Forces Behind the Depreciation of the Real
Executive Summary:
It is very hard to gauge the tendency of the exchange rate, but the task is easier when the economy is plagued by large risks. In the Brazilian case a close correlation exists between the exchange rate and two risk measures: the CDS quotations and the EMBI-Brazil. In the past two years, the (strong) growth of the risks basically reflects the worsening fiscal picture.
When the fiscal situation deteriorates, demand for Brazilian assets drops, leading to a decline in capital inflows and depreciation of the real. However, since the start of 2012, the Central Bank has neither bought nor sold currency in the spot foreign exchange market, meaning that the exchange rate has fluctuated sufficiently to clear the inflows and outflows. It is thus no coincidence that in this period the balance of payments has been in rough equilibrium, with a very close correspondence between the oscillations in the current accounts and the total net capital inflows. When risks grow, the inflows fall, causing the exchange rate to weaken and net imports to decline.
Over the past two years, the current account deficit has been falling markedly. If the capital inflows had remained stable, this would have caused the real to appreciate. But the capital inflows depend on the magnitude of the risks, which will only fall – raising the capital inflows and strengthening the real – if the fiscal picture and public debt dynamic improve. In the absence of progress on the fiscal policy front, the trend will be for higher risks and a weaker real, forcing a decline in the capital inflows and current account deficits.
The increase in risk is not only reflected in the sovereign debt yields. Through principal component analysis, we estimated a measure of the risk premiums on corporate bonds, which closely follow the evolution of the risk premiums on sovereign bonds. Higher risk depreciates the real, which boosts net exports and consequently expands aggregate demand. But it also raises the interest rates on corporate bonds, and the greater the fiscal imbalance is, the higher will be the cost of capital. The contraction of fixed capital investments acts in the contrary direction to the increase in net exports.
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