In August, the Central Bank of Brazil (Banco Central do Brazil or BACEN) made public its plans to sell some $500 million a day (USD) in daily intervention swaps and $1 billion a week in USD-cash repos. The program, in total, is to be capped at $100 billion for 2013.
An impressive amount for one of the world’s largest emerging markets, yes. However many in the know and those with knowledge of how Brazil’s Central Bank thinks and operates, sees the market intervention as business as usual for BACEN.
Since early 2013, Brazil’s Central bank has been offering approximately the same amount of USD daily intervention swaps to the market on a regular basis, according to Brazil economists and analysts. The key difference with the action taken in August is that the Bank had actually been intervening in the markets via larger auctions, less frequently and on unpredictable dates. In essence, by shifting to a regular schedule and making their plans public, BACEN has now reassured the market, as well as helped to stabilize any expectations, particularly during days of reduced liquidity, explains Paulo Vieira da Cunha, Former Deputy Governor of the Central Bank of Brazil.
According to Vieira da Cunha, “the Central Bank continued to accumulate FX reserves even as it was offering this massive volume of DI/Swaps.” Overwhelmingly, the majority of FX transactions handled in Brazil are done through the futures market, which trades at BM&F Bovespa. The country’s cash (pronto) market is a small one and often illiquid.
Not surprisingly, price discovery is done through the first future. Therefore by making moves directly through this market, “BACEN maximizes its power to influence FX expectations” says Vieira da Cunha, who is now Partner and Head of Research at EMVal Partners, LLC, and Chairman of the Banking & Capital Markets Committee of the Brazilian-American Chamber of Commerce.
“Demand for local USD-linked investments as an alternative, for example, to inflation-linked securities or government bills, and for corporate hedging is supplied through the derivatives market in Brazil, not the cash market.”
And, he explains, all settlement is done in local currency so there is no foreign exchange transaction. “The operations do not involve the use of FX-reserves. In fact, BACEN continued to accumulate FX reserves even as it was offering this massive volume of DI/Swaps.”
Known to those with their eyes on the emerging markets, Brazil’s currency has proven it can be a volatile one. If market players are willing to go along for the ride, BACEN’s latest moves will help ease volatility in the FX market. After all, it is the overall position of the balance of payments that determines the net demand for FX, not the daily fluctuations in the market, a position that was hugely in surplus in recent years in Brazil.
One issue it will not change, however, is what Vieira da Cunha refers to as “the longer-run trend in the exchange rate.”
In addition, the steadily rising larger deficits in the Brazil’s current account were more than amply financed by the combination of foreign direct investment (FDI), portfolio inflows and shorter-term borrowing by banks and corporates. The amounts left over by default increased the stock of reserves Brazil was accumulating.
More recently, however, and with the onset of the U.S. Fed tapering plans, the inflow of capital shrunk, and yet the deficits in the current account take time to adjust. So for a while, “Brazil will live with increasing demands for the USD with decreasing supply,” Vieira da Cunha says.
Such a combination will only press the exchange rate to depreciate. At what rate, the market must wait and see, but Vieira da Cunha says it would not be surprising to see the BRL/USD rate at 2.50/60 by the end of 2014.
On The Right Path
The BACEN’s intervention move is one in the right direction. By forcing a change in relative prices (if BACEN succeeds in not allowing the depreciation to pass through to inflation), the moves in the exchange rate will increase exports and reduce imports, adjusting the current account, thus reducing external funding requirements. Also, it may reduce unit labor costs expressed in foreign exchange, increasing profits, and real incomes in local currency while decreasing consumption.
“The two effects, as well as the increase in net exports, will trim down domestic demand,” says Viera da Cunha. “For example, absorption, and therefore help to stabilize the Brazilian economy.”
The recent unwinding taking place across some emerging markets of late is not an isolated case, nor is Brazil immune to it. The most obvious symptom has been the resurgence of high inflation. The most pressing problem, analysts say, is the fiscal excess both on the revenue and expenditure sides of the budget. The BACEN has altered its expectations as to the future stance of any fiscal policy. It now expects fiscal policy to move to neutral from stimulative, placing it at odds with what was projected in its 2014 budgetary announcement in late August. The bank stated its plans were to reduce the public sector primary surplus target to 2.1 percent of GDP, from 2.3 percent in 2013, by adjusting down the central government target to 1.1 percent GDP (from 1.3 percent this year), and keeping unchanged the target of local governments.
“In all, we remain skeptical that the government will deliver the 2.1 percent GDP primary surplus next year,” wrote Guilherme Loureiro, a Sao Paolo-based analyst with Barclays Capital, in a note published by the firm in September. An overly optimistic assumption on local government surpluses (especially in an election year) and inflated tax-revenues are two large sources of risk for such forecasts.