Brazil: Strong real leads to new IOF fears
IOF tax blamed for fall in Bovespa; Brazil ‘must stop jerry-rigging’
The Brazilian government is expected to introduce new charges against FX derivatives positions and possibly reimpose the IOF tax on foreign investments in equities after the appreciation of the real against the US dollar.
In the year to February 10, FX inflows reached $14.4 billion, according to data from HSBC, and led to the appreciation of the real close to the floor of its unofficial band of R$1.70 to R$1.95 to the dollar.
On February 15, the Ministry of Finance and Brazilian Central Bank (BCB) announced the creation of a technical group "to assess and propose measures that stimulate a balanced and safe growth of the derivatives market in Brazil".
The group is also monitoring derivatives exposure of financial institutions and corporates.
The HSBC report says: "The group attests to the government’s intention to increase monitoring and regulation in FX markets. In addition, recall that, in July, the Exchange Commission was granted enlarged powers to amend regulations affecting FX regimes. Precedent shows that the authorities are intent on limiting FX activities deemed to be speculative in nature. We view the intervention deterrent as a credible one at this point."
Nick Chamie, global head of emerging markets research at RBC, agrees: "While the [BCB] has been absent from the FX market for months, as we approach the 1.70 barrier, we expect the BCB will once again reintroduce its regular USD-buying auctions. Other measures to stem BRL appreciation, including reverse repos or tax/regulatory changes, will be re-employed if USD/BRL slides into the 1.65 to 1.55 range."
As well as possible new taxes on FX derivatives, equities bankers who had been pleased to see the scrapping of the IOF tax on Brazilian equities in early December now fear it might return.
"The Brazilian government will toggle [the IOF tax on equities] when they see a need to," says one ECM banker, who believes any reintroduction would damage the rally in the Bovespa, which has risen 17% this year. "It was a very strategic move that they lowered those taxes. It’s not a coincidence that the market rallied."
Some bankers also believe the IOF was part of the reason the Bovespa fell so heavily last year. "An important element was that the offshore investors saw the IOF to be punitive, and they thought they were better off selling and watching the market go down – they didn’t play it down," says one. "They waited for the bottom to come back in and that probably meant the bottom ended up being lower than it otherwise would have been."
Fixed-income professionals still face a 6% IOF charge on international investments. The aim was to prevent flows of money into the country, and thereby lower its currency valuation. But some believe it has had the opposite effect and has, at times, prevented the depreciation of the currency.
"The flows diminished after the IOF tax was introduced but the interesting thing was the way it behaved during the time of the tragedy in Japan," says Javier Murcio, deputy fixed-income portfolio manager at BNY Mellon’s Standish. "There was a belief that Japan would have to repatriate capital, and Japan over the last few years has been a major investor in the local market.
Jim Craige, Stone Harbor Investment Partners
"Ironically, the perverse result was that the IOF served as a way to keep capital in the country because being a high-quality name and double-digit returns in an appreciating currency made being in Brazil very attractive. So Japanese investors maintained their capital in Brazil because the IOF tax meant that if they left, it would be more costly to go back in." International fixed-income investors in Brazil, such as Jim Craige, partner at New York’s Stone Harbor Investment Partners, which manages EM fixed-income funds, believes Brazil’s macro-prudential approach creates imbalances in the economy that need to be addressed.
"If Brazil wants to be a real-world country, it should do real-world things and that includes not jerry-rigging your currency," he says. "It keeps interest rates higher, it restricts the full functioning of their capital markets – it’s an unfortunate distraction and it is very expensive for them."
Steffen Reichold, chief economist at Stone Harbor, says that, aside from the huge expense incurred by building dollar reserves of more than $350 billion, the prevention of its currency appreciation is damaging the economy’s long-term development.
"If the currency appreciates, one side-effect is lower inflation in the system, which in turn enables interest rates to fall," says Reichold. "It’s an expensive place to do business and a free-market economy eventually sorts itself out and they should be willing to do that."