The total amount of international reserves has surpassed $160 bn. This is an excessive amount, especially considering the country’s needs and its reality. It is time for the Brazilian Central Bank to stop intervening in the exchange rate.
By the end of 2003, the external public debt reached $120 bn. In the same year, the total amount of international reserves achieved $49bn. Today we have the opposite situation. The external public debt is around $70bn, which represents less than half of the amount of international reserves. In fact, reserves have surpassed total estimated imports by 42% in 2007. If this trend of intervention continues, international reserves will be greater than the total external debt of Brazil sometime early next year.
The current pattern of reserve accumulation in Brazil has already gone beyond the optimum level. This is so because reserve accumulation is only justified as a cushion of liquidity to be used against ‘sudden stops’. Indeed, such policy is a natural outcome of a fixed exchange rate regime, but it becomes less justifiable in the current flexible exchange rate regime. In this case, changes in exchange rate, like the one we witnessed by the end of 2002, when Brazil on the verge of a crisis, helped to adjust net capital inflows that led to an equilibrium in the balance of payments. The policy makers are, of course, aware of this and the reason for the continuation of such policy is to control the exchange rate, it placing the country in a “ de facto” managed (or dirty) floating regime.
The issue at stake is the effectiveness of such policy as well as its associated costs. The figure below displays net foreign reserves and the average exchange rate. We can see that the increase in the net purchases since January 2007 did not have a significant impact on the exchange rate. Indeed, in the first seven months of 2007, international reserves increased by $66bn whereas the average exchange rate decreased from 2.14 to 1.88R$/US$. Would the exchange rate be even more appreciated had the Central Bank not intervened in the FX market? Possibly yes because during this period Brazil registered a high trade surplus and a decrease in the country risk. Besides, there has been a noticeable improvement on the perspectives of the economy with a rapid capital market expansion that attracted sizable foreign investments. Still there is room to believe that the Central Bank policy was counter productive. This is so because there is a third and important component to explain the exchange rate appreciation: the interest rates differential that attracts the speculative capital to profit from the arbitrage between domestic and foreign interest rates.
The attractiveness of such operation depends on the interest rates differential and the expected risk of the domestic currency depreciation within the time frame of the operation. Regarding the first component (interest rates differential) there is not much to be done, given for the need to keep inflation within the targets. But with respect to the second component (risk of depreciation of domestic currency) there is a reason to believe that the current policy is backfiring. This is so because when the monetary authority massively intervenes in the FX markets on a regular basis to avoid further appreciation of the domestic currency it also signals to foreigners a decrease in the risk of depreciation in the domestic currency. Hence such process tends to increase the prospective profits of these operations. Had the monetary authority stopped intervening, we would have observed an exchange rate appreciation as well as an increase in the investors’ risk perception. This is so because the more appreciated is the exchange rate the greater are the potential losses for foreign investors. Therefore, the massive and predictable interventions increased the attractiveness of such operations for foreigners and hence the capital inflows. In turn, the process goes on and on, forcing the monetary authority to keep buying reserves in a vicious circle. As in “Alice in the Wonderlands”, where one has to run twice as fast in order to move.
According to some analysts, the arbitrage process between the real and the dollar was the best deal of the planet for foreign investors. On the flip side, the deal should have been the worst for the Central Bank of Brazil. In fact, excess reserves in the amount of $40 bn would cost $2.6 bn, assuming the ongoing conditions for the exchange rate swap and an unchanged exchange rate for one year. Expected gains can become a loss as the ones who had to unwind the swaps in August witnessed, and nobody has a crystal ball to foresee the future. But the relevant question is: does it make sense for the Brazilian government to borrow to speculate in currencies, paying a high premium and counting with a depreciation of the real to cover the cost with the interest rate differential?
The logic behind the flexible exchange rate is to fluctuate according to market conditions, bringing equilibrium to the balance of payments. The additional domestic currency appreciation would harm some and benefit others. The export prices are still high, and exports are expanding, even at the current exchange rate. Besides, the increase in GDP as well as in the industrial production has contributed to an increase in the employment, greater disposable income and foreign investment. On the other hand, inflation has already displayed signals of increase, requiring the Central Bank to be more cautious. In this case, an exchange rate appreciation would reduce aggregate demand and allow a further reduction in interest rates with positive spillovers in the economy. Therefore, the cost-benefits and risk-return relationships point out for the free floating as being a superior strategy to the one in place. It is time to stop managing the exchange rate and go back to the original concept, allowing the exchange rate to truly float.
Originally published by Valor Economico and translated to English by RGE monitor.