The fact that the Brazilian currency is overvalued and that the Central Bank increased its reserves in $40 bn in 2007 is well known. We learned with Italo Lombardi, Tom Trebat and Marcio Garcia that Brazil has room to decrease domestic interest rates as one measure to decrease the inflows to the country.
The Colombian peso is in a similar (or worst) situation as Brazil. Like Brazil, the Colombian Central Bank has bought $4.5 bn in 2007 until April. Net international reserves in Colombia respond for 12.5% of their GDP and in Brazil for 14% of the GDP. Sterilization policies in both countries seem to be unable to inhibit the inflow of capital. In turn, while the Brazilian real appreciation reached 7.6% against the dollar the strength in the Colombian peso is even higher: 14.5% against the dollar in 2007.
Different from Brazil, where inflation is bellow the target and inflation expectations are low, Colombia has been posting an increase in inflation: from: 4.5% in December/06 to 6.3% in April/07. In part because the Central Bank has tightened its target of inflation for 2007 to 3.5 – 4.5% from 4-5% in 2006, they have just decided to increase domestic interest rates to 8.75%.
According to Bloomberg, the Colombian Central Bank will keep fighting against inflation through an increase in interest rates and will reduce its intervention in the FX market. In turn, it is very possible that the peso to keep appreciating against the dollar.
The challenges that Brazil and Colombia are facing with their exchange rate are simply reflecting their previous decision to open up their capital accounts without fully realizing the damage it would cause in times of too much liquidity in the world. The rest is history.