“We have a currency war,” shrieked Brazilian finance minister Guido Mantega in March. A ‘tsunami’ of dollars that had washed up on Brazilian shores has been caused by “a depreciation in the value of the currencies of developed countries, thus impairing growth” in emerging markets, chimed in president Dilma Rousseff. If there is a currency war, Brazil has been winning the battles of late.
The real has been bouncing around in the past few years. It reached scorching levels in 2008 of close to 1.50 to the US dollar, just before the crisis bit, before a sharp devaluation when it slumped to 2.45 against the US dollar. Last year, the currency zoomed back up and hit 1.58 against the dollar.
At that level, Brazil was one of the most expensive places on the planet. In July of last year, The Economist’s Big Mac index pointed to the real as the world’s most over-valued currency when taking into account GDP per capita with an over-valuation of 149% against the US dollar. Executive salaries were the highest in the world, according to a Mercer survey. Costs of living in São Paulo became the highest in the Americas.
The slide in the real since last August then has been impressive too. The currency has tumbled from its 2011 high of 1.55 against the US dollar to close at just over 1.90 on May 7.
What caused all this turbulence?
In large part, the moves have come from a series of Brazilian government policies, themselves a reaction to the whipsawing in the FX market. Early on, Brazil’s response to the high real came predominantly via market interventions in the spot market and a building up of reserves. The first line of defense against a strengthening currency is no different to most countries. The Central Bank focused on intervention in the spot and swaps market. Last year, it implemented twice and even three daily interventions in the spot FX market. The country has also sought to temper the currency by rapidly building up international reserves. They jumped from $288.6bn at the end of 2010 to $352bn at the end of last year.
So far, so conventional. But the country has also been trying out more unproven measures to control its FX markets since 2008. These include a series of unorthodox and increasingly wide-ranging and deep capital controls. The vigorous interventions have make Brazil a keenly watched area by FX experts as a testing ground for such policies and their effectiveness. “The government has been committed to battle currency pressure using a variety of measures, some of which are not orthodox,” says São Paulo-based Ilan Goldfajn, chief economist at Itaú BBA, the investment banking arm of the eponymous bank.
Brazil had to resort to unconventional measures because of inflationary pressures. The country had not been able to bring down real interest rates as far as the developed world as the hyper-inflation of the 1980s was only vanquished as recently as 1994. That has made the Central Bank hyper-sensitive to cutting rates fast, fearing that a low rate environment could spark high inflation again.
With monetary policy strictly limited, Brazil resorted to a series of capital controls. In 2009, it imposed a 2% financial tax on foreign bond investors. That was extended in October to cover public and private equities. Last year, the government abolished the hated 2% tax on equities, but expanded the bond tax progressively to 6%, a level reached in March last year. It refused to tip its hand on its next moves.
The lack of transparency was a deliberate choice. To make its actions more effective: “the government opted not to reveal its intentions. That kept the market guessing that there may be more to come and discouraged inflows,” says Goldfajn. Putting off foreign investors is a risky strategy: Brazil has a macro situation that is different to other emerging markets as domestic savings are low, making the country dependent on foreign investments, he notes.
Goldfajn agrees that global economists are more forgiving of capital controls than they have historically been, but believes the unpredictable nature of the Brazilian government’s moves could prove detrimental to long-term investments. Moreover, even these taxes could not prevent the real from rising and a peak was reached last August.
It was only in that month that the real marked an abrupt turn-around and that was when a new tool came into play: monetary policy. A rapid series of interest rate cuts have succeeded in bringing down the currency. Rates have come down 3.5% since last August from 12.5% and the Central Bank has signaled that further rate cuts may be in order.
The interest rate cuts have prompted concern as well as praise. The policy follows last year’s appointment of Alexandre Tombini as president, under the new government of Dilma Roussef and a number of asset managers fear the government’s determination to reduce rates has undermined the Central Bank’s hard-won autonomy and could cause inflation to spike down the road.
“The Central Bank is working more closely with the Minister of Finance than they have done for the last 15 years,” says Alexander Gorra, senior strategist at BNY Mellon ARX in Rio de Janeiro. He sees further rate cuts with the Central Bank trying to push down both short and long term rates.
Ronaldo Patah, head of fixed-income in São Paulo at Itaú Asset Management, one of Brazil’s largest asset managers with R$300bn under management, thinks that the Central Bank has become much harder to read under the new president. “For fixed-income managers, life has been very tough over the last 18 months especially on the government yield curve. We weren’t able to read the Central Bank in an efficient way,” he says. A recent survey by Bloomberg highlighted the Brazilian Central Bank as the most unpredictable among the top 10 world economies.
Patah worries that the Bank has drifted away from its inflation-tackling mandate to consider GDP growth in its decisions. Officially, the Bank says it is only targeting inflation, but many economists and investors think the bank is also weighing GDP growth in its rate-setting policy, he says. He does not see the Central Bank having a fixed target for such growth but believes it has taken a leaf out of the Federal Reserve, which has an explicit growth consideration. The difference is that the Brazilian Central Bank has no such written mandate. “If they were more explicit at the Brazilian Central Bank, it would be easier for everyone,” he says.
The rapid cuts in interest rates has raised the spectre of renewed inflationary pressures in the medium term. At the start of the year, inflation expectations for 2013 were creeping up steadily, says Gorra. However, since then weak global economic conditions have vindicated the Bank’s rate cutting policies and the latest data, with consumer inflation at 5.24% in Brazil in March, is less than had been forecast.
The effect of lower rates is cascading into many areas outside the FX market too and ending the attractiveness of the carry trade. Lower interest rates are compelling investors to take a very hard look at their asset allocations with the real interest rate in the 3%-4% range. “We are reaching the pain threshold for institutional investors,” says Gorra. “Many have target returns of 6% plus inflation,” he notes. With nominal rates at 9% and inflation higher than 5%, real returns are already below 4%. The carry trade, typically using Japanese yen, is no longer as attractive and helps explain the fall in the real.
Investors are more likely to put money to work in both the public and private equity markets and alternatives, says Gorra. The lowering of the currency will help to ease a series of distortions that were skewing the economy towards extractive industries and consumption and away from manufacturing. Alessandra Ribeiro, head of economic analysis at Tendências Consultoria in São Paulo, reasons that the high cost of labour, especially when translated into US dollar terms, helps explains the low levels of international competitivity of Brazilian products. At the start of this year, Brazilian industrial production was shrinking and manufacturers were calling for protection. Now the currency pressure has eased, manufacturing is likely to get a boost.
Are there lessons for other Latin countries which are also sustaining high currency levels such as Colombia and Peru? Probably not. Peru and Colombia have not had to resort to macro prudential measures because of their much smaller, if rapidly growing, FX markets. The central banks of both countries are able to get more effect with direct intervention in the spot and swap market, both through interventions and building up international reserves.
Years of heterodox intervention in Brazil’s currency markets through taxation on foreign inflows have proven inconclusive. It is only a determined effort to bring down monetary policy that has paid dividends in Brazil. Lower rates could finally help Brazil rebalance its economy away from a healthy over-dependence on extractive industries and rescue its manufacturing sector. That is, if monetary policy does not lead to the far worse scenario of high inflation, an unlikely scenario for now given current global recessionary conditions.