By Mary Stokes.
Renewed fears of a disorderly eurozone break-up have driven a massive emerging market currency selloff over the last few weeks and the Brazilian real (BRL) is no exception. Since March, the local currency has lost 20% of its value against the US dollar (Chart 1). In May 24, it reached 2.08 BRL per USD, a level not recorded since May 2009 amid the global financial crisis.
The government initially displayed a complacent attitude towards the weakening of the BRL but the central bank, concerned about financial stability, finally intervened in the foreign exchange market to stem the currency depreciation. The government has wanted a weaker BRL to improve the competitiveness of ailing domestic industry. However, further weakening would harm the economy in several ways.
Different factors – such as the reduction in the benchmark SELIC rate, changes to the Financial Transactions Tax (IOF) and foreign exchange intervention – contributed to the weakening of the BRL against the US dollar since March. But it was the decline in global risk appetite that drove the currency lower in the last few weeks. On 22 May, the finance minister, Guido Mantega, stated that a weak BRL “benefits the Brazilian economy” and “provides more competitiveness” to domestic production. On that day, the BRL/USD exchange rate surpassed the psychologically important 2.0 level.
The central bank then swiftly stepped in to clarify that the excessive volatility of the exchange rate was a matter of concern. It began offering exchange rate swaps – equivalent to a sale of US dollars in the futures market – allowing investors to hedge against further currency weakening. These measures came less than two months after it had purchased US dollar futures in an attempt to stem a revaluation of the local currency.
Why is a sudden spike in the US dollar a matter of concern for Brazil’s policymakers? First, it makes it more difficult to service foreign currency-denominated debt, which tends to bear lower interest rates and longer maturities. While this is less of a problem for public debt now than it was ten years ago, private external borrowing remains elevated, standing at USD165 bn at the end of 2011 (Table 1). A sudden and sharp change in the exchange rate could balloon he corporate sector’s debt servicing costs in local currency terms.
Second, a weakening of the BRL could fuel inflationary pressures. Many firms rely on imported intermediate goods and/or rely on imports to complete their suite of products. A depreciation of the local currency will affect their costs, triggering a pass-through of the exchange rate to domestic prices.
Third, excess exchange rate volatility can dissuade foreign investment. Notably, there has been not a single foreign currency debt issuance since the exchange rate plunged in May.
Brazil has longed for a weaker exchange rate to improve the competitiveness of its sluggish industry, but with the BRL at these levels, further depreciation may not be desirable.