Wednesday, April 9, 2008

Measures in the FX Markets in Brazil - A Short Analysis

Last week, Brazil implemented a couple of measures to curb the appreciation of the Brazilian Real (BRL) and to boost exports. Our goal here is to examine these measures evaluate the efficacy of these measures. Two of the measures are closely related to the Brazilian exports and its competitiveness. The first one allow exporters to keep proceeds from exports offshore and a second one exempts export-related FX transactions from the IOF tax. The third, a new IOF tax on foreign investors’ fixed income inflows, aims to curb BRL appreciation by reducing capital inflows.

The new IOF tax imposes a 1.5% upfront charge on foreign investments in local fixed income instruments (funds and bonds, but not stocks, FDI, and loans). The market has been arguing that the current BRL appreciation is more linked to the US weakness than local specifics or that Brazil is primarily a commodity-export country. In this scenario, measures to decrease FX appreciation are not useful because they will not prevent a further decrease in the BRL/USD.

While the above arguments may be right, our point is that even though most of the recent BRL/USD appreciation has been driven by dollar weakness, interest differentials remain quite high and, the speculative trade BRL-bull could make a comeback in the medium-term whenever market conditions improve. The government-issued NTN-B’s (inflation n indexed bonds) and NTN-F’s (fixed-rate coupon bonds) are quite attractive bonds paying relatively high yields and could very likely become investors target again once global markets volatility bounce back. Nonetheless, the new 1.5% IOF tax could be just the beginning. The finance ministry could well use the tax to impose a barrier on foreign investors by increasing the burden in the future - further speculation could trigger further taxation. But the government knows that investors look at the net real interest rates paid by bonds. In other words, ceteris paribus, any additional taxation reduces the attractiveness of those bonds in real terms (considering the nominal yield remain unchanged), which might reduce the appetite for those bonds.

However, political economy has always some trade-off hiding behind measures and policies. By introducing the IOF for fixed-income bonds, the government basically introduces inefficiencies associated with any type of financial tax (CPMF, income tax and etc) over fixed-income instruments. Those taxes increase the equilibrium nominal interest rate, increasing overall financing costs and definitely putting a dent on investment incentives. In a short-term perspective, those results could be welcomed by the BCB, who’s now facing a quite different situation from less than a year ago, At that time (June-07), we argued for a faster decrease of interest rates and a less aggressive FX intervention. The Brazilian central bank may actually hike rates in case inflation does not show clear signs of moderation and inflation expectation remain too close to the established target. The policy though, hurts long-term investment perspectives and thus the potential GDP growth.

In brief, we believe that the new measures may not be enough to boost exports but more and foremost the measures are designed with the intent of decrease the capital flow to Brazil. Different from what we suggest last year in this blog, we observe that the Brazilian government is creating the barriers to reduce the flow of capital to Brazil. The question is whether the measures are designed to reduce the BRL appreciation or their implied goal is to go back to a closed capital account.

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