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Foreign Exchange

Brazil declares currency war; creates buying opportunity in real

Brazil has responded to the fresh liquidity measures in Europe by extending a tax on foreign borrowing and intervening more aggressively in the currency market to suppress the value of the real.

Guido Mantega, Brazil’s finance minister, said the country would not sit by passively while developed nations continued to pursue expansionary monetary policies at the expense of Brazil. The comments reflects concerns that part of the €529 billion dished out by the European Central Bank to eurozone banks at its second long-term refinancing operation this week will find its way out of the region and create a new euro-funded carry trade.

Mantega, who in 2010 coined the term “currency war” as the real appreciated after the Federal Reserve’s second round of quantitative easing, says: “When the real appreciates, it reduces our competitiveness. Exports are more expensive, imports are cheaper and it creates unfair competition for businesses in Brazil.”

The finance ministry extended from two to three years the minimum tenor for local corporates to be exempt from the punitive 6% IOF tax on foreign borrowing. The government is also closing a loophole by applying the 6% IOF tax on export loans of under 360 days – exporters having brought $8 billion into the country in advanced payment agreements so far this year.

The measures came after Brazil’s central bank surprised the market by carrying out larger than usual FX intervention this week.

However, many believe these fresh actions from Brazil will prove to be toothless.

“Not unlike previous episodes, these FX measures could be successful at temporarily weakening the real, but they are unlikely to prevent it from strengthening amid abundant liquidity abroad,” says Gustavo Rangel, strategist at ING Financial Markets.

Indeed, the IOF tax announcement only affects a small share of recent flows into Brazil.

The bulk of recent inflows are foreign direct investment (FDI) and longer-term financing, which the government regards as “good” inflows and has no intention of penalizing.

Of last year’s $112 billion surplus in balance of payment financing, for example, FDI, which is exempt from inflow taxes, made up $67 billion while long-term financing accounted for $48 billion.

 Brazil's current account deficit covered by FDI

 Source: Central Bank of Brazil

This highlights the limitations faced by officials trying to prevent appreciation in the real, says Rangel, since most inflows are “good” inflows.

The main strategy from the Brazilian authorities to contain the real appears to involve the central bank adding FX volatility, by moving away from pre-scheduled daily auctions and adding an element of surprise to the amount and timing of interventions.

“As a result, we see this real sell-off as temporary and a buying opportunity,” says Rangel. “We expect USDBRL to break below the R$1.70 level and to trade closer to R$1.65 in a relatively short time.”

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