Brazil imposes capital tax to reduce FX pressure
The spectre of capital controls in EM looms large
Brazil slapped a new tax on foreign investors this week, highlighting the re-emergence of capital controls in developing economies faced with sharply rising currencies due to capital inflows.
"What concerns me is the signal from Brazil that it cares more about its export sector than foreign investors," said Paul McNamara, local currency portfolio manager at Augustus Asset Management.
On Tuesday, the Brazilian finance ministry announced a 2% tax levy on foreign investors participating in both local equity and fixed income markets — though this does not apply to issuance of external debt by Brazilian companies. The levy in Brazil is higher than a previous 1.5% tax that was scrapped in October 2008 to encourage foreign capital inflows and the previous measure did not apply to equities.
Local reports suggest the central bank was not informed of the measure before the announcement. Guido Mantega, Brazil’s finance minister, said the tax was to "prevent excesses" in local asset markets, reduce speculative inflows and more importantly, cool appreciation pressures on the currency. There have been $17bn of net portfolio inflows into Brazil so far this year with $13.5bn in equities and $3.5bn in fixed income, according to HSBC researchers.
The currency conundrum
Emerging market governments, only recently, were scrambling to attract capital in the face of global deleveraging. In March, Chile announced its 17% capital gains tax for foreign and local investors in onshore bonds would be scrapped. However, Brazil’s move highlights how governments and central banks are now prepared to choke off capital inflows to boost export competitiveness.
"I am worried that Brazil’s tax levy is likely to introduce the use of capital controls in the domestic debate in places like Colombia and Peru where capital inflows are strong," said McNamara. Others agreed. "Colombia and Peru will be influenced by Brazil’s decision this week," said Sao Paulo-based ING economist Zeina Latif.
In the current environment of strong risk appetite, exceptionally low global interest rates and cheap liquidity, policy-makers are grappling with the fallout of large-scale capital inflows: currency strength and potential asset bubbles.
Nevertheless, economists argue taxation of capital inflows is an impotent tool in curbing currency strength in emerging markets faced with strong structural growth prospects and global liquidity. This is down to the economic policy conundrum known as the ‘impossible trinity’, which blighted policymakers in the global bull run. This states that it is impossible for countries to manage their exchange rates, control inflation and allow the free movement of capital all at the same time. Emerging market policy-makers have historically craved exchange rate stability by sterilizing inflows.
Brazil is particularly vulnerable to speculative capital inflows due to its chronically high interest rate environment compared with its Asian counterparts. This means the central bank’s mission of sterilizing capital inflows to bring down the exchange rate is costly. Nevertheless, analysts don’t expect Brazil to impose more extreme measures such as foreign exchange controls or additional restrictions on portfolio inflows.
If capital inflows continue to overwhelm emerging markets, the cost of sterilization will increase globally as inflation picks up, interest rates rise and asset price increase. As a result, economist fear emerging economies may see capital controls as the only weapon left in the battle to contain hot money inflows.
Russia, Romania and Poland have expressed concern in recent months over their sharply rising currencies. However, the introduction of capital controls in central and eastern Europe is unlikely as the region is not overwhelmed by a tide of foreign liquidity as interest rates are still being reduced, said a Citigroup research note this week. "There is much more scope for higher rates in Latin America to catalyse speculative inflows, reinforcing the incentives to experiment with capital controls. In CEEMEA a number of countries — Russia, Romania, Ukraine and Turkey — will still be cutting rates near-term, in our view." In addition, EU countries face legal obstacles to the introduction of capital controls.
Brazil’s move also comes hot on the heels of Turkey’s Constitutional Court that last week ruled against the differential application of a withholding tax on bonds to residents, who currently pay 10% while non-residents are exempt. The government will have nine months to come up with a new arrangement that equalises the tax treatment for local and foreign investors. If the government decides to keep the withholding tax at current rates, the 10% rate will apply to foreign bond investors as well.
The court made the ruling in response to a case brought about by the opposition Republican People’s Party (CHP) which has campaigned to boost the country’s export competitiveness. Foreign investors own around $17bn of Turkish bonds, predominantly government bonds, 15% of the total.
In the short-term, the market impact of the tax in Brazil is likely to affect the fixed-income mart disproportionately more than equities "due to the added illiquidity costs in the bond market and the immaturity of the asset class relative to equities", said a Brazilian investment banker.
Foreign investors are likely to flow back to the sovereign’s global real curve — which is paid in dollars but indexed to the currency — as the tax does not apply to external debt.
"The news from Brazil is clearly negative for investors but its short-term impact will be to trigger a migration into global government bonds rather than big outflows," said a debt capital markets banker on Wall Street.
Investors have tended to favour government bonds issued onshore, known as the DI curve, due to the higher yield pick-up of around 340bp, according to McNamara at Augustus Asset Management.
Brazil’s local debenture market largely comprises governments bonds. Risk aversion from local institutional investors, who demand firm pricing guarantees and often hold debt until it matures, has typically undermined liquidity in the asset class for private sector issuers.
However, a growing pack of yield-hungry foreign investors has triggered hopes in recent months that they will snap up private sector debentures and in turn, encourage greater private sector issuance.
Foreign investors already face separate taxes on private sector bonds so this measure has, in the short term, barely affected the nascent international interest in Brazilian private sector bonds issued locally.
But the new tax has, nevertheless, "re-enforced the attraction of cross-border dollar markets for medium-tier Brazilian firms", said Diego Torres, Latin American corporate debt analyst at ING. He said medium-sized issuers — that typically don’t have access to big-ticket syndicated loans — would stay faithful to cross-border debt issuance partly because the asset class is not vulnerable to unexpected taxation.
Nevertheless, the greater liquidity offered by the global investor base remains the key attraction for issuing dollar-denominated international bonds for Brazilian companies.