Global imbalances and the Brazilian Real: what comes next?

In these days no one reads other subject in the Brazilian economic newspapers that not related to the “unsolvable problem” of the appreciation of the real against the dollar.

These days we are experiencing a conjunction of important economic factors affecting Brazil’s exchange rate market. All of them are related to each other although they have different channels of impact on this market. Some of them have a more idiosyncratic aspect, others have more common origins. Alone, they would have one effect; together their effects have been intensified. It would be important to be able to distinguish each particular influence into the appreciation of the exchange rate, but it is almost impossible to do that.

There are two very important world economic factors affecting the exchange rate markets all over the world, but with greater impact on the emerging market economies nowadays. One is related to the real economy, the other to the financial one. In the last ten years the world and specially the commodity exporting countries, Brazil included, are helping to build a huge and “new” modern region, China and East Asia. Due to this major development, commodity prices have been increasing in the last years causing a strong positive impact into the Brazilian trade balance. Even the enlargement in the deficit of the income balance has been insufficient to surpass the trade one, generating since 2003 current account surpluses, changing dramatically Brazil’s previous scenario of scarce amount of dollars necessary to finance the country’s external account.

But this scenario of high economic growth around the world has developed in conjunction with increasing current account deficits in the American economy. It is important to note that, since the last quarter of 2005, the economy of the United States has had deficits in the trade as well as in the income balance; moreover, the current account deficits of the last fifteen years has transformed the American economy into a net foreign debtor, the largest one. Many prominent economists around the world argue that these imbalances cannot continue forever, some of them emphasizes that such imbalances must be reduced very, very soon. The fact is that the investors around the world are starting to diversify their portfolios and reducing - however slowly - their investments denominated in dollars. This modest change in portfolio choices of these world financial investors have been able to flood some emerging market economies - those who have been able to implement consistent macroeconomic policies in recent years - with large amount of capital inflows that are entering into different markets: debt, equity, real estate, commodities, etc. The fact that there is excess liquidity in developed economies does not fully explain the immense inflow of capitals to Brazil. Still, it is possible to argue that the part of this global liquidity went to Brazil. Indeed, in March foreign investors in Brazil have bought US$ 3.8 billion of fixed income bonds, both short and long-term ones, the highest amount since the end of fixed exchange rate regime in January 1999. Since January of this year, the net balance of these bonds purchased by non-residents has reached US$ 14.5 billion.

In turn, one could say that the significant increase in Brazilian exports as well as the greater capital inflow are the two major factors explaining the strength in the Real (against the USD), especially since 2005. But there is also a third related factor that is generating more pressure towards an appreciation of the brazilian real: inflows – or carry trades - based on the interest differentials, even if those carry trades mean a bet against the uncovered interest rate parity condition. In this sense one could argue that the Brazil may be subject to an unusual “speculative attack” in its forex market . Big foreign currency traders have intensified carry trades and long positions in real trying to bet against central bank implicit view that a R$ 2,000/US$ (or a modest range around it) would be a plausible and equilibrium level for the nominal exchange. In these last months the losses of the central bank due to its exchange rate position have been high. It is difficult to predict the result of this bet. There are analysts forecasting a dollar at R$ 1.900 at the end of this year. The central bank will probably try to sustain the level of R$ 2.000/US$.

The exchange rate is a forward looking economic variable in the sense that its value is based on current and future conditions. In this case many forecasters see the exchange rate more appreciated than the current level; if that were to happen, the central bank’s effort to prevent the appreciation could fail after a significant fiscal cost . On the other side, if the current account surplus were to be smaller in the near future or other global shocks were to lead to a reduction of the speculative capital inflows it is possible that the exchange rate could remain close to its level. The first scenario seems more likely but we have to wait and see…