Full “BRIC-hood” At Last?: The Currency Appreciation in Brazil

Many in and outside of Brazil have questioned the customary inclusion of Brazil among the more dynamic emerging markets commonly referred to as BRICs.  After all, the economy’s overall growth performance for decades has paled in comparison to its more glamorous counterpart nations.  Signs are emerging, however, that Brazil could over the next few years remove doubts about its eligibility for full and unquestioned membership in this exclusive club of fast growers.


Yesterday’s sovereign upgrade for Brazil (by S&P’s to BB+ from BB with a “positive outlook) gives us more reason to reflect upon the pros and cons of the tide of capital pouring into Brazil and the currency appreciation it has brought.  When reserves increase as rapidly as they have in Brazil (up $40 billion in 2007 alone), it is a sure sign that past patterns are changing quickly.    


The potential problem is that the currency appreciation (which owes much to the China-fueled boom in commodity prices) raises “Dutch disease” concerns for Brazil.  Granted, the data so far on non-primary exports and industrial performance do not support the fear, widely expressed in Brazil, that the economy is “de-industrializing”.  It is quite the contrary, in fact.  However, it would be foolish to dismiss out of hand the possibility that unchecked currency appreciation could undermine future manufacturing export performance.  It is a risk worth monitoring in the future. 


In the meantime, the government can do relatively little to halt the currency’s appreciation trend.  The Central Bank’s spot market interventions are ultimately counterproductive as a tool to prevent currency appreciation.   The level of the EMBI-Brazil is affected by the amount of reserves on hand in the Central Bank.   As the EMBI falls (it is now near an all-time low), the cost of external capital declines for Brazil bringing more dollar inflows from foreign investors and encouraging more Brazilian firms to borrow abroad and to issue equity at home.


While risks are present, I would emphasis that these times present Brazil with a spectacular opportunity to mend critical fault lines in economic policies and to prepare solid ground for much higher rates of growth of potential GDP growth in the future.    


Clearly, the first opportunity is with respect to monetary policy, more specifically to move rapidly toward interest rate convergence.  Inflation expectations have been tracking steadily lower in Brazil for many months; they are, in fact, well below the mid-point of the Central Bank’s target inflation rate.  Recent research by noted economist Affonso Celso Pastore of LatinSource suggests that the major factor explaining the fall in inflation expectations has been the appreciation of the currency.  As the pass-through effects from currency strength to inflation expectations operate with a lag, it is likely that inflation expectations in Brazil are likely to continue declining in the months ahead. 


Brazil’s double-digit nominal interest rates (the overnight rate is now 12.5%) are an anachronism in an economy growing only modestly and with well behaved inflation expectations.  A more aggressive easing posture by the Central Bank is in order, starting with the June 5-6 COPOM meeting and continuing throughout 2007.   The really good news in this is that Brazil’s nominal and real interests are headed down and credit availability is bound to improve for this most credit-starved of all the BRICs.   


The second huge opportunity for Brazil is to address the real economic Achilles Heel – the always worrisome public sector accounts.  Despite experiencing rising revenues for years, and despite Lula’s (bold, I would say) commitment to primary fiscal surpluses,  aggregate public sector accounts are still in deficit (about 3% of GDP) and the public sector debt to GDP ratio is still high at 43%. 


More than these aggregate numbers suggest, the problem in Brazil is that the structure of the public sector budget is awful: skyrocketing growth in numerous entitlement payments and other current spending, inefficient use of earmarked revenues, paltry public sector infrastructure spending, and a monstrous tax burden.  Given this weak fiscal backdrop, it is not surprising that the IMD in Switzerland in its recent World Competitiveness Yearbook ranked Brazil in sub-BRIC territory:  49th place out of 55 countries surveyed as a good place to do business.  


Brazil should be in a position, much as Chile is today, to be generating fiscal surpluses in rising revenue times such as these.  In the case of Chile, the fiscal surplus is 7% of GDP and the Chilean social investment fund which gathers this surplus is stored abroad in the form of a rainy day fund and a fund to cover future government needs, including infrastructure investments. 


None of this sort of counter-cyclical fiscal policy is remotely possible in Brazil today, in part because of the scale of inherited problems and in part because the fiscal reform zeal that characterized Lula’s first two years in office withered and died through the course of recent political scandals and re-election campaigns.


The good news on fiscal reform is that the government seems once again emboldened to act.  It has dusted off plans to reform the inefficient tax system and to take another bite out of the social security reform agenda, among other important fiscal measures.  The initiative could not come at a better time, in the midst of an external boom and in a non-election year.  The Lula government has talked reform before without delivering, so these initiatives may come to naught, but at least they are back on the agenda.  Moreover, the political environment is right;  with aggregate demand and employment both rising, Brazil can afford to address fiscal reform.


The third major opportunity for Brazil is with respect to international trade and, more generally, industrial policy.   While overall levels of industrial protection are lower in Brazil today than they used to be, tariff protection levels for many industrial sectors are still relatively high.  If Brazil had pursued serious trade liberalization in the past, the steady appreciation of the currency could have been attenuated earlier by a rise in productivity-enhancing imports, including much needed imports of new technology.   Instead, the tariff barriers, and onerous taxation of exporters, has walled the economy off to a large extent from global trade.  (Openness is still less than 30% of GDP, well below levels of the other BRICs.)


These imports are now occurring, but only after a considerable lag and still in the context of overly protected manufacturing and service sectors in Brazil.   Brazil has a golden opportunity right now in the context of the Doha Round (where it exercises strong leadership in the G-20) to forge a much more attractive bargain for what it wants in global trade talks (liberalization in agriculture) in exchange for what the rest of the world wants: a softening in Brazil’s defensive posture in manufacturing and services.  


These times of strong dollar flows, a huge trade surplus, and a lower cost of external capital present Brazil with its best chance in generations to lower interest rates, modernize the public sector accounts, and open the economy to free trade.  This is the path to faster potential GDP growth in the future and membership in the  BRIC club with no need for asterisks!

6 Responses to "Full “BRIC-hood” At Last?: The Currency Appreciation in Brazil"

  1. Nouriel   May 17, 2007 at 12:31 pm

    Tom, excellent set of arguments; real interesting and valid. Some questions: you may be very correct in arguing that further foreign exchange intervention will not be able to prevent the rise of the real and that some of that appreciation is needed and useful. But suppose the central bank stops intervening – and it has intervened to the tune of $40b in 2007 alone. Then the currency will sharply appreciate, much faster than it has given the current forex intervention policy. Then, at which point the real appreciation of the currency becomes painful for exports, competitiveness and growth? You suggest that, given low inflation, the central bank could cut rates at a faster rates and thus slow down the capital inflows. But if such inflows depend more on investors’ optimism about Brazil and a reduction in its sovereign spread, faster policy rates reduction may not be able to stem the inflows. So, should the central banks stop intervening altogether whatever the effects on the currency value and competitiveness may be? Is that what you are suggesting for the short run? Or is there a middle way between no intervention (and sharply rising currency value) and massive forex intervention?

  2. bsetser   May 17, 2007 at 12:34 pm

    A cynic might argue that a key feature of most of the BRICs (or at least the biggest BRIC of them all) is a central bank that resists currency appreciation —  China obvioiusly, but Russian reserve growth has also been rather impressive —  and in the process finances the US.   Brazil by that measure already joined the club.

  3. Ashok   May 17, 2007 at 12:55 pm

    Marketwatch today had news item on Brazilian equities being the favorite of fund managers according to a Merrill Lynch survey.  An aside on how Brazil fares as far as the rankings go: there is one economic beauty contests in which Brazil outshines the other BRICs in, which the Heritage Foundation’s Index of Economic Freedom where it is the only one of the BRICs below a 100, coming in at 70. That rank puts it in the ‘mostly free’ group. Their slant seems to be heavy on the security of property rights, while the World Bank’s Doing Business rankings have it at 121. Both China and Russia are below 100 on this scale, while India is far harder to do business in as any weary businessman would attest to. But perhaps its relative position with regard to the previous year is yet a better indication of where competitiveness is headed and by this measure on the IMD charts, Brazil may be seen to be losing ground.

  4. Tom Trebat   May 17, 2007 at 9:58 pm

    Nouriel, thanks for your comments. I agree that with international reserves now well in excess of $120 billion, the Central Bank is reaching the economic limits of its ability to intervene. The costs of sterilization are already very high and will only go higher with more intervention. Moreover, intervention in the present circumstances is self-defeating in terms of reversing the appreciation. You’re right, too, that a faster pace of interest rate reduction to fight the appreciation will also feed investor optimism resulting in more inflows.   What would happen if the Central Bank stopped intervening altogether? Of course, the Bank would have to worry about the rapid monetary expansion that would result. Apart from that, the currency would appreciate more rapidly than if the intervention had continued, but it would take a rapid and permanent currency appreciation to do real damage to exports and growth. International prices have improved for many exporters. The current account is still in surplus; exports are growing strongly. In real trade-weighted terms and measured against a basket of currencies (not just the dollar), the real is only slightly below its long-term average. Rising imports of goods and services would, in time, ease and reverse the appreciation.  Here is where I come out: The appreciation pressures in Brazil result from structural factors (terms of trade, improved sovereign risk) that are well entrenched. Massive intervention, such as we have seen, is inadvisable because of the economic costs and is even self-defeating. Zero intervention risks very sudden appreciations that could be de-stabilizing. The only option I see is for the Bank to engage in modest intervention enough to counter spikes in the currency, not so much as to create a one-way bet for arbitragers. The Bank should also lower nominal rates right away; doing so will spur the import growth which is already underway. The ideal solution for countering sudden appreciation – a more complete opening of the economy – is not in the realm of the Bank and not politically feasible in the short run.

  5. Guest   May 18, 2007 at 5:59 am

    Valid and good points on Brazil; but why is Brazil growth’s rate so much lower than that of the other BRICs (China, India, Russia)? Not clear to me.

  6. Nouriel   May 18, 2007 at 7:16 pm

    Tom, the approach that you suggest – effectively stop systematic intervention and have a faster easing of monetary policy – is certainly sensible. The only caveat that i would make is: suppose the currency appreciates too much once there is little intervention as exogenous speculative capital inflows driven by massive liquidity are exploiting the carry trade. Then, one could argues that excessive overvaluation (granted that the equilibrium real exchange rate is appreciated now) could at some point seriously hurt exports. Brazilian exporters are already complaining loudly and Lula is listening to them. Some of those complaints may be self serving – as in any case of a lobby – but the question remains: at which level of the Real the appreciation becomes too much? 1.8, 1.7, 1.6, more? There must be a point when the pain becomes real and a Dutch Disease may be triggered…or not?