Russian fallout puts Brazil and Venezuela back in the firing line

Latin America managed to defend itself against the first onslaught of the Asian crisis thanks largely to the vigour with which Brazil cut spending and raised interest rates. Now the pressure is on again, more intense than ever, because of the Russian crisis.

This time, the country most in the firing line is Venezuela. The growing popularity of a leftwing movement there led by Hugo Chavez, a charismatic former army officer, is adding a political dimension to the region's financial crisis. If Venezuela's currency collapses, it will be all the harder for the bigger economies of the continent - most importantly, Brazil - to retain international confidence and prevent a new flight of portfolio investment. For US companies that could have a bigger impact than the Asian crisis: through direct investment and trade, they have more at stake in Latin America than in any other emerging market region.

For much of the year Venezuela has been struggling as a result of the slump in the price of oil, which has fallen from nearly $22 (£15) a barrel last September to less than $13 a barrel now. The country, which accounts for 6 per cent of world oil exports and is the main supplier to the US, relies on oil for nearly half of its public sector income and more than two-thirds of its export revenues. The decline in oil prices, which partly reflects falling demand in Asia, has reduced government income, leaving Venezuela with an expected fiscal deficit of 5.3 per cent of gross domestic product. Many analysts think a devaluation is unavoidable.

Over the past few weeks investors have become increasingly worried by political uncertainty ahead of December's presidential election, especially by signs of growing support for Mr Chavez, who is now favourite to win. The Caracas stock market has plunged 24 per cent in the past two weeks; it has fallen more than 70 per cent since the beginning of the year (only a little better than Russia, which has fallen 83 per cent). Venezuela's international bonds are trading at levels that imply expectations of a default. Last Friday afternoon, yields on some Venezuelan bonds reached 40 per cent.

Mr Chavez came to prominence when, as a lieutenant-colonel, he led a bloody but unsuccessful military coup six years ago. After a period in jail he has emerged as the most prominent opponent of the government's programme of economic liberalisation; a fierce critic of corruption and mis-management; and an advocate of far-reaching constitutional change. These are all characteristics shared by another former general turned presidential hopeful, Alexander Lebed of Russia.

Earlier this year local analysts wrote off Mr Chavez's opinion poll showings as a flash in the pan. But his popularity has been repeatedly confirmed over the past five months. A recent poll by the Datanalisis polling organisation showed that 46 per cent of Venezuelans intended to vote for Mr Chavez in December, 19 points more than his nearest rival.

In recent weeks, local businessmen who have long been worried about Mr Chavez have been buying dollars, forcing the government to raise short-term interest rates to defend the bolivar, the local currency. And over the last two weeks in the wake of the Russian debt default, Mr Chavez's hints of a possible moratorium on Venezuela's debt repayments have assumed a new significance. "I think events in Russia have focused people's attention on what Chavez has said," says Mr Francis Freisinger, head of Latin American economics at Merrill Lynch in New York.

"In other countries you have a fair idea about what the policy will be after the election. But in Venezuela there is tremendous uncertainty about the future."

Venezuela may be unusual but it is not unique: some of its problems appear elsewhere. Brazil is also in the midst of an election campaign while struggling with a large budget deficit and a falling stockmarket. Its fiscal deficit - which reached 7 per cent of GDP in May - and sizeable current account deficit have been a source of concern for some time. "The markets are so nervous," says Mr Ian Campbell, head of Latin American Research at Banc-Boston Securities in Boston. "A Venezuelan devaluation would give the impression that contagion is spreading to Latin America."

Brazil is taking a mauling on the markets. Last week, shares on the Sao Paulo stock exchange fell by 13 per cent. Yields on one class of widely traded bonds rose by more than 4 per cent over the course of the week to nearly 24 per cent. So far there has been no sign that any of this will influence the result of Brazil's presidential elections in October, in which President Fernando Henrique Cardoso still enjoys a strong poll lead over Luis Inacio Lula da Silva of the leftwing Workers' Party.

But further falls in the bond markets will put pressure on the government to increase interest rates to defend Brazil's currency, the real, and that in turn would increase the burden of servicing the domestic debt. Brazil has room for manoeuvre - it has some $67 billion in international reserves - and should be able to defend itself for some time.

But there is little doubt that the shift in investor sentiment is changing the economic outlook for next year, when Brazil may need to borrow as much as $50 billion abroad in order to service its current account deficit and pay off creditors.

Analysts are worried that it will be more expensive and more difficult for the government to raise debt finance, and that it will be harder for big foreign companies to raise the money needed to fund ambitious investment plans.

"I am afraid that investment programmes will be revised downwards," says Mr Freisinger, who is one of a number of economists taking a more pessimistic view of growth prospects.

Even if the panic of recent weeks eases, Brazil - like the rest of Latin America - faces tough times. If it does not ease, Latin America could move from the outpatients' department of the global market hospital to the emergency ward.