Brazil loses monetary lever

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The Central Bank of Brazil is facing a credibility struggle, making it even harder for investors to predict when country’s turnaround will come.

"They took what remained of the central bank’s autonomy, dragged it outside and shot it in the head," was one particularly graphic assessment of the decision by the Central Bank of Brazil’s monetary policy committee (Copom) to hold interest rates at 14.25% in January.

brazil cb tombini 160x186
Alexandre Tombini,
CB governor

Facing double-digit inflation and a still-lax fiscal policy, central bank governor Alexandre Tombini had written an open letter to the market in January saying that he was prepared for a long, lonely fight against stubborn (indexed) inflation. 

One week – and a meeting with president Dilma Rousseff later – and the bank issued a highly irregular missive on the eve of Copom’s meeting highlighting the IMF’s reduced growth forecasts for the country. In truth, any data point would have done: the government had told Tombini that stimulating growth trumps downing inflation.

There are a few problems with this (and this is important far beyond the country’s massive borders). 

First, without a credible independent bank, inflation expectations will become (even more) unanchored and prices will rise rapidly. 

Secondly, the idea that growth can be encouraged by keeping Selic (the short-term interest rate) at 14.25% is to misunderstand the underlying problems – lack of confidence and investment, a heavy regulatory and tax burden and, linked, woeful productivity. 

Third, it adds weight to those who spy fiscal dominance at play in the economy: a phenomenon that means that raising interest rates fuels inflation rather than dampening it (as Brazil’s large public deficit and high interest rates mean that raising interest rates leads to much higher debt-servicing costs). Doubts about the government’s financial solvency lead investors to sell government bonds and the currency falls. And so, ultimately, any increase in interest rates leads to currency depreciation and, via pass-through, an increase in inflation.

Entry point

And here is why it matters outside of Brazil. Investors around the world are watching and waiting for the entry point. 

"Everyone is so negative inside and outside Brazil," says one New York banker. "But it’s a great, vast economy with huge amounts of local consumption and now [post depreciation] has a great opportunity for exports. Everyone knows that this negativity can change very quickly, there could be a huge rally. The reduction in prices in all financial instruments – local fixed income, equities, FX – has been so dramatic that the moment there is a change of sentiment there will be lots of money to be made. The name of the game this year will be who can time the turnaround of Brazil."

The question is when this is going to happen. The banker is half right – there will be a lot of money to be made when the rally comes. But that requires a short-term political catalyst, and Tombini’s capitulation – together with Joaquim Levy’s replacement as finance minister by Nelson Barbosa – point in the opposite direction. That’s where the banker is half wrong – this won’t be a game for 2016. And maybe not even 2017.