In a world of floating exchange rates, can we talk about the “overvaluation” of any specific currency? No. Under free exchange rates, it does not make sense to use a concept such as overvaluation. The price is always right.
However, in contrast to this economics textbook consideration, the world economy in 2008 is far from truly free and floating exchange rates. Many Governments intervene in exchange rate markets. There is a lot of dirty flotation. Even more: some analysts use the expression Bretton Woods II to reflect the fact that many countries continue to maintain fixed exchange rates, particularly in Asia, and normally pegged to the US dollar.
On the other hand, there is no doubt that what happened to the Brazilian currency in particular since the beginning of this XXI century is very impressive. Let us just use as examples some different currencies and different starting points to try to discuss – if possible – the degree of “overvaluation” of the Brazilian currency, the Real, as of July 17 2008. What follows is a list of fifteen different “measures” of the appreciation of the real (percentage numbers) with respect to some other currency and some specific base date:
July 17 2002-US$ 81 July 17 2002-Euro 15 July 17 2002-Yen 66 July 17 2002-Swiss F. 27 July 17 2002-B.Pound 42
July 17 2003-US$ 80 July 17 2003-Euro 27 July 17 2003-Yen 61 July 17 2003-Swiss F. 34 July 17 2003-B.Pound 43
July 17 2004-US$ 88 July 17 2004-Euro 48 July 17 2004-Yen 85 July 17 2004-Swiss F. 57 July 17 2004-B.Pound 76
Undoubtedly, such 15 calculations indicate a major appreciation of the real in the last few years – and of course mainly with respect to the US dollar. However, we believe that it is interesting to go back for more 18 months to the very beginning of this new century as another base or starting point (also percentage numbers, with the parenthesis indicating a “depreciation”):
January 2 2001-US$ 22 January 2 2001-Euro (37) January 2 2001-Yen 13 January 2 2001-Swiss F. (29) January 2 2001-B.Pound (10)
It is somewhat surprising that, considering the “whole new century” (seven years and 6 months), we find some depreciation of the Real with respect to European currencies and consequently of course the Euro itself.
Such finding at least might help us to raise a question mark about the true “degree” of overvaluation of the Brazilian Real – really excessive and impressive or less significant than some economic analysts have been arguing – and this is exactly the major purpose of our comments here in this article. Naturally, in order to take into account the movements of the Brazilian currency with respect to so many currencies, particularly major currencies such as US$, Euro and Yen, one could develop measures of the so-called Effective Exchange Rate in nominal and real terms, by generating “weights” for the different currencies, probably – just as an example – something like 50% for the US$, 35% for the euro and 15% for the yen (if we decided to consider a measurement based on three major currencies only).
But even here there is an unsolved problem, which is the question of the 100 base starting point. After all, any calculation about overvaluation has to be made – either considering the US$ only or the so-called Real Effective Exchange Rate – with respect to some previous equilibrium position.
In our numbers, there are two extremely different base periods: January 2001 versus July 2004. In the case of the US$ only, one can see “overvaluations” of 22% only or 88%. If we go to another extreme case and select the euro only, in contrast to an “overvaluation” of 48%, considering only four years (2004-2008), we are in fact somewhat surprised with the finding that the Brazilian Real had a “depreciation” with respect to the Euro (and of course Swiss franc and British pound) when one takes into account the whole new century, that is, seven years and a half.
Perhaps the “true story” – whatever that means – is, as always, in the middle-of-the-road, that is, by taking July 2003 as a “good” base position, to the extent that it reflects already good perceptions about the economic policy of the Lula Government – which started in January 2003 – and also at the same time it deletes a period (2001-2003) where the relationship between the dollar and the euro was somewhat stable (with only a slight devaluation of the US currency).
Assuming that July 2003 is the best starting base point to say something interesting about the Brazilian Real, we can make a very clear “separation” of two entirely different economic events:
a) A major devaluation of the dollar against the euro in the last five years (around 50%);
b) A clear “additional” appreciation of the Real, with respect to all major currencies, of the order of 30%.
We are confident that this exercise confirms that there is an “overvaluation problem” specifically with the Brazilian currency – certainly provoked by excessive capital inflows, due to high interest rates and a boom in Brazilian stocks, which led to an almost “permanent” speculative attack in favor of the Real, including the use of futures and forwards.
However, this “overvaluation” of around 30% has been somewhat magnified and exaggerated by the negative movements of the dollar against the euro.
From now on, in spite of the fact that interest rate differentials in favor of the Brazilian currency will even become higher, it is reasonable to expect a certain correction of the exchange rate between the Real and the US$ in the opposite direction. In other words, given the deterioration of inflation and of the current account of the balance-of-payments in Brazil in 2008, and probably more seriously in 2009, we would expect the real to devalue up to 30% (but no more than that) in the next 12 months. This probably means that one year from now we will see a 2:1 exchange rate R$/US$.
Undoubtedly, a country like Brazil, who became a major exporter of vehicles, airplanes, auto parts, steel, orange juice, textiles, shoes, ethanol, tourism services, as well as some basic commodities such as iron ore, soybean, meat and coffee, cannot afford the present existing overvaluation of the currency, even though it is less than some analysts believe, because of this confusion related to the US$ devaluation against the euro (and also the yen in a smaller scale).