Brazil was the first country to say openly that the world is facing a currency war. And its government is being increasingly active in opening battles in the defence of its rising real. The IOF tax on portfolio inflows into fixed-income instruments now stands at 6%, up from 2% one month ago. The government has also levied a similar tax on margin deposits on derivative contracts from non-residents. Perhaps more important, it then moved to close off easy loopholes to avoid the IOF – what it described as “regulatory arbitrage”. For example, foreign investors used to be able to avoid the IOF by buying and then selling equities, then using the real-denominated proceeds to buy fixed-income products that were not subject to the IOF. Now investments using proceeds from equity sales are subject to the full tax at the moment of conversion.
That these loopholes have now been closed signals the Brazilian government’s serious intent to address the rising valuation of the real against the dollar, rather than offer symbolic expressions of frustration. President Lula also recently stated that Brazil’s international reserves would reach $300 billion by December 2010, the end of his presidency. The stock of central bank reserves was $281 billion on October 15, which suggests that the central bank expects to be battling the rising real by deploying an active strategy until the end of the year.
The rest of Latin America’s governments look on at Brazil’s currency skirmishes with interest. No other country has yet turned to its regulatory armoury to combat the rising tide of the continent’s currencies. This might be because when faced with the US’s weapon of mass liquidity nothing seems to offer an effective response. QE2 is coming; the next new billions of dollars pumped into the world economy will have to find a home and the positive real interest rates in many Latin America economies contrast with the low-yield environment in developed ones. The flood of money heading south of the Mexican border is likely to simply wash over inflow taxes and other domestic policy sandbags designed to stem the dollar tide.
Much of Latin America, and Brazil in particular, is bounding along strongly. International bond issuance out of Brazil in September was a cool $11 billion – that’s similar to the amount the entire region raised in the first half of last year. More deals are in the pipeline until the end of the year. Now that the Petrobras record offering is out of the way, equity issuance too is expected to be strong through to the first quarter next year. International and local banks continue to build their Brazilian domestic presence (sparking a serious war for talent) to capitalize on this investment banking fee bonanza.
And it’s not just Brazil. Mexico issued a 100-year bond for $1 billion at a staggering yield of 6.1% – that’s inside where Ireland’s 10-year bond is trading. As impressive as Mexico’s development has been over the past decade let’s not forget that this is a country that defaulted in 1982 and devalued its currency 12 years later. Mexico is not the only creditor whose bonds seem inappropriately priced. And yet its order book, as with many other Latin American transactions, was oversubscribed several times.
So is Latin America facing a credit bubble? Unlike 2006-07, there’s less evidence of weak companies, with dubious financials and credit quality, accessing the market. And risk premia spreads still have some way to go before reaching historically tight levels – the Embi+ index is trading more than 100 basis points wide of its pre-crisis low. Still, with more cash coming, the relationship between fixed-income supply and rapacious international demand will become more imbalanced.
The rally in Latin America might last for a while longer but the region is reaching boiling point.
see also:
Foreign exchange: Volumes and volatility benefit in currency wars
