I thought it would be an interesting issue if we could open a discussion about the current Brazilian Central Bank’s (BCB) FX and monetary policy. The idea is basically to point out the main facts surrounding the CB policy trying to highlight some of the long term impacts of those policies, and study the possibility of a smooth change towards a superior long term equilibrium. 1) Introduction: The BCB has been intervening heavily on the FX market since the end of 2005, when government measures increased the openness of the capital and financial accounts, significantly increasing the inflow of dollars into the country. The big interest differential is one of the key forces behind the high attractiveness of portfolio and direct investments from abroad, and in 2006 the amount of dollars coming from the balance of payments’ financial and capital accounts was already bigger than the current account surplus, mainly driven by an important merchandise trade surplus. On the monetary side, the last two years were essentially the consolidation of the stabilization process, with inflation figures well below the center of established target, well anchored inflation expectations and sound public debt management. Nonetheless, most of the FX surplus originating from both sides of the balance of payments has been ‘cleaned-up’ by the central bank, in an effort to curb excessive appreciation of the Brazilian real (BRL). My question is whether this strategy is optimal and if the transition to an alternative framework could improve the overall long term outcome of the economy. 2) Facts: – As of May 2nd 2007, the BCB had a total of US$ 122.4 bn in international reserves, of which US$32 bn were purchased in 2006 and US$ 36.5 bn ware purchased so far this year. A realistic forecast of the total inflow of dollars for 2007 indicates that another US$ 60 bn is due to enter the country. In this case, if the current policy is maintained, year-end reserves could reach US$ 180 bn. – The sterilization of the monetary excess resulting from the massive intervention means that every additional dollar inflow will cost US$ 0.07 (seven cents) per year for the Brazilian government. The sterilization is done through the issue of internal debt, which currently pays a bit less than 12% per year, while the additional dollar in reserves will not yield more than LIBOR, 5.3% per year. By the end of the year, the total stock of international reserves will cost not less than US$12 bn per year, which is essentially 26% of the consolidated government primary surplus! – The accumulation of reserves reduce the net external indebtedness (makes it more negative, as the net position is actually long – assets) as a percentage of GDP, but is consequentially contributing to the increase of net internal indebtedness. Even though the net total (internal + external) debt as % of GDP is edging lower, gross debt increases in part as a consequence of this policy. Gross debt is also one of the main indicators monitored by credit agencies, as opposed to net debt only. 3) Do We Have a Solution? Obviously, I am not arguing that a drastic change in policy should be made. But what if the central bank slowly reduces the amount of dollar surplus purchased and starts to signalize a speed-up in the interest rate cut? Recently, market practitioners have increased their bets on the acceleration of rate cuts, as the last COPOM decision had three of the seven voting members calling for a 50 bps cut, against the 25 bps vote of the others. In my view, it would be a good opportunity for the BCB to cut the Selic rate by 50 bps already on the next meeting (June 6th). In addition to it, the BCB could analyze the possibility of one or two 75 bps cut in conjunction with a less active FX intervention. A combination of currency appreciation and lower interest rate outlook could be formulated so that inflation expectations remain under control and actual inflation figures do not peak up. According to some Taylor-rule exercises, there is space for further loosening of the monetary policy as long as the currency is allowed to float more freely and thus appreciate. We all recognize the benefits of the international reserves buffer in times of international turbulence, but I doubt the marginal benefit of international reserves is currently sufficiently higher than the marginal cost of it. The new strategy could reduce the total cost of the Brazilian debt, could reduce the cost of further accumulation of international reserves and possibly allow the achievement of investment grade sooner than later. More specifically, in this scenario, total debt would start a downward trend already in 2008, while on the status quo the figure would only start to decrease in 2010. Moreover, net debt as % of GDP could dramatically change from one strategy to another, going from 23.5% in 2015 to 20% in case the new strategy is implemented. However, we recognize the difficulties behind such a change in strategy. The BCB is the main responsible for the consolidation of the stabilization process, which was only possible because of a very responsive policy-making. The risk involving a new strategy should be considered as the economy is showing clear signs of strong domestic demand since the last quarter of 2006. I invite readers to give their opinion and suggestionS regarding this issue.
Share on Facebook Follow on Facebook Add to Google+ Connect on Linked in Subscribe by Email Print This Post