MercoPress. South Atlantic News Agency

In spite of latest measures, Brazil’s ‘currency war’ looks set to rumble on

Financial advisors Capital Economics says the strong Real will help contain inflation

If recent evidence is anything to go by, Brazil’s latest effort to stem the rise in the Real is unlikely to have a lasting impact on the markets, according to Capital Economics.

While rising inflation should mean that the authorities become more tolerant of a stronger currency in the short term, the fundamental driver of the Real strength – namely rapid capital inflows – is unlikely to dissipate soon.

Wednesday night Finance Minister Guido Mantega announced that a 6% tax on overseas borrowing by banks and companies would be extended to loans with a maturity of up to two years (from 360 days previously).

It is the third time in the past fortnight – and the seventh time since October last year – that Brazil has imposed targeted capital controls. The aims of the controls are well known by now.

First, the government wants to deter speculative inflows of foreign capital that could jeopardise the stability of the financial system. Second, and perhaps, more importantly, capital controls are just one part of a much broader attempt to stem the rise in the Real, which has squeezed the competitiveness of Brazil’s exporters and given a rather unbalanced look to growth.

The question is, will the latest round of measures work? Capital Economics is sceptical. After all, a tax of 6% is small change when compared to the differential between local and foreign currency interest rates (Brazil’s benchmark Selic interest rate is currently 11.75%, compared to a Fed Funds rate of 0.25%).

What’s more, while the various measures introduced since last October have succeeded in weakening the Real for a short time, they have failed to stem its trend appreciation against both the US dollar and the currencies of other trading partners.

Further more worryingly for policymakers, each successive measure appears to be having an ever smaller impact on the foreign exchange markets.

The key to weakening the Real over the long run lies in a much tighter fiscal position, which would allow the central bank (BCB) to lower interest rates and reduce the carry on the Real. But while the spending cuts announced earlier this year are a step in the right direction, political (and constitutional) barriers prevent more radical reform. In the meantime, while capital controls are unlikely to do much harm, FX purchases offer the best way to stem the Real rise.

The sterilisation costs which are estimated to be equivalent to 0.2% of GDP a year are a price that for now at least the authorities seem willing to bear.

As it happens, rising inflation means that concerns over the strength of the currency have slipped down the list of policy priorities. Data released Thursday show that inflation (on the IPCA measure) rose to a 29-month high of 6.3% in March.

Rising commodity prices means that it is likely to breach the upper limit of the Central Bank target range (6.5%) over the coming months peaking at just under 7% in Q3. For now then, there are good reasons for the authorities to tolerate a strong currency.

Nonetheless, worries about the Real are unlikely to slip off the agenda completely. Despite speculation to the contrary, Capital Economics are sceptical that the end of QEII will herald a slowdown in capital inflows to emerging economies over the second half of this year and into 2012. Meanwhile, even if the Brazilian authorities do tolerate a stronger Real, they are unlikely to welcome an influx of speculative capital.

Managing capital inflows – and preventing over-exuberance – will remain the defining policy challenge for the next couple of years. Accordingly, it only seems a matter of time before further targeted capital controls are unveiled.