photo: Justin Kiner
What a difference a year makes! For visitors to Brazil, a steak lunch in a top restaurant would have cost USD $120 per capita in October 2014 (not including caipirinhas or wine). Today the same meal costs roughly USD $65. The Brazilian real has experienced one of the most dramatic depreciations among currencies from emerging economies over the last 12 months. The good news is that this adjustment will help the tradable sector of the economy improve its international competitiveness. For an economy which is currently in free-fall (with an expected GDP contraction of roughly 3% in 2015), this is most welcome even though the low exposure of the Brazilian economy to international markets implies that this help will be at best moderate in terms of its macroeconomic impact. The bad news is that this will add to inflationary pressures and it will also impact the financial health of corporations that have borrowed abroad.
International depreciation trends
Over the last two years, many countries have experienced significant movements in the value of their currencies. As discussed in detail in the latest World Economic Outlook of the IMF (October 2015), these changes have often extrapolated the range of historical adjustments experienced by major currencies. Among industrialized countries the US dollar and the Swiss franc have appreciated more than 10%, while the Japanese yen has depreciated more than 30% in real terms (since mid-2012). Many emerging economies have also experienced significant depreciation of their currencies. The Brazilian real – which was identified by Morgan Stanley in 2013 as one of the so-called fragile five (a group that also included the Turkish lira, the Indian rupee, the South African rand, and the Indonesian rupiah) – has depreciated more than 35% in real terms since 2014 against a basket of relevant currencies of major trading partners. Actually, with the exception of the Indian rupee, the currencies of the other members of the “fragile five-club” have been among the worst performers among emerging economies currencies over the last two years.
To a large extent this should not be a surprise. These are economies with large current-account deficits, reliance on foreign financing, and in most cases significant exposure to the Chinese market. In the case of Brazil, the economic drivers of the adjustment are well known. Faced with a number of challenges (including the end of the commodity super cycle), Brazilian monetary authorities decided not to resist the pressures on the real, allowing the currency to adjust accordingly. Financial flows have contributed to these pressures as the slow-down of the Brazilian economy and the ongoing political crisis added to the uncertainty of investing in Brazil. Recent downgrades of the country’s credit risk by S&P and more recently by Fitch underscore these trends.
Currency war irony
It is ironic that Brazil, which as recently as 2010 had warned about the dangers of a “currency war” – reflecting concerns about interventions by major monetary authorities to limit upward pressures on their currencies in an effort to boost net exports – is now leading the “contest” in terms of global depreciation trends. To a large extent, this is a market-led process, but in the Brazilian case there are some additional influencing factors.
First, the current political gridlock associated with the tug-of-war between the Executive branch and Congress, amid the reverberations of the Petrobras corruption scandal, does not help. The Executive branch’s lack of credibility and the games being played by some members of Congress have significantly increased the pessimism about the prospects for recovery of the Brazilian economy. There is not only a crisis of governance, but also a crisis of ethics. Politicians seem to have fallen in what could be characterized as a Granovetter’s trap – after the name of sociologist Mark Granovetter – in which each “offender” feels that his/her unethical actions are not abnormal since the lowest threshold has already been made public by an earlier offender (e.g., those involved with the so-called mensalão, a large-scale vote-buying scandal uncovered in 2004). In short, the logic of the mob seems to be leading the country to the lowest common denominator for ethical behavior in the absence of credible leadership. Needless to say, this creates a field day for speculation against the real.
Second, the international environment does not help. This goes beyond the implications of the Chinese slow-down for Brazil. In reality, the current crisis provides another illustration of the behavior under stress of complex financial networks. The triggering event may be small in macroeconomic terms – e.g., the losses associated with the Petrobras scandal – but resulting collateral damage can be substantial, particularly, when the external environment suggests that in the near term additional headwinds will impact the country (for example, the expected increase of US interest rates). In short, markets tend to overshoot in their expectations about the future of a currency under stress.
There is, however, a silver lining. Economics does not stop operating below the Equator. As already mentioned, the depreciation of the real is impacting the tradable sector in a positive manner. Actually, the depreciation, combined with the slow-down of the economy, has translated into a substantial decrease in the Brazilian current account deficit (by roughly 30% compared with last year). Moreover, Brazilian assets are becoming increasingly attractive to foreign investors. In sum, no foreign exchange crisis is expected in the near future. But the economic crisis and the fate of the real will continue to be driven by the political imbroglio. In other words, more pain ahead.