Wednesday, May 20, 2009

China and Brazil and Their Convertible Currencies – Will It Happen?

As we all know, president Lula is in China this week. It seems that one of the goals of his visit is to enable Brazil and China to use their own currencies in trade transactions, rather than the US dollar. The move follows recent Chinese challenges to the status of the dollar as the world’s leading international currency. It should be clear that this deal is different from what China is doing with Argentina – currency swap. In the Brazil - China deal Brazil would pay for Chinese goods with reais and China would pay for Brazilian goods with renminbi. The move follows recent Chinese challenges to the status of the dollar as the world’s leading international currency.

In our view, this is an important step towards convertibility. Clearly, the country can afford to have a convertible currency because it has a healthy balance of payments and the government has been taking steps towards convertibility. A few steps in the direction of convertibility include the permits for exports to hold their proceeds abroad, for local hedge funds to open foreign accounts, and for financial institutions to keep deliverable BRL abroad for tourism related transactions. However, there are technical issues to be resolved. For example, the recent deal between Brazil and Argentina, where the two countries can issue their own currencies to pay for the goods traded between them, has operational problems. The main problem is to fix, at the day ARS/BRL and thus creates additional FX risks in the transactions, which tends to decrease its attractiveness. In turn, the volumes involved remain insignificant.

In any case,it seems that this initiative, if it comes true, is challenging the role of the dollar as the universal medium of exchange, unit of account and store of value. While the dollar’s status as the major reserve currency will not vanish overnight, we can no longer take it for granted. Sooner than we think, the dollar may be challenged by other currencies, like the Brazilian real and the Chinese renminbi.

While it will take time for Brazil to have a convertible currency, this is the perfect opportunity for Brazil to push forward with the modernization of the FX market. While Brazil has a small current account deficit it has a surplus in the capital account, explaining then the balance of payment surplus and hence the increase in international reserves. We do not expect BRL to become a convertible in the short term, but the trend is clear, and it will be an additional element supporting BRL appreciation in the medium term.

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