Monday, 9 February 2009

The Brazilian Real’s “Fundamental” Problem

by Annina Kaltenbrunner

Between August and December 2008 the Brazilian Real depreciated by more than 60 %. At the same time, foreign exchange reserves at the central bank stood at over US$ 200 billion in August 2008 and for the first time in its history the country had acquired “net creditor status”. Forgotten were the claims of “decoupling”, as the international financial crisis (once again) hit the countries at the periphery. However initially, “decoupling” seemed to have become reality.

When financial markets in the developed world first started to be shaken by the sub-prime implosion in autumn 2007, money continued to pour in some emerging markets as high real interest rates became particularly interesting in the face of falling yields in developed markets. Indeed foreign reserves at the Brazilian central bank continued to increase by near 30% between August 2007 and 2008 and the Real gained another 20% against the US dollar over the period.

Then, in August 2008 the market turned, first slowly and later in an accelerated fashion as the US government refused to support the struggling Lehman Brothers. Although expectations of faltering domestic growth – on reduced external demand – and slowing commodity prices might have contributed to the currency’s decline, the Brazilian Real’s main “fundamental” problem was (and is) the country’s increased and ongoing integration into international financial markets and the financialisation of the domestic economy.

First, as losses in international financial markets mounted, deleveraging and the flight from risky assets did not spare emerging markets. Brazilian (currency) assets are among the most liquid and widely traded emerging market assets in (international) investors’ portfolios, whose adjustments can result in large capital flows and currency movements, seemingly unwarranted by “fundamentals”. And indeed, Brazil’s capital account reversed from an average monthly surplus of around US$ 6 billion over the first half of the year to a deficit of more than US$ 9 billion in October and November 2008!

Second, the reversal in the currency’s value hit several of Brazil’s biggest companies, which – on the backdrop of years of sustained currency appreciation – had taken substantial currency bets on the derivatives market. The increased involvement of real sector companies in the financial market weighed on the currency through two channels: first, a scramble for foreign exchange as the affected companies hurried to cover their losses; and second, concerns about financial sector stability, as uncertainty about banks’ exposure to the affected companies reigned.

Finally, and probably most importantly for currency dynamics, increased financial integration has not only affected exchange rate behaviour through capital markets, but also through the banking sector. Although unique among Latin American countries in having a strong presence of domestic banks, Brazilian banks have increasingly used the wholesale market to acquire - short-term - funding. Thus, as international money markets dried up in the wake of the crisis, so did credit lines to Brazilian banks, which found themselves unable to extend short-term financing, mainly trade credit lines. The inability to obtain and/or rollover outstanding external debt and the necessity to meet other foreign exchange payments again led to scrambling in an already strained foreign exchange market, pushing the currency to recently experienced depreciated level.

And why should we care? Around 44% of the income generated in Brazil continues to accrue to the richest 10% of the population (and this excludes wealth!), while the 20% poorest of the population earn a total of 2.9%. This is also related to the processes described above, because while gains on currency speculation are reaped by a few market participants, the costs of (currency) crisis are borne by the population as a whole!!

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