Brazil: Inflation Targets and Exchange Rate Overvaluation

By any possible measurement, the exchange rate in Brazil is extremely overvalued, particularly with respect to the US dollar. Just three examples: the real is worth today 2 pesos (Argentina); adjusting for inflation, the real is worth today more than in 1994/1995, when – due to the so-called Plano Real – the US$/R$ rate became 1 to 1 and even less than that for some time; between 2003 and 2008, the rate against the dollar appreciated from almost 4 to less than 1.7.

This excessive overvaluation is naturally good for inflation, but terrible for the trade balance. Brazil was lucky in the past few years with high commodity prices, but manufactured exports are being hurt tremendously and imports are now growing very fast.

Basically, this is being caused by the present monetary policy regime, which deals with interest rates based exclusively on the so-called “inflation target model”. Recently, for example, the basic Selic rate was again raised to near 12%, in contrast to a rate of inflation of less than 5%, just because this is the basic rule of the model: after all, the “target inflation” is around 4%.

Such high interest rates, however, are bringing huge inflows of short-term capital, coming particularly from Japan, Switzerland and the USA where interest rates are now very low. The Brazilian Central Bank is unable (or does not want) to sterilize these financial inflows and there was recently an acceleration of the exchange rate appreciation more and more (reaching now less than 1.7 with respect to the dollar).

The old interest rate parity theory does not work here because short-term investors believe that the interest differential is so great (around 10% per year, if you consider Japan or Switzerland) that they ignore expectations of devaluation of the real. On the contrary, they gain twice, with the interest differential and the appreciation of the currency. Can you imagine how much can be gained, using leverage?

It is true that countries like New Zealand, Australia, Venezuela and Turkey also have high interest rates, but for many different reasons the focus of the market is on the “real”. Certainly, one of the major reasons is that Brazil has the highest “real interest rate” – around 7% – giving perhaps confidence to investors.

However, the fact is that the “inflation target model” in Brazil is showing and provoking a dilemma, which is the conclusion that the right interest rate to attack inflation is not unfortunately the correct interest rate to avoid capital inflows. Naturally, we are not suggesting that Brazil should necessarily move in the direction of countries like Argentina or China or other Asian countries, where the “target” is sometimes the exchange rate itself, rather than inflation.

But it is clear that there is a serious dilemma brought by one policy instrument (the interest rate), which is not able to deal with two targets – inflation and exchange rate. The Brazilian Central Bank simply adopts a policy of ignoring the exchange rate as a target, that is, the very definition of a truly flexible exchange rate.

We feel that it is important to point out, however, that there are other economic policy instruments, which are not inconsistent with the “inflation target Central Bank model” that could be taken into consideration. We are talking, for example, about higher capital “taxes” and lower import “tariffs”.

Paradoxically, Brazil seems nowadays excessively open for capital movements and still full of import controls and tariffs. Why not revert these trends and instruments?

When one thinks about the basic Brazilian interest differentials and translate it into 90 days, for example, we are talking about something like 3%. The introduction of a 3% tax on short-term capital inflows is not incompatible with the Brazilian inflation target model. Moreover, a greater openness for all imports – with lower tariffs and controls – is also obviously consistent with antiinflationary goals.

The fact is that the existing macroeconomic situation seems to be entirely unsustainable: 12% interest rate, 5% inflation, clear overvaluation of the currency, and a growing deterioration of the trade balance. The projections for GDP growth in 2008 are good – around 5% – but they could be severely hurt by this excessive mix of tight monetary policy and overvalued exchange rate. Additionally, fiscal policy does not help at all, with growing current expenses and growing nominal deficits, in addition of a huge tax burden.