Global imbalances and the Brazilian Real: What Comes Next?

These days the main subject of discussion in the Brazilian economic newspapers is the “unsolvable problem” of the appreciation of the Brazilian real against the U.S. dollar.

We are currently experiencing a conjunction of important economic factors affecting Brazil’s exchange rate market. All of them are related to each other although they have different channels of impact on this market. Some of them have a more idiosyncratic aspect, others have more common global origins. Alone, they would have one effect on the currency value; together their effects have been intensified. It would be important to be able to distinguish each particular influence in the appreciation of the exchange rate, but it is almost impossible to do that.

There are however today two very important world economic factors affecting exchange rate markets all over the world, but with greater impact on the emerging market economies. One is related to the real economy, the other to financial factors. In the last ten years the world and specially the commodity exporting countries, Brazil included, have been contributing to build a huge and “new” modern region, China and East Asia. Due to this major development, commodity prices have been increasing in the last few years leading a strong positive impact the Brazilian  terms of trade and trade balance. Even the increase in the income balance deficit has been insufficient to dominate the increasing trade surplus. Thus, since 2004 Brazil has, generated current account surpluses, changing dramatically the economy’s previous scenario of a scarce amount of foreign currency necessary to finance the country’s former external deficit.

But this scenario of high economic growth around the world has developed in conjunction with increasing current account deficits in the U.S. economy, the phenomenon of global current account imbalances. It is important to note that, since the last quarter of 2005, the economy of the United States has had deficits in the trade as well as in the income balance; moreover, the current account deficits of the last fifteen years has transformed the American economy into a net foreign debtor country, the largest one in the world. Many prominent economists around the world have argued that these imbalances cannot continue forever, some of them emphasizes that such imbalances must be reduced soon to prevent a disorderly rebalancing. The fact is that the investors around the world are starting to diversify their portfolios and reducing – however slowly – their investments denominated in dollars. This modest change in portfolio choices of these world financial investors has “flooded” some emerging market economies – those who have been able to implement consistent macroeconomic policies in recent years – with large amounts of capital inflows that are entering into different markets: their debt, equity, real estate, commodities markets. The fact that there is excess liquidity in the global economy does not fully explain the immense inflow of capital to Brazil. Still, it is the case that part of this global liquidity went to Brazil. Indeed, in March foreign investors in Brazil have bought US$ 3.8 billion of fixed income bonds, both short and long-term ones, the highest amount since the end of fixed exchange rate regime in January 1999. Since January of last year, the net balance of these bonds purchased by non-residents has reached US$ 14.5 billion.

In turn, one could say that the significant increase in Brazilian exports as well as the greater capital inflow are the two major factors explaining the strength in the Real (against the USD), especially since 2005. But there is also a third related financial factor that is generating more pressure towards an appreciation of the Brazilian real:  inflows – or carry trades – based on the interest differentials even if those carry trades mean a bet against the uncovered interest rate parity condition In this sense one could argue that the Brazil may now be subject to a form of “speculative attack” in its Forex market . Big foreign currency traders have intensified carry trades and long positions in real trying to bet against central bank implicit  view that a R$ 2,000/US$ (or a modest range around it) would be a plausible and equilibrium level for the nominal exchange. In these last months the losses of the central bank, due to its exchange rate position, have been high. It is difficult to predict the result of this bet. There are analysts forecasting a dollar at R$ 1.900 at the end of this year. The central bank will probably try to sustain the level of R$ 2.000/US$.

The exchange rate is a forward looking economic variable in the sense that its value is based on current and future conditions. In this case many forecasters see the exchange rate more appreciated by the end of the year than the current level; if that were to happen, the central bank’s effort to prevent the appreciation could fail after a significant fiscal cost.  On the other side, if the current account surplus were to be smaller in the near future or other global shocks were to lead to a reduction of the speculative capital inflows it is possible that the exchange rate could remain close to its level. The first scenario seems more likely but we have to wait and see…

6 Responses to "Global imbalances and the Brazilian Real: What Comes Next?"

  1. Guest   May 15, 2007 at 2:28 pm

    And today the Real broke the 2.0 barrier…   Brazil Real Hits BRL1.999, Strongest Level Since Feb 2001  Tue, May 15 2007, 13:53 GMT, Dow Jones. http://www.djnewswires.com/eu  Brazil Real Hits BRL1.999, Strongest Level Since Feb 2001 -2-  The real has been gaining ground against the dollar all year on heavy trade surpluses and foreign investment inflows. The real began 2007 at BRL2.13 per dollar.  However, the Brazilian Central Bank has been quick to act aggressively in the market to halt previous gains. The central bank intervenes by buying dollars on the spot market at snap auctions or by offering foreign exchange swap contracts to investors. The swap contracts reduce the overhang from future dollar inflows.  Analysts said investors were anxious to test the two-to-one barrier to see how serious the central bank is about controlling what officials have called “excessive volatility” in the market.  A series of positive economic reports in Brazil and the U.S. boosted investor sentiment Tuesday, analysts said.  Earlier Tuesday, the Brazilian Census Bureau, or IBGE, said that retail sales volume increased a seasonally adjusted 1.1% in March compared with February.  The result came in above the median forecast of analysts polled by the Estado news agency, which projected sales volume to rise 0.6% in March.  Retail sales jumped 12% in March compared with March 2006, IBGE said. The year-on-year comparison wasn’t seasonally adjusted.  In addition, the U.S. Labor Department said that the closely watched consumer price index rose 0.4% in April, compared with a 0.5% increase in March. The core CPI, which excludes volatile food and energy prices, rose 0.2%, compared with 0.1% in March.  The tame inflation figures eased expectations for future interest rate increases in the U.S., which typically sap investment flows from emerging markets such as Brazil.  In an interview with the local Global television network, economist Alexandre Mathias of Brazil’s third largest private bank, Unibanco, said, “It is inevitable that the real will break the two-to-one barrier because of the heavy inflows we have been seeing.” Mathias said the real will likely remain in the BRL1.90 to BRL2 range “for several months.”  -By Jeff Fick, Dow Jones Newswires; 55-11-3145-1481; Jeff.Fick@dowjones.com

  2. Anonymous   May 15, 2007 at 2:34 pm

    Central banks and economists support the stronger real but exporters are complaining and now Lula is coming to the rescue of manufacturing exporters..  Brazil Officials, Economists Endorse Brazil Forex System  Tue, May 15 2007, 20:05 GMT http://www.djnewswires.com/eu  Brazil Officials, Economists Endorse Brazil Forex System  By Tom Murphy  Of DOW JONES NEWSWIRES  SAO PAULO (Dow Jones)–Brazilian officials and private-sector economists Tuesday endorsed Brazil’s floating-rate foreign exchange system despite some problems caused by the strengthening of the Brazilian real against the U.S. dollar.  On Tuesday, the Brazilian real broke the psychologically important barrier of BRL2.00 per dollar, closing at BRL1.981. It was the first time the real closed stronger than two-to-one since January 2001.  But Finance Minister Guido Mantega downplayed the significance of the real’s strengthening, saying it was simply the consequence of Brazil’s “good economic fundamentals.” He added the strengthening of the real was also caused by the worldwide weakening of the U.S. dollar against various major currencies.  “The government is not going to alter the floating-rate foreign exchange system,” Mantega said. “We have learned that there is no use in artificial measures in the realm of foreign exchange.”  Private economists agreed.  “Brazil is entering a new paradigm, based on sound economic fundamentals and strong attractions for foreign capital,” said Octavio de Barros, chief economist of Brazil’s largest private bank, Bradesco. “We will simply have to learn how to live with the problems that come from too many dollars.”  Brazil’s currency was closely controlled by the government from the 1950s until 1999. The government used various systems, including fixed rates, currency bands and centralized control over foreign-exchange transactions to control the value of the real.  In January 1999, the government abandoned the centralization of foreign exchange transactions and a cumbersome system of tightly controlled “currency bands” in favor of a floating-rate system based on freely operating market forces.  From 1999 through 2003 the tendency was for the Brazilian real to weaken against the U.S. dollar. Since 2003, however, a combination of economic stability, attractive interest rates and large trade surpluses has led to a tendency for the real to strengthen.  The real gained 14.2% against the dollar in 2005 and 8.8% against the dollar in 2006. As of Tuesday’s close, the real has gained 6.6% against the dollar so far in 2007.  But the strong real has brought problems for some sectors of the economy. Textile and footwear manufacturers, for example, have complained that the cheap dollar has brought a flood of Chinese imports into the Brazilian market. Similarly, small- and medium-sized exporters of manufactured goods have complained that critical export revenues have been hurt by the strong real.  “But overall Brazilian exports are booming,” pointed out Paulo Leme, managing director of the Goldman Sachs investment bank. “Brazil will continue to enjoy ample markets for its commodities exports at high prices.”  Brazil racked up a $46.1 billion trade surplus in 2006 and is headed for another big surplus this year.  Said Barros, “Brazil now has a trade surplus that is structurally above $40 billion per year.”  Even President Luiz Inacio Lula da Silva, a non-economist, waded into the foreign-exchange debate Tuesday. At a news conference, he noted that, according to sound economic theory, the strong real will force domestic manufacturers to become more competitive. “This is what we want,” he added. “We want to be competitive. Remember, we’re not competing against the U.S. or Germany. We’re competing against China.”  Both the president and Finance Minister Mantega also reiterated previous statements saying the government will offer some form of tax abatement to industries hurt by cheap imports. Mantega said the government will offer details on such incentives in the next few days.  What the government will not do, Mantega said, was reinstate the currency controls and fixed exchange rates of the past.  “Let me repeat it so everyone understands – we have a floating-rate foreign exchange system and we’re going to stick with it,” the minister said.  -By Tom Murphy, Dow Jones Newswires; 55-11-3145-1478; brazil@dowjones.com

  3. Ernst   May 15, 2007 at 7:57 pm

    If the Central Bank would lower overnight rates we should see some solutions. The Real would begin depreciating against the USD and the EUR. The interest rate differential would diminish reducing the appeal for a carry trade. The internal economy would be stimulated, leading to a higher GDP growth instead of the dismal growth it has showed last year beating only Haiti in Latam. It would make exports more profitable and imports more expensive, therefore, protecting local businesses from cheap imports.  Ernst

  4. Ernst   May 15, 2007 at 8:03 pm

    Parente do Henrique?  Ernst

  5. Ernst   May 15, 2007 at 8:11 pm

    The inflation in Brazil seems to be well under control. A decrease in the short term rates should not result in inflationary results since economic growth appears to be well beneath potential. Should inflation take off, which is unlikely by the reasons above mentioned, it would be far better to curb it through a mild contraction in money supply rather than by rising interest rates again, since you will be faced with the same current problems.  Ernst

  6. Ricardo Meirelles   May 16, 2007 at 4:22 pm

    At the end of the fourth paragraph, it was erroneously written “Since January of this year”. The correct form, already posted, is “Since January of last year”. I thank Fernando Dantas, from Agencia Estado, for having pointed it out. Thanks also for all other comments. By the way, no familiar links with Henrique Meirelles.