The BRL has appreciated more than 100% vis-à-vis the USD under the Lula administration. In real terms the BRL appreciation was somewhat less pronounced. The factors driving exchange rate appreciation have varied. Following a massive depreciation in the run-up to the October 2002 presidential elections, the currency appreciated in late 2002 and early 2003. From then until 2005, the currency remained stable-to-appreciating while Brazil took advantage of the emerging surplus on the current account and recovering portfolio equity inflows to retire external bond and loan obligations (including IMF loans). In 2006 net debt inflows turned positive again, driving a huge balance-of-payments surplus and leading to aggressive central bank FX intervention. Strong non-debt-creating foreign currency inflows (portfolio equity, FDI and current account flows) and the resulting increase in FX reserves led to a sharp decline in net external debt over the entire 2002-2007 period.
All major balance-of-payments items will stay in surplus in 2008. This will keep the BRL under appreciation pressure, especially vis-à-vis a weakening USD. Equity inflows will remain strong on the back of lower domestic interest rates. FDI investment looks more attractive than in the past thanks to improved medium-term economic growth prospects and greater macroeconomic stability. The positive carry will continue to attract fair debt inflows. We expect the balance-of- payments to register a surplus of USD 50 bn.
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| Source: Banco Central do Brasil |
If and how much the exchange rate will appreciate will depend on the reaction of the authorities. Open macroeconomics suggests various options how to prevent the exchange rate from appreciating. First, the authorities may seek to restrict short-term borrowing by banks. But the government seems committed to keeping the capital account open and changes restricting short-term foreign-exchange on prudential grounds (e.g. changes in rules governing commercial banks’ foreign exchange exposure during this summer).
Second, the government will not implement steep cuts in real primary spending. This would lower primary spending and raise the primary fiscal surplus, limit domestic demand and weaken upward pressure on the prices of non-tradables, allowing for lower interest rates. Unfortunately a substantial slowdown in real primary spending is unlikely, as “mid-term” elections are less than a year away.
Third, in the absence of fiscal tightening the central bank will not implement a large interest rate cut in order to weaken the currency while strong domestic demand is putting upward pressure on inflation. The central bank focuses on inflation and is concerned about safeguarding its autonomy. It will also not want to give the markets the impression that it targets a specific exchange rate level. (It is not clear that given the composition of capital inflows, heavily skewed towards equity flows, an interest rate cut would do much to reduce capital inflows. With the Fed easing, the carry would remain substantial and lower interest rates might even lead to a further surge in equity inflows on the expectation of higher corporate earnings.)
Finally, the central bank is unlikely to absorb the entire balance-of-payments surplus. The benefits of further reserve accumulation are declining from the central bank’s perspective. (The current level of FX reserves provides a more than adequate level of “risk insurance”. At more than USD 160 bn, FX reserves are comfortable giving Brazil enough of a war chest to weather a “sudden stop” in capital inflows. The carrying costs amount to around 1% of GDP. This won’t break the bank, but the incentive to accumulate further FX reserves is clearly limited.) But for political and economic reasons, it will also not want to open itself unnecessarily to political attacks in the run-up to the mid-term elections. The central bank is therefore likely to continue to intervene, but less aggressively. Assuming that the central bank purchases USD 30 bn in 2008, the remaining USD 20 bn surplus will be enough for further currency appreciation.
The BRL looks strong, but not massively overvalued relative to its historical average. This does not mean that the BRL cannot temporarily weaken. From a fundamental balance-of-payments perspective, the currency should remain under appreciation pressure though. If our analysis is broadly correct, the exchange rate will strengthen to around 1.6/USD next year. Some of the capital inflows are clearly speculative, pushed by ample global liquidity.
Fundamentally we are witnessing an economy and financial markets transitioning to a permanently lower level of risk. Lower country risk, lower domestic interest rates and a declining equity risk premium are pushing up asset prices and leading foreign investors to increase their exposure to Brazil. The prospect of Brazil reaching investment grade by 2009 will further underpin this largely structural trend in foreigners’ willingness to take Brazil exposure.