It’s back to the future for Brazil on currency and inflows.
Data over the past few days provide clear evidence of sustained foreign inflows sparking renewed currency appreciation and trade weakness in Latin America’s largest economy:
-International investors plowed a record 7.17 billion Brazilian reais ($4.13 billion) into Brazilian stocks in January
- Brazil posted a trade deficit of $1.291 billion in January, the biggest ever recorded for the month, as European weakness and a still-strong Brazilian currency hurts the country's ability to export.
- Brazil’s real rallied to the strongest level in almost three months on Wednesday, touching 1.7295. It has gained more than 6% vs. the dollar since the start of the year.
Trade and finance officials have ratcheted up the rhetoric in response, warning of the negative impact of a renewed wave of currency appreciation:
- Tatiana Prazeres, secretary of foreign trade, warned of the negative impact of the strengthening appreciation on the trade deficit at a press conference in Brasilia yesterday. "It's undeniable that the exchange rate is having an effect on exports. The real isn't at a comfortable level for Brazilian exporters,” she said.
-Finance minister Guido Mantega pledged last week that the government would "continue with our policy of preventing the appreciation of the currency and the policy of trade defense."
Sound familiar?
To recap, a combination of persistently high interest rates, solid GDP growth (until the second half of 2011, at any rate) and the direct and indirect effects of ultra-low rates and quantitative easing in developed markets drove strong currency appreciation in Brazil from early 2009 until mid-2011. This was despite the introduction of a series of measures designed to stem the tide of speculative inflows and halt the appreciation of the currency. These included a tax on foreign purchases of domestic equities and bonds, hiking reserve requirements for foreign investors and increasing levies on foreign loans and currency bets on derivatives markets.
In common with most EM currencies, the real subsequently saw a decline vs. the US dollar during the second half of last year. But the recent rally has seen the Brazilian currency recoup much of this lost ground against the dollar, a major concern given that, by most analysts’ reckoning, it remains significantly overvalued. A Barclays Capital report last week suggested that real’s current value was around 25% higher than fair value, making it the most overvalued of the major currencies that it tracks (see chart below).
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With Brazilian policymakers fretting about the likelihood of a slowdown in demand from Europe, the possibility of a moderation in demand from China, as well as the prospect of long-term near-zero rates and the likelihood of further liquidity measuresby both the US Federal Reserve and the European Central Bank, analyst expectations are mounting that Brazilian policymakers may resort to a fresh round of capital controls in a bid to prevent further appreciation.
Here’s UBS’ Brazilian economist Andre Carvalho:
| With the BRL rallying strongly to begin the year and now trading below BRL1.75 per dollar, we see the potential for new official measures to curb BRL strength on the horizon. Specifically, we expect the Central Bank to resume its dollar purchases and the Finance Ministry to contemplate the introduction of new FX policies. |
And BarCap’s Olivier Desbarres and Nick Verdi:
| We think the risk of central bank FX intervention is mounting, in our view. So far, verbal intervention has dominated but market participants have become more sensitive to intervention risks given that USD/BRL is only 3.5% away from the level (1.70) at which the central bank started its intervention programme. |
Brazil has built up a reputation in recent years as being an early mover among large EM economiesin policy terms. Its policymakers have also been extremely unspoken on currency matters – finance minister Guido Mantega warned in October 2010that the world faced an “international currency war”, whereby some countries had sought to weaken their currencies to boost exports and improve trade balances, at the expense of others, such as Brazil, that had seen their competitiveness plummet as their currencies soar. Following Brazil’s implementation of capital controls, a large number of EM policymakers followed suit, with even the IMF acknowledging that such interventions were justified in exceptional circumstances.
Should the current EM FX rally last, prompting Brazil to intervene to defend its currency once again, it would rekindle fears of a fresh round of currency interventions and a rise in protectionism, with potentially negative consequences for global trade and growth. Given that China’s exchange rate is likely to be a key theme in the upcoming US presidential elections, these concerns appear well-grounded.
Of course, as UBS’ Carvalho points out, the outlook for the real, and for government policy, depends to a large extent on the global macro outlook.
Carvalho adds:
| The BRL is likely to remain one of the highest-beta currencies in Emerging Markets (EM), and thus a critical determinant of the currency's value will be global macro conditions. Assuming no major disruption in the Eurozone, however, macro forces remain supportive of long-term BRL appreciation. We expect BRL to reach BRL1.60 per dollar at the end of 2013, its strongest level in real terms since at least 1980. This would be a bad scenario for most exporters. |
This is, of course, a big assumption, and despite current market exuberance, the risks to global growth remain acute. But it is certainly a policy risk to watch.