FROM THE ECONOMIST INTELLIGENCE UNIT
Brazil is continuing its battle in the currency wars: the finance ministry upped its tax on capital inflows on October 18th, the second time in a month, as the Brazilian Real continued its sharp ascent. Such action may weaken the currency in the very short term, but the ministry's moves will do little to curb its appreciation beyond that. Real interest rates remain high and alluring for investors and will remain so, given that developed economies such as the US do not appear ready to tighten monetary policy anytime soon.
The Real's ascent has shown little reprieve. Having appreciated by more than 37% since the beginning of 2009, it has risen by 6.2% since the start of September. Indeed, since late September, it has been trading above the psychologically important R1.7:US$1 level, hitting R1.65:US$1 on October 14th before easing slightly thereafter.
This persistent strengthening spurred the finance minister, Guido Mantega, to raise taxes on foreign inflows into fixed-income instruments for a second time in the space of a month, to dampen investors’ appetite. The financial operations (IOF) tax was taken up to 4% in early October for fixed-income investments (the levy on equity portfolio investment remained at 2%) and to 6% on October 18th. A 6% tax is now also to be charged on guarantee margins for derivatives operations, up from 0.38% previously. (The IOF tax was reinstated, at 2%, in October 2009 after having been suspended a year earlier.)
Monetary authorities in the large developed economies appear to be intent on keeping their interest rates low—and the US is ready to resume quantitative easing—which will keep liquidity levels very robust. At the same time, Brazil's benchmark Selic rate remains high. The Banco Central do Brasil (BCB, the Central Bank) raised the benchmark Selic rate from 8.75% to 10.75% between April and July. And although the BCB has since paused this cycle (owing to concerns over currency appreciation), real interest rates remain at around 6%.
The Economist Intelligence Unit expects monetary authorities to keep the current Selic rate stable at its meeting of October 19th-20th, but we forecast that the central bank will lift it by another 50 or 75 basis points by mid-2011. This would take real rates to around 7%. Meanwhile, the strengthening of the Real will serve to dampen inflationary pressures. In September the 12-month rate of inflation was 4.7%, and it is expected to ease towards the 4.5% central target. A radical shift from inflation-targeting to exchange-rate targeting is extremely unlikely.
In the medium to long term, the authorities will have to do more than simply buy dollars and try to deter capital inflows by means of taxes. A longer-standing solution would require cutbacks in public spending. Given the continued boom in consumer and government spending there is plenty of room to make such moves (retail sales volumes growth hit a five-month high of 12.2% year on year in August, despite a less favourable base of comparison a year earlier).
Congress, at least, appears to be heading in the right direction. It passed a 2011 draft budget law adopting a fixed nominal primary surplus target of R125bn (US$71bn, equivalent to 3.3% of GDP), rather than adopting a target in GDP terms, which would potentially allow for increased public spending at a time of such strong economic growth.
However, there is unlikely to be much improvement in the primary surplus. Assuming that Dilma Rousseff, the governing party’s presidential candidate, wins the presidential election at the end of this month, spending will remain high, as she presses ahead with enhanced investment and social spending programmes. Furthermore, the government's practice of transferring funds to the state development bank (BNDES) for on-lending as a countercyclical tool during the 2009 downturn has continued in 2010, and further transfers, albeit at lower levels, are likely to be forthcoming. (These are not registered either in the primary balance or in the more widely followed net public debt statistics.).
Currency forecast adjusted
Overall, the authorities’ efforts are unlikely to prove more than a temporary fix given the wave of global liquidity. They will need to take other actions if they hope to push the Real back below the R1.7:US$1 level and keep it there. Past experience suggests that taxes and similar moves have done little more than slow the Real’s rise temporarily. In light of the latest developments, we now believe that the Real will remain strong, at US$1.70:US$1, at year-end 2010 (our previous forecast was that it would be US$1.78:US$1 in December). Further appreciation to R1.60:US$1 or so cannot be ruled out. With the Real set to be over 30% stronger than its average real trade-weighted value over the past 15 years, exporters will encounter competitiveness challenges. This may explain why industrial output has been virtually flat since April, even though retail sales continue to power ahead.
Having battled against the risk of an overheating economy, Brazil faces considerable policy challenges in the months ahead. Should the US dollar remain weak, there will be little that can be done to hold the Real back from further appreciation. We expect the currency to remain strong in 2011, and, as this makes imports more attractive, the current account is likely to widen.