Without structural reforms to increase productivity and a serious fiscal adjustment, foreign exchange measures will be tantamount merely to “anaesthesia without surgery”.
Complaints about the BRL’s appreciation have recently been gaining strength. They have mobilized the whole government, even the President of the Republic. Should the strong BRL be combatted at any price? Even if the answer is positive, one should ask what in fact can be done to contain the appreciation of the exchange rate.
The appreciated BRL makes Brazilian exports more expensive, penalizing especially manufactured goods. It also cheapens the imports that compete directly with our domestic producers. It is this two-fold effect that has been responsible for most complaints. However, a brief reflection is enough to doubt that a strong BRL is in fact so undesirable. Compare the country’s situation in 2002 – with the dollar worth around BRL 4,00 – to what happened during the following years. The popularity of PT governments is due, in large part, to the strong BRL. The low inflation and reasonable growth recorded by the Brazilian economy would probably not have been possible without an appreciated BRL.
It is important to realize that if Brazilian continues to “do well”, or grow at moderates rates with inflation under control and exploiting its comparative advantages, the strong BRL is here to stay. One may disagree about precise levels but not about the fact that the excessively devalued exchange rates, that used to make it profitable to produce almost anything internally, are a thing of the past. A strong BRL scenario is not only the most probable one. It is also very likely the most desirable.
The priority should thus be to increase industry’s productivity and competitiveness. A diagnosis of the issues to be tackled has been with us for a long time: prioritize education; improve the economy’s deficient infrastructure; rationalize and reduce the tax burden (which involves reining in public spending’s excessive growth); reform labor legislation and improve the business environment by fostering competition and reducing bureaucracy and judicial insecurity, amongst other measures.
However, what one is seeing is the adoption of ad hoc relief measures for sectors and businessmen “anointed” by Government, involving subsidized credit, tax breaks and protection against foreign competition. It is highly probable that these casuist measures will have a net negative effect on productivity, not only because they fail to tackle the economy’s underlying problems but also because they make the economy even more complex and less competitive.
Alongside these relief measures, the government has resumed, with renewed vigor, its initiatives to weaken the BRL, acting on two fronts: restrictions on capital inflows and foreign currency purchases by the CB. The result has been a devaluation of the BRL against the dollar of around 10%, since the end of February, with the exchange rate currently hovering close to BRL 1.9/USD. What are the limits to this new foreign exchange policy aimed at weakening the BRL?
Two basic clarifications are in order here. Firstly, it is the real, not the nominal exchange rate that matters for the competitiveness of Brazilian products. And the behavior of the real exchange rate in turn depends on the difference between Brazil’s and its foreign competitors’ exchange rates. In other words, if domestic inflation is higher than foreign inflation, the exchange rate will appreciate, thus wholly or partially neutralizing the effects of a nominal devaluation.
The first clarification leads on to the second. The CB can, at any time, raise the exchange rate to much higher levels than those currently prevailing. All it needs to do is to accumulate reserves and let the Selic rate fall sharply, abandoning the sterilized foreign exchange purchases it nowadays performs, which keeps the Selic rate at the level fixed by the COPOM (Monetary Policy Committee). The sole reason it does not adopt this policy is because it knows that it would lead to an acceleration of inflation that would soon eat away the real exchange rate devaluation that had initially been obtained.
It is true that a combination of controls on capital inflows and sterilized foreign exchange purchases seems to have recently contributed significantly to the weakening of the BRL. If inflation does not increase, the depreciation of the real exchange rate, which is what matters, will last longer. Therefore, it is necessary to analyze the possible inflationary impacts of what appears to be the new foreign exchange policy of establishing a floor for the nominal exchange rate.
Econometric studies by Affonso Pastore indicate that the pass-through coefficient of exchange rate depreciations to inflation has fallen in recent years, thus perhaps limiting the recent 10% exchange rate devaluation’s short-term impact on inflation. The problem is that the new exchange rate policy of placing a floor under the nominal exchange rate, together with the continuing decline in interest rates, will probably keep raising expected medium-term inflation. If current monetary and exchange rate policies are maintained, the tendency will be for inflation to increase, leading to a new appreciation in the real exchange rate. What will the government do when this happens? Will it carry out new rounds of currency devaluation accompanied by interest rate reductions that would only generate more inflation?
The dilemmas we are facing are not specific to the Brazilian economy. Even the Chinese economy has been facing high rates of inflation due to its policy of low interest rates and foreign exchange interventions. What is specifically Brazilian is that we face much stricter limits on lowering interest rates and depreciating the exchange rate without generating inflation. There is no conclusive evidence regarding the causes of such limitations, but many economists – and I count myself among them – identify the Brazilian economy’s reduced savings capacity, especially negative public savings, as being the main cause. Given that the government continues to increase public spending, as well as parafiscal expenditures (through subsidized Treasury credit to the public banks), there is little hope that that this reality will change.
No government lets its currency appreciate unduly without reacting. Foreign exchange interventions and capital controls are not bad, per se. The problem with foreign exchange interventions is the high fiscal cost of foreign exchange reserves, owing to the large interest rate differential. As for capital controls, even though they seem to have been working in recent months, their effect tends to diminish over time. This is because nobody wants to close all doors to the entry of foreign capital. Given that the domestic Brazilian savings rate is much lower than the investment rate needed to grow 4% or more, it is necessary to resort to foreign savings, that is, foreign capital. As capital is fungible, it begins, after a certain period of time, to flow more intensely through the channels that have not been affected by capital controls. In other words, the effectiveness of controls is necessarily temporary. It is legitimate to adopt them. but not in an isolated fashion If the reforms needed to elevate the economy’s productivity, as well as a serious fiscal adjustment, are not carried out, performing foreign exchange interventions will, as Simonsen, the former finance minister, used to say, be tantamount merely to “anaesthesia without surgery”.