Brazil: Exchange Rate Policy

The Brazilian Central Bank cannot aim at placing a floor for the depreciation of the real.

The announcement, on May 22, that QE3 would be gradually tapered in the future led to a turmoil in international financial markets, as investors turned back to developed economies’ assets, giving way to a significant depreciation of the emerging countries’ currencies. From May to August, the Brazilian real depreciated over 20%, with the US dollar rising from R$ 2 to R$ 2.45.

The Brazilian Central Bank (BCB) started to intervene heavily, via exchange rate swaps, akin to sales of US dollar futures. After selling US$ 43.9 billion in exchange rate swaps, on August 22, the BCB launched a program committing itself to sell half billion dollar in exchange swaps daily from Monday to Thursday, and to auction one billion in credit lines on Fridays. The program, together with previous interventions, would total US$ 100 billion in interventions in 2013. Up to December 11, the BCB had sold 76.6 billion in swaps and extended 14.7 billion in credit lines to banks. The chart below illustrates the evolution of the BCB’s interventions and the exchange rate (in units of real per US dollar, i.e., an increase means a depreciation of the real). The program’s announcement coincided with the reversal of the exchange depreciation trend. However, it is important to bear in mind that FED’s decision to postpone the tapering, in mid September, also allowed many other EM currencies to appreciate.

Last week, the BCB announced that it would proceed with the program in 2014, with some adjustments, that shall be announced over the next days. Which adjustments would be advisable? What should the BCB be doing from now on?

The fundamental question is: what is the true goal of BCB’s interventions? The present current account deficit, a measure of external savings, is at the high level of 3.7% of GDP (about US$ 80 billion). Given that Brazil investment/GDP ratio is quite low, less than 20% of GDP, such high deficit indicates that Brazil is using external savings to finance consumption above what it produces. And this raises at least a yellow flag.

The best way of reducing the current account deficit is by depreciating the real exchange rate, which would involve allowing the nominal rate to depreciate above the difference between Brazilian and our foreign commercial partners’ inflation. If the BCB’s interventions are stemming the real from depreciating to a new equilibrium, they would also be hindering the economy’s external equilibrium adjustment, which is not good.

The BCB worries about the currency depreciation because of its effect on inflation, which has been under pressure since 2010. To manipulate directly the exchange rate in order to keep the inflation at bay is not the best macroeconomic strategy, because it hinders the correction of the economy’s external disequilibrium. It would be better to combine the on-going interest rate increase with a true fiscal adjustment, reducing public expenditure and subsidized loans given by government-owned banks, and letting the currency depreciate. But this is unlikely to happen in an electoral year, despite the official recent statements on the contrary. The likely scenario for macroeconomic policy in 2014 is a combination of today’s fiscal and parafiscal expansionary policies with moderate interest rate hikes and foreign exchange rate interventions, as already announced by the BCB.

This mistaken combination of macroeconomic policies would lead economic agents to further doubt that the BCB’s foreign exchange interventions are only aiming at providing liquidity and mitigating excess volatility and overshooting. This is especially true if the intervention program for 2014 keeps the “daily rations” swaps sales by the BCB. After all, if the goal is to provide liquidity, it makes little sense to intervene every single day, even when there is no liquidity shortage.

Taking into account its fire power of US$ 360 bi in international reserves, the BCB is able to keep on intervening for a long time in currency markets. If, however, it is intervening to place a floor on the depreciation of the real, instead of just guaranteeing FX liquidity, it will be creating a much bigger potential problem in the future.

Brazilians know by personal experience that an artificially appreciated currency tends to cause severe and fast devaluations, which, among other bad consequences, creates havoc in the country’s international trade, leads to balance sheet problems for firms indebted in hard currency, reducing investment, and raises inflation. Brazil should not take this disaster-prone road once more.