How Far can the Central Bank go to Secure the Exchange Rate?

BRAZIL ECONOMICS - Report 14 Jul 2014 by Affonso Pastore, Cristina Pinotti and Marcelo Gazzano

Executive Summary

In situations where the exchange rate is near equilibrium (the current account deficits are being financed by capital inflows not artificially stimulated), but is highly volatile, interventions in the foreign exchange market are perfectly acceptable. They dampen the volatility but do not move the exchange rate from its “equilibrium” position. This is not the case of the Central Bank’s interventions in the future forex market.

The sharp deceleration of growth prevents the Bank from using the interest rate to reduce inflation, which is threatening to exceed 6.5%. This is the reason for its sale of foreign exchange swaps, to at least contain inflation of tradables. By stabilizing the exchange rate, it reduces for some time the probability of depreciation, raising the net differential between the interest rate in Brazil and the rates in the United States (and other countries that compete with Brazil for capital), and attracting investments seeking carry trade gains.

The monthly current account deficits are now running at an annualized rate of US$ 80 billion, a figure that only does not exceed the capital inflows because of the arrival of approximately US$ 30 billion over the past 12 months in portfolio investments in the fixed-income market (a large part seeking carry trade gains). These capital flows are volatile, in contrast to direct investments, which predominated until recently. Hence the quality of financing the balance of payments is now worse, raising the vulnerability of the exchange rate.

The Central Bank’s efforts have been aided by two events. The first is the declining yield on Treasuries, which is temporarily giving some breathing room to emerging countries. The second is the “benefit of the doubt” given by the markets to the fiscal adjustment promised by the Rousseff administration. We show here that the fiscal adjustment is more apparent than real. The conclusion is that the factors favoring the Central Bank are very fragile, with low probability of remaining unchanged, so that in due course the forces for depreciation of the real will likely prevail…​

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