Friday, May 18, 2007

Interest Rates and Exchange Rate In Brazil

Despite the daily interventions by the Brazilian Central Bank, the BRL/USD broke through the two per dollar level for the first time since 2001. The BRL/USD reached 1.9960 reais per dollar after the government announced that retail sales rose 11.5% in March from a year ago.

News agencies like Bloomberg explain that the Real reached 1.9960 because of the latest IPCA (inflation lower than expected) or even because of Fitch upgraded Brazil’s sovereign debt to BB+. In the above chart, we display the daily change in net reserves (due to Central Bank purchases of U.S. dollars) and the correspondent exchange rate, since January 2007. Indeed, the central bank has sought to slow the real's advance and shore up dwindling profit margins at manufacturing exporters by buying dollars in the currency market and selling reverse currency swaps. In 2007, the Central Bank bought $36.5 bn (until May 2) swelling its foreign reserves to a record $122.4 billion. These purchases did not prevent the BRL/USD rate to appreciate by 6.9% this year.

As mentioned by Italo Lombardi there is room for a more aggressive decrease in interest rates in Brazil. In part because Brazil has an extremely developed financial system with an open capital account, it may be the case interest rates cuts will not reduce, in a significant way, these capital inflows.

It is not clear whether the Central Bank will cut domestic interest rates at a faster pace to reach 10% in December. Because of the stable macro fundamentals in Brazil, ‘yield hungry investors’ may preserve their high capital inflows to Brazil. In our view, high interest in Brazil does not fully explain the high levels of capital inflows. Brazilian interest rates have been high since 1999 without attracting such significant capital inflow. A major institutional change created by the Central Bank during 2005 was the elimination of restrictions in the capital account. The capital account liberalization (in tandem with greater global liquidity) in the highest interest rate country in the world explain the significant increase in capital inflows. In turn, the decrease in interest rates with imposition of some type of capital controls might help to decrease the inflow of capital to Brazil.

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