial authorities of key emerging markets and will continue to watch developments in world markets closely," said U.S. Treasury Secretary Robert Rubin in a statement.
U.S. banks and other financial institutions which could be hurt most due to exposure in Brazil may be able to avoid the major problems they've had in similar circumstances, such as the Russian financial crisis last summer.
Firms in the United States saw the problems in Brazil coming, according to John Williams, global economist at Bankers Trust.
"In a sense, I think we've kind of been there and done that on this issue," said Williams.
"So, most major financial institutions, presumably, are not overly exposed to emerging markets. At least, [they] are aware of the problems and have kept their exposure to a minimum. We shouldn't, I think, see quite the same impact on financial markets, generally, this time around."
IMF strictures loom
Brazil won't be free and clear to do whatever it wants to deal with any repercussions of its most recent financial moves.
In November, the International Monetary Fund, with the United States' urging, unveiled a $41 billion loan package to help Brazil along the path to better financial times.
The agreement was part of a new IMF policy which hoped to pump aid into at-risk countries before financial problems became widespread.
As with most IMF aid packages, this one required Brazil to use high interest rates to preserve investor trust in the embattled real. The IMF's plan, according to economist Cooper, didn't quite go as expected.
"The IMF was unable to forestall the mass exodus of foreign exchange and reserves from the country and Brazilians themselves lost confidence, so the inevitable result is the devaluation," she said.
"The question is how big it will be and when does the market level out."
Still, Brazil has much going for it, including an $800 billion gross domestic product, or about 3.8 percent of the total world's GDP.
In addition, the government maintained some semblance of continuity by choosing Lopes, already a key player at the Central Bank, to take Franco's place.
"Brazil has in many ways a very robust economy," said Peter Scott, chief executive of Beta Funds.
"It has a very strong corporate sector, a very sensible government and Brazil is a place that is going to do extremely well over the medium term after this rough patch is out of the way."
-- from staff and wire reports