By Gabriela Fernandes (Source: Itau BBA).
Since mid-May, the exchange rate has been moving within the range of 2.00 to 2.10 reais per dollar. This level represents a depreciation of about 20% from the end of January, when the Brazilian currency was slightly weaker than 1.70 reais to the dollar. The deepening European crisis, interventions in the foreign exchange market and tighter capital controls are some of the reasons behind this move. In the medium to long term, however, macroeconomic variables, which theoretically influence the currency path, show us that the trend will be towards a stronger real. In the short term, more intense inflationary pressure or deterioration in global volatility may cause the Brazilian exchange rate to move outside the above-mentioned range.
In January, foreign exchange data show an inflow of $6.9 billion to financial portfolios, an historically-significant amount. On February 6, Brazil’s central bank started to act in the spot market and has since purchased over $11 billion in this market. Additionally, $7 billion were purchased in the forwards market and $3.8 billion were auctioned in the form of reverse currency swaps. These interventions were kept up until late April, when the exchange rate reached 1.90 reais to the dollar. The Finance Ministry also acted in the process, extending the maturity of external debt issues liable to pay 6% in IOF taxes to five years from two years. On another front, the central bank published a note limiting anticipated payment to exporters to maturities up to one year and financed directly by the importer*.
After that, the external scenario seemed to dictate the dynamics of the currency. As the European crisis deepened and fueled speculation about a possible rupture in the euro zone, higher risk aversion drove the exchange rate to levels above 2.00 reais to the dollar. By the end of May, with the threat of the real weakening further than 2.10, the central bank used traditional currency swaps (Chart 1). These tools, which are equivalent to sales in the future market, prompted “good behavior” from the exchange rate and have kept it within the range of 2.00 to 2.10 reais to the dollar ever since. However, what do variables that usually influence currency in the medium and long term show us?
Several variables, according to economic theory, are helpful when forecasting the path of exchange rates. In our models, we use five key variables: terms of trade, net external liability, real interest rates, global volatility and sovereign risk spreads. The first two items affect mostly the exchange rate in the long term, while the three last ones are short and medium-term drivers.
When terms of trade (the ratio between export and import prices) go up, ceteris paribus, our trade balance gets bigger surpluses (or smaller deficits); there is more inflow of foreign currencies through exporters, causing the local currency to strengthen. Terms of trade have been constant since early 2012, which we see as a trend for the next periods. While agricultural items pressure this index upward due to the recent drought in the U.S., iron ore — our number one export product on an individual basis — continues to experience a downward path in terms of prices. As we believe both movements will be reversed in the medium term, we forecast these prices will return over time to levels that are more consistent with their recent historical averages, reinforcing our premise of stable terms of trade, albeit at historically high levels (Chart 2).
A share of 33.6% of Brazilian GDP equals our net external liability, defined as the difference between our stock of foreign investments and our investment stock abroad, minus international reserves. This figure shows foreign capital is very important to the country and signals international comfort with Brazil’s external soundness, a situation that we expect to last for at least the next several years.
The ex-ante interest rate (i.e., market interest rate expectations less inflation expectations for the next 12 months) is a variable that impacts our short- and medium-term models. A high interest rate attracts foreign inflows in search of high yields. This factor has been more important recently, as interest rates fell by 4 pp in the past 12 months, to 1.8% p.a. from 5.8% p.a., mainly due to the easing cycle in the monetary policy rate (Chart 3). Looking ahead, we expect stability for ex-ante interest rates at low levels for the next months, with a slight upward trend starting in the second half of 2013.
Volatility in the external scenario, as measured by the VIX index, is significant because in moments of uncertainty in the global scenario, a flight to quality is usually triggered, i.e., when investors withdraw their money from emerging markets to invest in assets regarded as safe, such as the U.S. dollar or the Japanese yen. This kind of movement causes the Brazilian real to weaken against the dollar. Sovereign risk spreads, as measured by credit default swap rates, are also related to this movement, as these contracts quantify how unsafe a country is perceived to be, and thus, how intensely affected it would be in a situation of flight to quality. Following an uptick between May and June due to the worsening European crisis, these two indexes have moderated and remained at lower levels. If there are no more grave threats of rupture and if domestic fundamentals remain benign, the trend is for sovereign risk to remain on that path and not go up again, though it is very hard to predict its behavior, given the scope and complexity of the information that this variable responds to.
As a consequence of our expectations of constant terms of trade, well-behaved net external liability, slightly higher real interest rates and controlled volatility, our models point to appreciation in the Brazilian currency in the medium term. Our scenario assumes an exchange rate at 1.95 reais to the dollar by year-end and strengthening to 1.90 in 2013.
From the standpoint of the need for savings to finance investments in Brazil in the long run, we also expect a stronger exchange rate. Domestic savings are insufficient to finance all of the country’s investment, thus leading to the need to obtain external savings —current account gaps that, in equilibrium, are compatible with a stronger exchange rate.
Going beyond the base-case scenario, what could prompt the real to move outside of its recent interval? On one hand, a faster or more-intense-than-expected rebound in economic activity could cause undesired inflationary pressure in an environment that already experiences higher commodity prices. In this case, economic policy could choose to accept a stronger exchange rate. On the other hand, if the crisis in Europe becomes more severe than anticipated, with the risk of rupture becoming more intense again, we expect the central bank to accept a weaker exchange rate with less concern.