Recently (July 24) Antonio Carlos Lemgruber argued that the “overvaluation problem” of the Brazilian currency was somewhat overblown, albeit he concluded that some “overvaluation” (about 30% with respect to the major currencies) could be identified. Depending on the base period used for comparison of the appreciation of a set of currencies against the US Dollar (all measured as the domestic currency price of one dollar), any result is possible, including the favorite for Brazilian manufactured exporters, that the real is the currency that has shown the greatest appreciation relative to the dollar.
The problem in this kind of analysis, as Lemgruber states, is to choose the base period. He adopts a “King Solomon wisdom” type solution: neither July 2004 nor January 2001, but somewhere close to the midpoint of the two extremes, say, July 2003. But that is just as arbitrary as the two extremes and so is not a “solution” at all.
As I will argue there is a more structured way to find an adequate base period in this particular case once we note that most currencies (those not tied officially to the dollar) began appreciating after the end of 2001. What happened around that time? As for most things nowadays, for good or ill, the culprit is China. In December 2001 China was admitted to the WTO, becoming a full-fledged member of the “trading club”. Figure 1 and 2 show what happened to commodity prices (CRB) and to Chinese trade after that point.
Chinese exports went up by a factor of 4.5 from 2002 to 2007, while imports multiplied by 4. The CRB index of commodities fell after the Asian crisis of mid 1997, staying down for the next three years before surging in early 2002. With world-wide growth staying strong the US did not have to play its role of “buyer of last resort” that had contributed to avoid a global slump in the aftermath of the Asian crisis of 1997. Commodity prices went up and the dollar went down relative to most currencies.
Figure 4 illustrates the real appreciation of the euro, Brazilian real, Australian dollar and the trade-weighted index1 of a broad set of currencies (including the ones pegged to the dollar) from a base established in December 2001.
There is nothing special about the Brazilian currency, except for the initial depreciation. But this “contrarian” move was the direct result of the initial fear that leftist presidential candidate Lula was likely to win the October 2002 election. Lula´s discourse when elected placated those fears and the real joined the other currencies appreciating relative to the dollar.
It is easily seen why different choices of base period give widely different information. It all hangs on the strong initial depreciation.
Brazil is an important commodity exporter. So is Australia (but not the eurozone countries). Figure 4 illustrates with the example of Australia what happens to the domestic currency exchange rate following a positive terms of trade shock like the one experienced after 2001.
The strong correlation is evident. Notice that in 2004 – 2005, when commodity prices remained stable, the A$ stopped appreciating, resuming the trend when commodity prices climbed again.
Given the diverse interest rate behavior in the various countries and regions, it appears that world growth and commodity price factors have been more important in determining exchange rate behavior. If so, when (if) a world growth slowdown materializes we should observe a resumption of dollar appreciation.
(1) Since the real, A$ and euro exchange rates are not calculated on a trade-weighted basis, they overestimate the degree of appreciation. The same pattern of significant appreciation is observed for currencies that are not “commodity-based”.