BRAZIL – Central Bank Intervention: Facts and Ideas

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.

10 Responses to "BRAZIL – Central Bank Intervention: Facts and Ideas"

  1. bsetser   May 14, 2007 at 11:32 am

    Dr. Lombardi —  I basically agree with your proposed policy course. Among other things, reducing the real interest rate should encourage a higher level of investment.   I know Brazilian’s have strong memories of inflation, but inflation has been fairly low for a couple of years — so the need to sustain current, very high levels of real rates isn’t obvious to me.  And I agree with your analysis that the costs of adding another $60b in reserves (with large negative carry on sterilization) likely outweigh the additional layer of insurance that those $60b in reserves would provide.   $50b in reserves was too few. $200b strikes me as too many. $100b is about right.

  2. Nouriel   May 14, 2007 at 12:40 pm

    Reducing interest rates at a faster rate makes sense. But suppose capital inflows continue at a sustained rate in spite of lower rates, then the dilemma returns for the Brazilian monetary authorities: should they let the currency appreciate further risking to lose competitiveness or should they start accumulating reserves at a faster rate again. Lower rates may help to resolve that dilemma but if lower rates – compatible with the country’s inflation objective – are not enough to stem the inflow what should Brazil do? Any room for prudential controls of inflows of hot money of the sort that Brazil used in the past? Or is that option passe’ today? If so why?

  3. Italo Lombardi   May 14, 2007 at 2:23 pm

    I believe the reduction in interest differential combined with some appreciation of the BRL (towards BRL1.950/USD – BRL1.850/USD) would reduce the attractiveness of the currency sufficiently, to the point where FX inflows would tend to converge to normal levels. This appreciation would reduce expectations for further gains of the BRL and could even create some expectation for depreciation depending on how fast the movement takes place. That is why a smooth transition would be crucial. I would avoid controls of inflow initially, but in case flows continue to surprise, a cost / benefit analysis of a stronger currency should be considered and a possible inflow or outflow control could be taken into consideration, even though the BCB would in fact, most likely increase the amount of intervention again.

  4. Ernst   May 14, 2007 at 9:51 pm

    A reduction of the overnight interbank offering rate is desirable, I believe, since it is my understanding that interest rates are currently too high given the current and expected inflation. This would increase economic activity as well as the dismal GDP growth it has experienced (only higher than Haiti in LA last year). Clearly below Brazil’s potential. As for the reserves I agree with Brad on a level of USD 100B. The rest should be invested in foreign assets with good returns and in foreign companies that supply Brazil’s current and future import needs. Something like Singapore did and what China will begin to do shortly.  Ernst

  5. Mark Weisbrot   May 15, 2007 at 2:49 am

    Thanks for the nice summary from Mr. Lombardi, with which I am in agreement, as well as with Nouriel. Hopefully sufficient interest rate cuts would actually reverse the appreciation of the real, which is overvalued and hurting much of Brazilian industry as well as overall growth.   I would add that, last I looked, Brazil’s interest on the public debt was about 7.9 percent of GDP, with about 40 percent of that tied to the Selic rate. So an accelerated reduction of the Selic rate would have the added advantage of significantly reducing spending, which is something that(by other means) the business press has been crying for.  Unfortunately this does not seem to be in the cards. For an interesting historical explanation of monetary policy under Lula, see Antonio Palocci’s recent book, “Sobre Formigas e Cigarras.”

  6. Guest   May 15, 2007 at 11:13 am

    Thanks everybody for the comments. What is interesting is that the real finally traded below BRL2.000/USD “psychological” mark today helped by a better than expected U.S. CPI data. Notice that the BCB hasn’t released the international reserves data since May 3rd, when the institution reported total reserves of US$ 122,389 Mn for May 2nd. So far today (1:10pm NY time) the BCB hasn’t intervened in the FX market and the government, including Mr. Lula himself has stated that there was little the government could do to avoid the appreciation of the currency – “…companies need to rely on technological progress to fight loss of competitiveness caused by the appreciation….” Maybe we are already seeing a change in regime …

  7. Claus Vistesen
    Claus Vistesen   May 17, 2007 at 11:06 am

    Congratulations with the new blog … We all need to free up a slot in our RSS readers for this one I think :).   The topic at hand is of course very important since Brazil is fast coming one of the world’s biggest economies along side India and China. Basically, think BRIC but without the R for Russia.   My knowledge on Latin America and Brazil is not that great but clearly that is going to change now I suspect.   regards  Claus

  8. Ryan Darwish   September 28, 2007 at 1:56 pm

    Upon initial examination of the issue, I’d be inclined to take exception to the preponderance of the esteemed opinions offered. The primary driver of the Real appears to be the dynamic, relatively groundfloor, opportunities avialable in Brazil. For example, considering the natural resource base and demand from countries such as China, a strategic imperative might be acquistion of these opportunities at almost any cost. The parity of exchange for China is not correctly viewed as a strictly monetary phenomenon, it is a strategic drive for acquistion of vital resources. As such, the belief that the adjustment of interest rates would dampen the demand for the Real is probably more diminished than what appears to be represented by these comments.

  9. Phippe Rafat   September 29, 2007 at 9:36 am

    The Hong Kong monetary policy and exchange rate policy are an interesting case as they provide asymmetrical answers. Hong Kong has always given more credence to the pegged exchange rate against the USD than to the effect of a pegged monetary policy to the US Federal reserve and yet balance of payment, balance of trade, budget were showing steady surpluses.  The outcome is,has always been assets inflation; domestic inflation and boom and bust cycles, which have not been, smoothened by an independent monetary policy. Is the choice to import a currency exchange rate stress or to achieve a stable domestic policy?

  10. Marco   October 1, 2007 at 5:42 am

    A very personal consideration I would drive your attention to another aspect of the problem. Although the Brazilian phenomenon is impressive as for the speed with which it is turning in a global developed economy, there are still some difficult challenges the country has to face. Brazil is divided into the “developing southern states” and a number of poorer states in the north and in the amazon where life conditions are far from “developed”. Policy makers will have to deal with this, sooner or later, and I believe we are likely to see a substanbtial in the levels of taxation and spending (probably not in the next few years, but a point will come where the need for helping the north will become clear). In this longer view, I believe the “conservative” policy of BCB makes sense, as stockpiling reserves and keeping a tighter grip on inflation allows fiscal policy makers more flexibility in spending.