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Foreign Exchange

Brazil likely to ramp up measures to quell real appreciation; nears 12-year high

Brazil is likely to further restrict foreign direct investment and domestic credit provision, analysts say, as the real hit a fresh high of R$1.56 against the dollar last week and inflationary pressures remain high.

In light of a persistently weak dollar, driven by loose US fiscal policy and minimal expectations of Federal Reserve rate rises this year, Brazil has been forced to take tough measures of its own to dampen inflows that have sent the real soaring.

This has been problematic because Brazil’s inflation is on track to hit 6.6% this year, according to Goldman Sachs’ projections, second regionally only to Argentina. Next year’s forecast is scarcely better at 6.5%. Banco Central do Brazil has had limited scope to control inflation via conventional monetary policy without spurring further yield-hungry buying of the real. The dollar has weakened consistently against the real since the advent of quantitative easing in the US, falling from an October 2008 peak of R$2.46. Brazil’s base rate already stands at 12.25%.

“There's probably room for a further small rate rise this year,” Clyde Wardle, senior emerging-market FX strategist at HSBC in New York, tells EuromoneyFXNews. “We expect rates to move to 12.5% and stay there through 2012.”

 Clyde Wardle   
 
 Source: HSBC

The Brazilian authorities have had to rely on other measures. In March, the BCB extended its IOF tax (payable on foreign transaction inflows) to include external loans shorter than two years. In April, the same levy on consumer credit was doubled from 1.5% to 3%.

The central bank may now consider raising the IOF levied on equity transactions, Wardle says. At present it stands at 2%. The IOF is levied on all direct foreign investors into the country. Under Brazilian law, all foreign financial institutions must register foreign investor accounts, which are subject to the tax.

Such policies aren’t entirely new, though. As HSBC notes, Brazil has made frequent use of non-conventional tightening since 2008, with a focus on macro-prudential policies – especially on credit cards and consumer loans.

Domestic consumers have felt the pinch. Last month, the government raised the minimum monthly repayment on credit card debt from 10% to 15%. In December that will rise to 20%. Taxes on credit card expenses were raised by 4% in March to 6.38%.

While president Dilma Rousseff’s comment on July 7 that her government’s top target was controlling inflation, not the real’s value, the two are very closely correlated, and more so than for most emerging markets.

In its latest weekly economics strategy note, Goldman Sachs charts the pronounced link between nominal inflation and currency appreciation (see chart). Among charted emerging-market nations, Brazil’s inflation-appreciation link is second only to China’s.

Wardle says the government is already becoming more active in the FX market. Earlier this year, the BCB re-permitted the use of reverse currency swaps, making it easier to buy real futures. The bank might also use its sovereign wealth fund to intervene in the swap market, Wardle suggests. One Day Interbank Deposit Futures on BM&FBovespa are among the most traded short-term rate contracts in the world.

Deutsche Bank, in a research note dated June 30, calls the real the most overvalued currency in the region, from both short-run and medium-term valuation perspectives (see chart). Still, HSBC continues to retain a long real recommendation versus the dollar in its most recent emerging-markets strategy note. The bank has a $1.52 year-end target for the currency.

UBS, in its latest EM trade recommendations note, takes a different tack. “We do not expect any meaningful policy measures in the short-term, although extending the IOF taxes could become a greater risk if the real moves towards 1.5000,” the bank’s currency strategists write.

“A more immediate risk is the very elevated long-BRL positioning, which has reached new historical highs. Given the current levels (1.5600 on July 8), we prefer not to have outright exposure to the BRL.”

 Correlation of FX appreciation with inflation

 
 Source: CS Global ECS Research
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