Some Comments on the Overvaluation of the Brazilian Currency

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).

7 Responses to "Some Comments on the Overvaluation of the Brazilian Currency"

  1. Vitoria Saddi   July 24, 2008 at 8:57 am

    Antonio Carlos,Great piece. Don’t you think that the real/USD tend more towards 1/1 than 2/1?ThanksVitoria

  2. Robert Fay   July 24, 2008 at 8:58 am

    Do you really believe that there will be a ‘natural correction’ in the Real against the USD?

  3. sar   July 24, 2008 at 10:37 pm

    The selection of 30% as the percentage of overvaluation appears arbitrary. Why does 2003 reflect a state of equilibrium, especially since fundamental changes have occurred in the economies both the US and Brazil. In order to come to a more accurate number you would have to consider the real changes that have occurred in Brazil (lower debt, improved credit rating, more controlled inflation, growing commodities market, larger consumer class, etc…) and the US (increased debt, economic crisis, very low interest rates, inflationary threats, etc…) as well as the effects of the "irrational" carry trade – I believe you had a very good article on how hedge fund managers are not risk averse (because they don’t participate in downside losses) and are therefore chasing yields without regard to currency volatility. If you could quantify the effect of this irrationality, that would more precisely determine the percentage of overvaluation.

  4. Ricardo C. Amaral   July 25, 2008 at 4:18 am

    In my opinion, Brazil should adopt the New Asian Currency at the inception of the new currency.In the near future Brazil should lock its exchange rate against a basket of major Asian currencies during the transition period until Brazil is able to fully adopt the New Asian Currency.The reason for Brazil to adopt the New Asian Currency is explained on these two articles. This is the path that Brazil should follow in the 21st Century.*****“While China Rises the US Falls in Brazil and Latin America”Written by Ricardo C. Amaral Thursday, 02 June 2005,584 views and 92 comments as of 07/20/08*****“Here is Why Brazil Should Adopt the New Asian Currency”Written by Ricardo C. Amaral Friday, 02 March 2007,145 views and 43 comments as of 07/20/08.

  5. ACLemgruber   July 25, 2008 at 12:49 pm

    I will try to make some general comments about the first four comments by Vitoria, Robert, Sar and Ricardo.I believe that 2008 is the turnaround of the overshooting of the Brazilian Real. In spite of a favorable nominal interest rate differential, economic agents are going to consider more and more from now on the devaluation risk, particularly after greater domestic inflation as well as the end of another major overshooting in commodity prices such as soybeans and other agricultural products. The deterioration of the current account of the balance-of-payments has already begun. One year from now we will see the real around 2 to 1 with respect to the US dollar. This does not mean of course that one might have still an additional appreciation, say, to 1.5, but it will never lead nearby 1 to 1.Consequently, yes, there will be a "natural correction" with trade and services negative flows as well as negative capital inflows in 2008 and 2009.The impact of nominal interest rates on exchange rate movements is somewhat paradoxical. At some point, the market perceives that higher nominal interest rates are in fact racing against higher domestic inflation and consequently are leading in fact to lower real interest rates. It is true that any measurement of overvaluation is arbitrary. The major point of my article was as a matter of fact to point out that some analysts were neglecting a 50% devaluation of the dollar against the euro and consequently the real might be less overvalued than some people argue. In other words, one should not expect the real to go back to 3 against the dollar, only against the euro.As far as the asian currencies are concerned, I did mention very quickly the new discussions about Bretton Woods II. My feeling is that countries like China and India would not adopt fixed exchange rates with respect to the US dollar in a different scenario, but as a matter of fact they were "taking a ride" and also devaluing their currencies against the euro – in contrast to Brazil.The fact is that the events of the last few years as far as exchange rates are concerned will probably raise new doubts and new discussions about the beauty of free markets and freely floating exchange rates. It seems that we have to take a good look again at what really happened in the seventies when we had the oil crises, stagflation, and the end of Bretton Woods I. The fact is that there are pros and cons in the old debate fixed versus floating rates. And this is even more important in the new century when capital flows are much more mobile internationally than they were in the seventies.A.C.Lemgruber

  6. Ricardo C. Amaral   July 26, 2008 at 4:09 am

    You said: “It seems that we have to take a good look again at what really happened in the seventies when we had the oil crises, stagflation, and the end of Bretton Woods I.”I don’t think looking into the 1970’s would be helpful today since the entire ball game is completely different today.The US does not have the monopoly that the US had in the 1970’s when we still going through the cold war and the Soviet Union still around.In the 1970’s we still had a manageable amount of daily global flow of foreign currency transactions. Today the total of these daily transactions are mind-boggling.In the 1970’s the US dollar was king – in the first decade of the new century the euro is becoming a major competitor to the US dollar.The days of the monopoly of the US dollar are over.The US economy is in trouble for many years to come – cost of fighting wars in Iraq and Afghanistan, plus the tsunami of expenses related to the baby boom generation are coming due and at the same time the global economy is being restructured by technology as never seen before. In 20 years we are going to look back and be surprised by how much the global economy has been rearranged in such a short period of time by new technologies and by reevaluating each countries resources mainly in regard of its freshwater resources..

  7. Ricardo C. Amaral   July 26, 2008 at 4:25 am

    One more thing – Ben Bernanke has turned the Federal Reserve into a graveyard for all kinds of companies that should be going out of business; first Bear Stearns, then Fannie and Freddie, next the US airlines, then some major US banks and only God knows what else is in the pipeline – I have no idea how many more companies are going to be nationalized by the US government by the time the dust settles.This massive amount of losses being absorbed by the US government is going to have an impact on the value of the US dollar – a negative impact. (I doubt anyone has a clue about how much is going to cost the US government to bailout all these companies.).