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Dilemma of Brazilian Real

Posted in Finance Articles, Total Reads: 2603 , Published on October 11, 2011

Over the last two decades Brazil has made significant strides toward economic prosperity. The reforms carried out in mid 1990s had brought about significant currency stability, sustained growth in commodity exports, rising levels of employment, wage growth and also enhanced credit availability. The consumer and business confidence in the economy has risen.

Brazilian Real - The dilemma

However in the recent years post the economic meltdown of 2008 and the existing European Sovereign Debt Crisis Brazil has been involved in a ‘currency war’ with other emerging economies like China etc. where all of them fighting to keep their currencies from appreciating. Due to increasing foreign Capital Flows the Brazilian currency Real has appreciated significantly hurting the economy’s prosperity and causing instability in the economic environment. The country is also struggling with inflation which has soared much above its accepted levels. Brazil has had a traumatic history with inflation, and there are fears that since the country’s economy is booming — possibly overheating — inflation might return again.
The situation seems to have culminated into a ‘Vicious Circle’. The dilemma that Brazil faces today is whether to allow currency appreciation or inflation.
The problem started with a surge in inflation which is rising due to the worldwide increase in food and fuel costs and also due to the fast growth being experienced by the country. Rise in wages and increased credit availability due to rising foreign investments has led to surge in consumer spending. Thereby inflation that had stabilized in the last few years has increased again and is currently hovering around 6.7% while the target rate is 4.5 %. In order to keep inflation in control the Government has exercised several monetary policy measures and increased the interest rates five times in the last two years taking them to a record high of 12.5%. The real interest rates now stand at around 6%. The Central Bank has coupled these measures with steps aimed at slowing rapid credit growth.
This has subsequently led to volatility in foreign markets. Foreign investors are fleeing from the advanced countries like US, UK and Japan that are offering less than 1% interest to emerging markets esp. Brazil that is offering relatively very high returns. The ultra-loose US monetary policy, known as quantitative easing, is also blamed for pumping liquidity into the global economy which has found its way to Brazilian Markets. This has led to inflating asset prices and forcing governments to implement defensive capital controls. These capital inflows have pushed up the effective exchange rate (the Brazilian real measured against a basket of international currencies) by over 35% since January 2009 to November 2010.
The relentless strengthening of the country’s currency is a headache for the Country’s administration, which is concerned that it is reducing the competitiveness of the country’s manufacturing and export sector. Hence in spite of the bright picture the industry is struggling to live with the effects of a stronger currency.
Brazil has responded to all this with the so-called “currency wars” - a series of capital and currency controls aimed at curbing the appreciation of Real. It has imposed a complex system of taxes designed to discourage short-term hot money flows. However despite the capital controls the total flow of investment into the country has only risen. Financial Flows reached US$61.8bn in first five months of 2011, almost double the US$33.7bn for the whole of 2010. The composition on the other hand has improved with foreign direct investment flooding in and cross-border portfolio investment in the country’s stock market during the first six months of this year dropping to $2.89bn from $9.74bn in the same period of 2010.
One of the other measures that have not been used adequately by the Brazilian government is a tighter fiscal policy. Brazil should implement stricter control on public spending and should run a surplus budget. While recently a tighter fiscal policy has been adopted and the primary budget (i.e., excluding interest payments) is on track to hit a surplus of almost 3% of GDP. But that is not sufficient. To reduce consumer demand and interest rates and the overall budget (i.e., including interest payments) should be in surplus. Further pension reform is urgently needed in a country that is ageing fast, has absurdly generous pensions and in which the average woman retires at 51. The tax system also needs to be amended to better increase government revenues.
With these measures in place the valuation of Real may become much fairer and with lower interest rates and the exchange rate more devalued, the country will attract the investments that suit it better - ones that increase its ability to generate wealth.

However to ensure that this happens Brazil has to move beyond the three policies that were implemented a decade ago: flexible exchange rate; inflation targeting; and fiscal balance. Considering that today it is a much bigger economy grappling with many more challenges it needs to adopt a more encompassing strategy that includes: improvements in productivity; the removal of bureaucratic acronyms; modernization of the institutional framework; the improvement of public administration, including the composition of revenues and expenses; and building policies to improve the country's productive base.

About the Author

Tamanna Khemani is a student at NMIMS, Mumbai.

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