Consequences of a Distortion in Measurement of the Real Exchange Rate

BRAZIL ECONOMICS - Report 27 Oct 2014 by Affonso Pastore, Cristina Pinotti and Marcelo Gazzano

Executive Summary

Since August 2011 the real exchange rate measured in relation to the basket of currencies has depreciated by more than 25%. However, seasonally adjusted monthly exports and imports have continued to fluctuate around an approximately constant level, generating nil trade balances. Why haven’t imports and exports reacted to the real exchange rate?

In this report we show robust empirical evidence that starting in 2011 the conventional measure of the real exchange rate (nominal exchange rate multiplied by an index of international prices divided by the IPCA) no longer indicates changes in the relative prices of tradable and non-tradable goods. Exports are only stimulated and imports discouraged when the prices of tradables rise in relation to those of non-tradables. Using two real exchange rate metrics (the conventional measure and the quotient between the indexes of tradables and non-tradables obtained within the IPCA), we show that the second one manages to predict the behavior of exports, imports and trade balances with high precision, while the conventional measure totally fails in this respect starting in 2011.

The divergence between the two real exchange rate measures is one of the consequences of the economic policy errors committed in recent years. The government has naively been trying to restore industrial competitiveness by generating a weaker exchange rate, but by tying the Central Bank’s hands, preventing it from raising the interest rate sufficiently, the governments has felt forced to act against inflation by controlling the prices of tradables instead, to prevent depreciation of the nominal exchange rate from reaching relative prices.

This is one of the many distortions inherited by the country from a period during which erroneous economic policies were executed and impelled by voluntarism. Since Brazil cannot count on any impulse from global trade growth and increasing commodity prices, a huge burden has been placed on the adjustment of the exchange rate.

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