Exchange rate and pension reform
Bets on the exchange rate are frequent, and in general extreme. In July 2018 and thereabouts, some observers were predicting the real would be as weak as R$ 4.50/US$, and now some affirm that if the pension reform proposal (with what terms?) is approved, the real will strengthen to R$ 3.00/US$. Based on empirically relevant fundamentals, here we discuss what can be expected from the exchange rate path if a pension reform is approved that provides savings of at least R$ 1 trillion in 10 years. For that purpose, we examine the forces that explain the nominal exchange rate (an asset price) as well as those that explain the real exchange rate (a relative price between tradable and non-tradable goods).
It is most likely that due to deceleration of world growth – especially in China and Europe – that the period of declining terms of trade will be extensive. It is also likely that even with approval of a robust reform of the social security system, the country’s credit rating will continue for a long time to be classified as “speculative grade”, meaning that non-resident investors that are affected by their respective national regulators will not return to the country in force all that soon. Although further appreciation in relation to the recent level at which the real has been fluctuating cannot be excluded, the chances are low that this would be as intense as observed in past episodes of substantial undershooting.
What might happen if everything goes right, i.e., the government succeeds in winning approval of a pension reform that can save more than R$ 1 trillion in 10 years? In the short run, the real would appreciate, although this would be contained by the terms of trade situation and by the brake on capital inflows because Brazil no longer has an investment grade credit rating. However, in this case, fixed capital investments would grow, leading to an increase of imports and higher current account deficits, which in the medium term would cause the real exchange rate to depreciate.
In this scenario, the result would be temporary undershooting of the exchange rate, which due to the declining terms of trade and the speculative grade rating would not be as accentuated as in previous episodes. The real could oscillate at the new stronger level for a while, but the combination of an increase of gross fixed capital formation and appreciation of the real exchange rate would lead to higher imports and current account deficits, later producing a return of the real exchange rate to its “fair value”.
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