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Argentina falls, but no longer drags down Brazil

– When Argentina fell into the economic abyss a decade ago after defaulting on its sovereign debt, Brazil suffered right along with it, nearly following its neighbor into insolvency.

Argentina's economy is again facing a currency plunge and inflation spike, but this time its ability to inflict economic damage on Brazil has greatly diminished.

Over the past decade, Brazil has built up its foreign reserves to $359 billion, more than nine times what it had been during the Argentine crisis of 2001-02. That means the Brazilian government has more room to take action against any dangerous currency slides resulting from Argentina's turbulence.

Brazil's middle class has also swelled by 40 million, creating new consumers that drive domestic demand and make the country's fortunes less dependent on foreign trade.

And unlike in the past, foreign investors distinguish between Argentina's economic policies of widespread price and import controls, versus the more orthodox route Brazil has taken. As a result, there's less risk that investors will pull their money out of Brazil and spark a cash crunch.

"Brazil's exposure to Argentina is far less than it used to be; there is much less risk of contagion," said Ilan Goldfajn, chief economist at Itau Unibanco, Brazil's largest nongovernment bank. "I don't think Argentina is going to make a big difference for Brazil."

While Goldfajn and other economists still fault Brazil's government for wielding too heavy a hand in its economy, they say Argentina's policies have been far more interventionist. Widespread price and currency controls and rampant social spending have eaten into the country's foreign reserves, which have dropped by half in the past two years to $27.8 billion. Last month, the Argentine government was forced to stop spending dollars to defend the peso and let it lose 20 percent in one recent week.

"The investors we talk to definitely differentiate between the policy mix of Argentina and that in Brazil," said David Becker, the Sao Paulo-based chief Brazil economist for Bank of America Merrill Lynch. "It's difficult to see that we'll have a situation like we had back in 2002. Then it was a perfect storm."

In 2002, poverty rates in Argentina spiked to a half of the population and rioting rocked the country as banks froze savings accounts and the economy shrank by 28 percent. The turmoil spilled over to Brazil where the real fell more than 50 percent, in large part because of Argentina.

Today, Argentina remains Brazil's No. 3 trading partner, after China and the U.S., and Brazilian companies export many of their cars, washers, refrigerators and other products to Argentina. However, the weight of Argentina in overall Brazilian exports is shrinking, falling from 15 percent a decade ago to 8 percent now. That's been replaced in large part with more Chinese trade.

Goldfajn and other economists said the woes in Argentina may cut .3 to .4 percentage points off Brazil's gross domestic product this year, far less than the damage Argentina used to be able to cause.

However, that doesn't mean Brazil can rest easy.

The U.S. Federal Reserve's program of reducing, or "tapering," its massive stimulus package has raised yields on U.S. debt and sucked investor money out of emerging market nations such as Brazil, as bond buyers seek the increasing returns on more stable American debt.

The other big danger lies in Asia, and especially slower growth planned by China's government.

"By far, the thing that would hurt Brazil the most would be a hard landing by China," said Goldfajn. "But that's also not very likely. China's deceleration will be highly controlled. The more likely risk for Brazil is the rising interest rates in the U.S."

China's projected 7.5 percent growth rate this year, down from the double digits of the recent past, ratchets up pressure on Brazil to find new buyers of its raw goods. In the past decade, Brazil has enjoyed an export boom of iron ore, soy and other products to China.

Brazil did itself no favors during that period by failing to streamline its own economy or make significant improvements to infrastructure such as roads and ports that could help Brazilian companies more efficiently get goods to market.

A research note this week from London-based research group Capital Economics said such infrastructure problems and the U.S. stimulus tapering mean Brazil's growth will remain "extremely weak," adding that the country is "vulnerable to recession if market turmoil escalates."

Still, the chances of any domino effect in South America remains unlikely, the group said.

"The emerging world has become a far more diverse place over the past decade," the Capital Economics note read. "In the past, financial crises have tended to sweep from one emerging market to another, primarily because they shared many of the same vulnerabilities. The situation today is very different and it no longer makes sense to view the emerging world as a single group of economies."

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Bradley Brooks on Twitter: www.twitter.com/bradleybrooks

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Associated Press writer Michael Warren in Buenos Aires contributed to this report.

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