By Mary Stokes.
Capital controls in Brazil appear to have successfully discouraged inflows of ‘hot money,’ or speculative capital. Fears that such controls would dampen overall foreign investment have proved unfounded. Instead, net capital inflows to Brazil have remained strong and their composition has improved.
Foreign direct investment (FDI) – which tends to be a relatively stable source of investment – reached an all-time high of USD67.7 bn in 2011, almost double the amount received in 2010. Meanwhile, portfolio investment (flows into stocks and bonds) and other investment – which together serve as a proxy for hot money inflows – waned (Chart 1). Research has shown that capital inflows dominated by FDI tend to be less prone to sharp reversal in the event of an external shock.
Not all emerging markets enjoy the same quality of external financing. Net FDI inflows financed less than half of the current account deficits in India, Poland, South Africa and Turkey in 2011. In contrast, it fully funded Brazil’s deficit.
The pattern has continued into 2012. In the first quarter, FDI flows continued to dominate, reaching USD20.4 bn, while portfolio investment and other investment totaled only USD2.5 bn.
Some analysts contend that the shift in the composition of Brazil’s capital inflows is the result of hot money sneaking into the country disguised as FDI in an effort to skirt taxes. This is a legitimate concern. However, the available evidence indicates it is not occurring on a large scale.
The Institute of Applied Economic Research (IPEA), a government-led research organisation in Brazil, examined FDI inflows in the first two quarters of 2011 and found that most of the inflows – roughly two-thirds of the total, or USD20 bn – were the result of large transactions of over USD100 m each, which suggests they were long-term investment rather than short-term and speculative in nature.
Challenges lie ahead. With global uncertainty high given the unresolved eurozone crisis, capital inflows to emerging markets are slowing and Brazil is no exception. The Institute of International Finance (IIF) projects capital flows to Latin America will slow to USD274.1 bn in 2012 from USD283 bn last year. Nevertheless, the composition of Brazil’s capital inflows should enhance the economy’s resilience to capital flight.
In acknowledgement of the changing global environment, the Brazilian government announced a partial rollback of capital controls on 14 June. The financial transactions tax (IOF) of 6% will now only apply to foreign borrowing maturing in two years or less. It had been extended to borrowing of up to five years just three months before. The finance minister, Guido Mantega, reportedly intends this easing of capital controls to be a relief measure that increases the availability of credit and reduces companies’ cost of borrowing.
Nevertheless, we do not expect the rollback to give capital inflows much of a boost. Concern over further depreciation of the local currency could make borrowing from abroad less attractive to Brazilian companies. The Brazilian real has fallen by almost 20% against the US dollar since 1 March. Moreover, sluggish domestic economic activity will likely translate into less demand for credit.
While we view the government’s easing of capital controls as a positive sign given the changing global circumstances, the fast pace of change in capital control measures is a concern, underscoring the growing perception that government policies lack predictability.