Tax removal a bullish game-changer for Brazilian real

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By:
Peter Garnham
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The Brazilian real looks set to escape the sell-off sweeping across emerging market (EM) currencies after the country’s government scrapped the tax on overseas investments in domestic bonds.

EM currencies have dropped sharply during the past month as speculation mounted that the Federal Reserve has started to consider scaling back its quantitative easing programme.

The prospect of the tapering of Fed purchases sparked a sell-off in global bond markets, and hit EM currencies hard as the prospect that investors might pull funds out of local markets triggered a sharp rise in volatility.

The Brazilian real was not immune to the sell-off, with the country’s central bank intervening to support the real as USDBRL threatened to break through R$2.15. In early May, USDBRL stood at just R$2.01.

In response, the Brazilian government announced late on Tuesday it was abolishing the 6% IOF tax on onshore fixed-income assets, a levy which it introduced in October 2010 in a bid to stem the inflow of hot money into the country.

At the time, Guido Mantega, Brazil’s finance minister, was a virulent critic of the expansionary monetary policy stance of the world’s largest central banks. He accused them of initiating a currency war as the funds created by their asset-purchase programmes found their way into developing markets, pushing up the value of currencies such as the real.

However, now Mantega says with the market normalizing, and the movement of the Fed to reduce its “expansionist policies”, Brazil is able to remove the barrier to foreigners investing in its domestic bond market.

Robert Habib, strategist at Morgan Stanley, says the move is a welcome development, likely to be followed by an increase in flows into the Brazilian fixed-income market and a flattening of the local bond curve.

He expects USDBRL to move towards R$2.10 in the short term, especially given that investors are positioned very long of dollars, according to data from the Brazilian Mercantile & Futures Exchange.

Credit Suisse is even more optimistic on the real’s prospects, calling the abolishment of the tax a “bullish game-changer” for the currency in the near term.

The bank says even though IOF taxes and other forms of restrictions on foreign inflows – including derivatives and foreign loans – still apply, it believes the removal of the IOF levy on fixed-income instruments will result in a sharp increase in non-resident investment flows into Brazil in the coming weeks.

“This casts a bullish near-term outlook on the real and brings us to revise our USDBRL forecast to R$2.05 in three months,” states the bank.

Indeed, the resumption of flows into the Brazilian bond market could bring a fundamental change to Brazil’s capital account.

As the chart below shows, since the IOF tax on fixed-income securities was increased to 6% in October 2010, the composition of foreign financial inflows into Brazil has shifted in favour of foreign direct investment, with a notable reduction in the portfolio investment balance.

FX capital controls have undermined Brazil's portfolio inflows in recent years  

That shift, engineered by the Brazilian authorities with the aim of reducing hot money inflows, has harmed the real this year as the country’s current account has widened, but has not been matched by an increase in foreign inflows.

The abolishment of the tax on foreign bond holdings could, therefore, bring the flows that will help to offset Brazil’s deteriorating current-account deficit.

The lowering of barriers to foreign investment, along with the recent hawkish monetary policy shift from Brazil’s central bank, is likely to enhance the real’s attractiveness as a target for carry trade investors.

 Brazil remains attractive as carry trade target  

Along with Indonesia, Brazil is one of the few EM countries that has a tightening monetary policy bias. However, the move from Brazil’s central bank to raise rates by 50 basis points to 8% on May 29 failed to lift the real, as the currency was undermined by rising expectations of Fed tapering.

“While we acknowledge that US monetary policy expectations are likely to remain a powerful driver of price action, we also note that Brazil’s tightening bias stands out across all emerging markets,” says Credit Suisse.

The bank forecasts a further 75bp of rate hikes in Brazil this year, whereas it projects US 10-year yields to be at 2.4% by the end of the year, just 25bp higher than current levels.

“Our forecasts would be consistent with a wider interest rate differential by year-end, further in favour of the real,” states the bank.

Presumably all carry-trade investors in Brazil require is a reduction in currency volatility. For now that looks like what the country’s authorities are manufacturing.