"We do have some diversification and criteria to diversify a portion of our reserves that are not used for hedges"
The role of Henrique Meirelles has indeed changed, and fast. He has overseen the Banco Central do Brasil in a period when the country has achieved stability that’s unprecedented in living memory for most of its population. He is applauded for holding a steady course on interest rates and facing down powerful critics. But he faces a new test. He has to maintain his record when expectations are high and in an environment with which Brazil is entirely unfamiliar: stability.
When talking about Meirelles, unflattering adjectives like "steely", and "guarded" are often used. A different personality to his more flamboyant economist predecessor, Arminio Fraga, Meirelles came up through the ranks of commercial banking. He has overcome his lack of experience as an economist and has become increasingly savvy during his tenure, say market watchers. His experience of financial and capital markets – he became president of the central bank in January 2003 after spending most of his career at BankBoston – and the private sector have worked to his advantage in communicating a clear message too.
His steady character has proved invaluable in maintaining a consistent policy in the face of criticism from politicians, particularly Guido Mantega, the finance minister, who often pushed for faster interest rate cutting from the bank with the argument that relatively high rates were unnecessarily choking growth. Meirelles stood firm and is reaping the rewards now with high public confidence. The result is that today there are far fewer brickbats from politicians and he has the unqualified support of President Luiz Inácio Lula da Silva. Esteem in an institution that has still not been made officially independent from the government is about the best legacy he could hope to pass on.
Interest rates and inflation
In the past few years Brazil has quelled fears that it was perennially unstable and the central bank has played an important role in achieving that. The benchmark Selic short-term rate stood at 25% when Meirelles became bank president. He has not shied away from raising rates when needed, but has fought to bring them down consistently and when the market allowed. "The track record of the central bank has been very good. You don’t need to look any further than falls in inflation and interest rates," says Ilan Goldfajn, economics professor at the Pontifícia Universidade Católica do Rio de Janeiro and himself a former deputy central bank governor. The Selic is now 11.5% and inflation is estimated at 3.7% for 2007.
The global and domestic economy have helped as has the last three years’ appreciation of the real, which has aided in containing inflation, giving scope for continued rate cutting. Even so, Meirelles must take a lot of the credit. Each year, inflation has fallen, Meirelles notes proudly, from 9.3% in 2003 to 3.1% in 2006. "We are getting used to being a regular central bank and taking a longer-term view," he tells Euromoney.
Stability is a phenomenon that exposes the bank to a host of unfamiliar situations. "It doesn’t have the historical data for this new economy. Recent history has all been about change and shocks so although the bank has sophisticated econometric models, it has no history of how the economy reacts to stability," says Lisa Schineller, director of the Sovereign Ratings Group at Standard & Poor’s.
The paucity of historical data makes it hard to predict what data inputs might do to the economy, she reasons. And she was disappointed by the June decision of the national monetary council, the CMN, to set a mid-point inflation target in 2009 of 4.5%. It would have sent a signal of growing maturity and ever-deeper targets and helped to consolidate downward trends in inflation if the bank had pushed the target down, perhaps to 4%, believes Schineller.
The central bank might have little time to enjoy the praise it is basking in. The huge improvement in the economy and the strong currency are changing the engines of growth by turbo-boosting domestic demand. The impact of this, together with global food price increases, is leading inflation to trend back up. In 2007, inflation is slated to be a subdued 3.7% against a mid-point target of 4.5%. That’s still very positive, but higher than last year.
Although commodity exports continue to perform strongly, some industrial sectors are struggling in the face of Chinese exports and the strong real. Some economists argue that this is creating a two-tier Brazil, split between a competitive commodities sector and a dying manufacturing base while politicians regularly call for the central bank to contain the appreciation of the currency. China is a tough competitor in some sectors but Brazil is still increasing manufactured exports, counters Meirelles.
He points out that commodities contribute just 30% of exports and hi-tech areas including aviation are growing fast. "The export drive is progressing well and our job is to keep exchange markets working effectively without creating distortion through protecting specific areas of the economy," he says. Specific competitive problems need to be dealt with through anti-dumping procedures, he adds.
Economists believe that the inflation problem is controlled for now, but that there is a risk of acceleration. Paulo Leme, managing director at Goldman Sachs, says that domestic demand is being pushed by expansionary fiscal policies, which are in part going to higher wages for public sector employees and support for poorer families. That has helped further pump up consumer demand. "Demand is running very hot and we’re beginning to see indices, including core and sub-components, going up," he says.
And although it’s not a huge concern yet, it is changing the interest rate environment, he believes. The prolonged cycle of easing is coming to an end. For now, he sees the Selic at 10.75% by the end of the year and three more cuts to bring it to 10% by April. After that, he believes the central bank will be forced to pause and there is a reasonable chance that this might happen sooner.
The increased spending by central government, particularly on the current account, is temporary, reasons Meirelles, who stresses that Brazil is still set to post a primary surplus target of 3.8% of GDP this year. "The government so far is beating the target by a reasonable margin and our expectation is that the target will be met," he says. He notes that there has been a very healthy increase in tax collection as a result of GDP growth. He admits that spending is increasing but says it is an aberration because of commitments for this year and says it will slow next year and in 2009 because of measures including a cap on wage increases.
In the longer term, Meirelles expects progress on fiscal reform but notes that it is subject to tough discussions between federal, state and municipal governments. He is less confident about labour and pension reform, which "would be subject to a larger negotiation and discussions regarding social security. We have to see how the fiscal reform moves on before tackling the next areas." Economists, however, are less optimistic that the central government will be able to rein in the beast of spending. If Meirelles is wrong about the government’s ability, that could lead to the wrong bases for calculating economic data.
Communication and reserves
The central bank has built a good reputation for communicating well with the market. "It’s much better than it was a couple of years ago, and a couple of years from now it will be better still," says Meirelles, who adds that during August’s turbulence he put out additional statements and gave interviews, reassuring the market of Brazil’s strong position.
Economists agree that the bank’s releases are timely and accurate. However, they add, recent deeper splits in Copom will test the bank’s skills at putting forward a coherent message. At the July meeting, four members were in favour of a 25 basis point cut and three wanted 50bp, Goldfajn says. It’s hardly surprising, given the changes in the economy, that interest rate setting has become more controversial. The changing economy has set the hawk among the doves. Some economists are even predicting a reversion to the interest rate hikes last seen in 2004, says Leme. Send a muddled message to markets and you add to interest rate volatility, he warns.
Communication might have helped minimize the effect of recent market turbulence, in which there was a relatively weak pass-through to Brazil. But in larger part that’s because the republic has slashed its exposure to dollar debt and built up sizeable international reserves. In 2004, the central bank announced a policy to build international reserves and decrease exposure to FX risk, says Meirelles. The programme has been an unqualified success and Brazil now has some $160 billion of reserves. That compares with a low of $40 million. "The build-up has proved instrumental in reducing the impact of market turbulence," he says. He adds that the bank’s interventions in FX markets are not aimed at specific rates but are used to build reserves when advantageous. Most economists agree that the bank has not been pressured into protecting the real.
For now, the bank is unlikely to diversify much of those reserves away from dollars and treasuries, a tactic China and some Middle Eastern funds are pursuing. Leme points out that Brazil’s reserves are nowhere near their level and Meirelles adds that most of Brazil’s liabilities are dollar denominated so it makes sense to have dollar assets. Still, Meirelles adds: "We do have some diversification and criteria to diversify a portion of our reserves that are not used for hedges. If reserves grow, further diversification would be a subject for consideration."
The central bank of Brazil has done a good job in predicting the direction of the Brazilian economy, fine-tuning interest rates to maintain falling inflation, and building reserves to help in crisis times while ignoring howls of protest from senior politicians and the public. It’s now revered as an institution with the Midas touch, encouraging consumers to stack up credit and the belief that inflation has been vanquished. That’s surely when the dangers start.