Emerging economies with open capital accounts, liquid domestic financial markets and high interest rates have attracted very large amounts of foreign investment. A change in G3 monetary conditions is bound to have a significant impact on non-FDI inflows. In Brazil, potentially “fickle” foreign investment in Brazil has risen very tangibly, reaching USD 500 bn in Q1. Significant official reserves and a favourable foreign liability structure in terms of currency denomination would allow Brazil to ride out a “sudden stop” in capital inflows via currency depreciation.
Low G3 interest rates and low global risk aversion have attracted large capital flows to high-yielding, fast-growing emerging markets. Economies with open capital accounts, liquid domestic financial markets and high interest rates have attracted especially large amounts of, especially, foreign portfolio investment over the past two years.
According to Stein’s law, if something cannot go on forever, it will stop. This phrase was originally coined in the context of balance-of-payments deficits, which indeed cannot last forever. Balance-of-payments surpluses, on the other hand, may be less unsustainable in this sense. Nonetheless, surpluses are unlikely to last forever, either, as capital inflows eventually decline (or even reverse), foreign liabilities increase to unsustainable levels or a widening current account deficit reduces the overall surplus.
If the past is anything to go by, a change in G3 monetary conditions is bound to have a significant impact on non-FDI inflows. As the IMF has pointed out, this time the “normalisation” of G3 monetary conditions is likely to have a greater-than-normal impact on EM capital flows given the very low initial level of interest rates. Naturally, the more precipitous and the less anticipated the G3 rates hikes, the greater their impact on EM capital flows. The ECB is already tightening, but EM capital flows will be most impacted once the Fed signals a shift towards raising the funds rate.
Brazil’s balance-of-payments dynamics have been benefitting not just from a surge in capital inflows, but also from a favourable current account (or terms-of-trade) shock. To some extent, capital inflows are being pulled in by rising commodity prices. This also means that a tangible decline in export prices will have a negative effect on capital inflows. In short, capital and current account flows are correlated. Not surprisingly, Brazil’s terms-of-trade and the real exchange rate are at multi-decade highs and 12M cumulated gross capital inflows are running at a staggering USD 175 bn as of March (more than three times its ten-year average) – half of which consist of portfolio debt and equity flows.
The value of foreign investment in the local bond and equity markets and other potentially fickle short-term “other” investment (mainly deposits, short-term credits) has risen quite substantially since 2009, rising from a low of USD 160 bn in Q4 2008 to almost USD 500 bn by Q1 2011. By comparison, FX reserves amounted to almost USD 320 bn as of March (or USD 330 bn today). The FX coverage ratio remains very comfortable. That said, the large stock of short-term liabilities makes the currency vulnerable to an increase in foreign interest rates or a rise in risk aversion. It is worth noting that the stock of these claims fell from USD 300 bn in mid-summer 2008 to USD 160 at the end of 2008 – much of which was due to currency depreciation and the decline in equity prices. The loss of reserves was very limited, even though FX intervention in the derivatives markets and other types of non-spot-market interventions are not fully reflected in reported FX reserve losses of USD 20 bn (or a mere 10%) between September 2008 and February 2009.
Substantially, Brazil’s external financial position remains solid. First, the current account continues to be more than fully financed by FDI inflows. On a 12M accumulated basis, FDI inflows amount to USD 60 bn versus a current account deficit of USD 50 bn. Moreover, the current account deficit remains relatively small, below the 3% of GDP level generally considered to be “safe”. This puts Brazil into a significantly more favourable position than many other countries (e.g. South Africa, Turkey). Second, and perhaps more importantly, FX reserves have risen at a pace comparable to the stock of potentially “fickle” foreign liabilities. FX reserves continue to exceed the stock of “fickle” debt liabilities.
To what extent a “sudden stop” would impact the exchange rate would of course depend on the propensity of the central bank to intervene. If 2008 is any guide, the BCB would intervene to the extent necessary to ensure overall financial stability and limit “excess” domestic financial market volatility. But it would not intervene to prevent a, potentially, very sizeable depreciation of the currency. In the face of an admittedly very severe shock, the BRL depreciated by almost 40% vis-à-vis the USD at some point between August and November 2008. The central bank spent very limited amounts of foreign exchange in order to achieve a relatively “orderly” – from a financial stability point of view – depreciation.
Brazil is very unlikely to experience a similarly dramatic capital account shock. Foreigners own around 15% of both the equity and domestic government bond market. This is not excessive compared with many other emerging markets, let alone developed markets. Foreign holdings of government bonds exceed 30% and 20% in Indonesia and Turkey, respectively. A lot will depend on the relative importance of dedicated and/or real money accounts versus more opportunistic, cross-over investors, searching for short-term carry- and appreciation-driven returns – and the degree of volatility they are willing to sustain. But whatever investors’ risk tolerance, thanks to an overall solid external position, Brazil is not at risk of experiencing a financial crisis in the event of even a severe capital account shock.