Monday, April 2, 2007

De Jure versus De Facto Exchange Rate: Brazil 2007


According to the latest data released by the Brazilian Central Bank, international reserves increased by $61.3 billion in the first six months of 2007. The COPOM minutes emphasize the inflation target regime and do not stress the accumulation of international reserves. The issue is whether the monetary authority is targeting not only the inflation but also (and mostly) the exchange rate.

The following chart (using data from the Brazilian Central Bank), suggests that the monetary authority may be following a ‘crawling peg’ for the exchange rate. According to the data, the volatility of daily exchange rate is not above 2%. To preserve the level of the exchange rate within that band, the monetary authority buys increasing amounts of international reserves on a daily basis.

Levy-Yeyati and Sturzenneger (LYS) propose a ‘de facto’ classification for the 185 countries listed at the IMF ‘de jure’ classification. For the IMF, Brazil is classified as ‘independently floating’, that is the exchange rate is market-determined, without any official foreign exchange market intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate.

When we apply the LYS methodology to Brazil, we say that Brazil has low exchange rate volatility and high international reserves volatility. It may be the case that Brazil is back on a crawling band, implementing a dirty floating exchange rate policy while announcing to the market their target of inflation. Why not announce the exchange rate target? Fear of floating? Well, even if this is the case, it is becoming more and more clear that the Central Bank is getting far from an ‘independent float’ and closer to a crawling peg regime.

In our view, the intervention process started back in 2005 with the goal of reducing the volatility of the exchange rate in order to avoid big swings in market expectations. In 2005, the main reason for the monetary authority to intervene in the exchange rate was to avoid unnecessary noise to the inflation target mandate, given the high pass-through registered in the economy.

Since then, the amount of dollars flying into the economy has increased dramatically. As a by-product, the Central Bank has increased the amount of intervention in the FX market to curb the BRL appreciation. The Central Bank may argue that the need for exchange rate intervention comes from the fact that an excessive appreciation could lead to an abrupt depreciation in case of a flight to quality (for any exogenous reasons). The unexpected depreciation would then increase inflation expectations and then inflation. One might argue that the ‘crawling band’ implemented by the Central Bank is working as a buffer to the inflation-targeting regime. In addition to it, the announcement of a ‘crawling band’ or any type of exchange rate target would be a much inferior framework vis-à-vis the inflation targeting regime and could put in risk all gains of credibility the BCB has accumulated so far.

The issue at stake is that monetary authority seems to be violating the ‘impossible trinity’. The fear of floating induces the monetary authority to accumulate reserves. But then, given high term premium Brazil started to receive large inflows of ‘hot money’. In turn, it seems hard to believe that the monetary authority will be able to set interest rates, exchange rates and preserve an open capital account. However, it remains to be seen if the market players will tag along with the Central Bank. Remember the January 1999 episode?

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