My last paper published in the FX Outlook, Building with the Brazilian BRIC, dealt with growing economies of widely-used BRIC acronym for the emerging economic countries of Brazil, Russia, India and China. Specifically, I talked about the economic success story of Brazil. If you recall, I said "the bottom line is that Brazil's fundamentals look good. The currency should remain strong as capital inflow continues, BRL interest rates remain attractive, and Brazil keeps its economic house in order." Developments have occurred over the past eight weeks that warrant a little deeper dig into the longer-term strength and more recent volatility of the Brazilian real (BRL) currency.
Most economic indicators continue to point to a strong and robust Brazilian economy. An 8 percent gross domestic product (GBP) for 2010 is likely. GDP per capita is expected to be over $11,000 dollars by 2011, up from only $3,100 in 2003. Unemployment will likely remain under 7 percent. September's unemployment was reported at 6.2 percent, a record low. Strong economic growth will keep inflation elevated on higher commodity and food prices, leading to increases in wages. As a result, interest rates will remain over 10 percent in an attempt to keep the central bank's target inflation rate near 4.5 percent (currently at 4.7 percent). The expectation is that the central bank will resume inter-bank interest rate hikes this April, reaching 11.75 percent by June. Record tax collections and oil revenue should allow the government to maintain its budget surplus. In addition, Brazil's credit rating could be upgraded or return the outlook to stable. Currently Brazil's sovereign debt is an investment grade, with a Baa3 rating and a positive outlook.
Stem the Tide
There has been much talk of a potential currency war among the G20. While continuing the battle against the risk of an overheating economy, Brazil has been quietly waging a battle on another front. The BRL has strengthened nearly 35 percent in the two years. Since the Brazilian real broke the exchange rate of 1.70BRL to the USD, this past September, the Banco Central do Brasil (the Central Bank of Brazil) has been intervening in the currency spot market more aggressively to help curb the BRL strength. In addition, the government has raised the IOF tax on short-term investments from overseas into the local fixed-income market. Most recently, the government raised the Imposto sobre Operacoes Financeiras (IOF financial transactions tax) to 6 percent on October 18, after having raised it to 4 percent only two weeks earlier. It had been at 2 percent since October 2009. Finance Minister Mantega stated the measures aim to reduce short-term speculative inflows and to reduce volatility in the FX market. The minister noted authorities detected large capital inflows and noticed significant interest among large funds to move into Brazil. Matega's goal is to "moderate the appetite to invest in Brazil." He added that investors with a two to three year investment horizon will pay the tax and continue to invest in Brazil.
Furthermore, margin deposits by non-residents on derivative contracts at the Futures Exchange will apparently also be taxed at 6.0 percent, up from 0.38 percent. By taxing margins on derivative contracts the government is seeking to reduce the profitability of derivative operations and reduce the amount of leverage in the derivatives market (i.e., the size of leveraged bets on the currency). In fact, Minister Mantega stated concerns that at current margins, US$20 billion could leverage US$200 billion. The tax on inflows into equities will remain at 2.0 percent. So far, the efforts have had limited success.
According to Brazil's constitution, the president can only be elected by gaining more than 50 percent of the vote. The current president, Luiz Lula da Silva (often called "Lula") is not eligible to run again and a replacement election was held on Oct 3. Because none of the candidates received enough votes, a run-off election was held on Halloween. Dilma Rousseff, handpicked to run by Lula and a former Marxist guerilla has become Brazil's first female president. She defeated Jose Serra with a 56 to 44 percent margin. The thought is there will be few changes to the policies of the current administration that has been largely credited with putting Brazil on the global economic stage and helped create more than 14 million jobs since 2003. Ms. Rousseff is hardly a fiscal conservative. She is a firm backer of social program spending and favors a strong state role in strategic areas, such as banking, petroleum and energy. As one voter summarized what many thought, "I'm voting again for Rousseff. Lula was a great president and Rousseff represents continuity." In her victory speech she noted she would "know how to honor his legacy, I will know how to consolidate and go forward with his work."
The Trend is Your Friend
I continue to believe the BRL will benefit from the basic forces of supply and demand. Capital inflow will remain strong, as Brazil continues to offer a carry trade benefit and there is an abundance of liquidity in market. In addition, most major developed economies will keep interest rates low in an attempt to spur domestic demand. The U.S. Federal Reserve Bank seems to have embarked on a new round of quantitative easing, which should further boost liquidity. All these factors are creating demand for investment flows to attractive emerging markets like Brazil. The BRL will also continue to benefit from strong fundamentals and a stable government. In turn, the government will continue to intervene in the FX market and continue higher taxation on foreign investment in the fixed income and derivative markets to at least slow BRL strength. As of today, efforts have had limited success. The BRL is trading below the 1.70 level again.
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