Brazil: Reacting to Adverse External Scenario

In a scenario of capital flight, the BCB must intervene also via FX reserves sales.

When, in late May, the FED announced the tapering, market reaction was dramatic. Yet, when it announced, in late December, the actual plan it intends to put into effect starting this month,  reactions were not as intense.

The chart shows the substantial depreciation suffered by the emerging markets (EM) currencies, among which the Brazilian Real. It also shows that EM currencies are well correlated with the 10-year Treasury yield, the most important interest rate for the US economy. Therefore, the depreciation of the real, along with the other EM currencies, was a global phenomenon, caused by the liquidity reduction in international markets.

Still, the question remains. Will there be another shock akin to the one of last May? Or is the worst over, as the December reaction seems to suggest? There are several explanations for the market’s different reactions in the two occasions. First, it is news that move markets: May’s announcement was a surprise; December’s was already priced in. Second, the US economy improved significantly between May and December, with stronger growth and better prospects for the quality of economic policy.

But there is also a less optimistic scenario. The FED, apparently surprised by the market’s negative reaction to the tapering announcement, seemed to have eased and delayed the future monetary policy tightening. This made speculators buy back risky assets. If that is the case, when the liquidity crunch eventually materializes, the effect can be quite strong. How would Brazil be affected in this difficult scenario?

Analyzing the reaction to the tapering announcement last May, Einchengreen and Gupta (2013),[1] concluded that better fundamentals (smaller fiscal deficits, lower debts, bigger FX reserves and higher growth rates) did not insulate EM from the tapering effects. Much more important was the size of its financial markets: the bigger it is, the larger the depreciation was. Also, countries that allowed the largest appreciations and the current account deficits in the run up to the tapering were the ones that suffered the largest depreciations.

Brazil has a large and highly liquid financial system. Despite recent depreciation, the BRL is still appreciated, and the Brazilian current account deficit is still high (around 4% of GDP). Thus, it is very likely that the BRL suffers a lot if the negative scenario materializes.

What could be done in order to mitigate these effects? The most important measures would be to change fiscal and parafiscal expansionary policies. This would help to depreciate the exchange rate and reduce the current account deficit, besides helping to keep inflation under control and allowing interest rate reduction. Wayward fiscal policy, together with the lack of progress in the structural reforms, have been threatening Brazilian economy rating and driving away long term capitals, which are very important it times of excessive volatility.

Much more likely is that BCB will have to struggle to find ways to avoid problems in the foreign exchange market. The BCB should not try to avoid the real exchange rate adjustment but rather provide liquidity to prevent overshooting and excess volatility.

The largest amount of sales of foreign exchange performed by the BCB has been done via swaps,[2] which are settled in BRL. The aim of this kind of intervention is to preserve the FX reserves. Swap sales raise the onshore dollar rate, the “cupom cambial”, that is the dollar interest rate that banks earn from borrowing abroad and irrigating the forex market. Note that banks do not bear exchange rate risk, because the onshore dollar rate is quoted in USD, albeit settled in BRL.

Banks, however, have limits on the size of their matched exchange rate books and their total short position in the spot exchange rate market, today already at their highest, over USD 20 billion. Thus, in times of havoc, with capital outflows and large increases in the spread between the onshore dollar rate (cupom cambial) and the US interest rate, banks would not be able to “transform” the swaps purchased from the BCB into spot dollars in the required volume to keep the spot exchange rate market liquid. I.e., the size of the spread between the onshore dollar rate (cupom cambial) and the US interest rate is a measure of the illiquidity of the spot exchange rate market.

If and when this turns out to happen, the BCB cannot hesitate to intervene also via FX reserves sales. The current Finance minister started a panic episode in the exchange rate market during the crisis of October 2008, when he suggested that President Lula had determined that reserves should be preserved. Then, the BCB eventually got the authorization to sell the reserves, which in fact it did. If the external scenario deteriorates again, as the recent events in Argentina seem to suggest it might happen, it is important to ensure that such costly policy slippages are not repeated.

Chart:

Tapering Talk, Emerging Markets Currencies and 10yr Treasury yield

 



[2] Brazil: Exchange Rate Policy  Economonitor (17/12/2013).