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Brazil Wants ‘Real’ity Check

Posted by Larry Doyle on October 21, 2009 9:04 AM |

Brazil is increasingly concerned by the flow of capital pouring into its economy. Why? Isn’t that a good thing? Well, when the money is ‘fast money’ (meaning largely speculative) and it drives a nation’s currency dramatically higher, it can have an extremely negative and potentially destabilizing impact on a nation’s trade flows, primarily its exports. Let’s navigate.

There is no doubt the global markets are being driven largely by the cheap funding that is emanating from the United States. The oft-repeated statement by Fed chair Ben Bernanke that he will leave the Fed Funds rate unchanged at 0-.25% for an extended period has provided real comfort to speculators, traders, and investors around the world. What are these market participants doing? Selling the U.S. greenback to purchase a variety of global risk based assets. While investors may like positive returns generated to date on their investments, rest assured foreign central bankers are significantly less enthused with the strengthening of their own currencies relative to the greenback. Why?

As I highlighted in my weekly recap, October 10, 2009: Month to date Market Review:

While I think Washington is not disappointed in a relatively weak dollar, although they should be (”Dollar Devaluation Is a Dangerous Game”), other countries are not overly keen about further dollar weakness. Why? A weak dollar puts those countries in a marginally less competitive position in international trade. ECB President Jean-Claude Trichet voiced his concerns on this topic. Rest assured, the Asian nations feel the same way although they are careful in their comments.

Let’s navigate south and visit Brazil. The Brazilian currency, the real (pronounced “ray-al”), has appreciated by approximately 36% against the greenback this year alone. The real has appreciated over 50% against the greenback from its lowest valuation a few years ago. While that appreciation is a positive for Brazilian consumers, it is a major headwind for Brazilian exporters.

While many foreign central bankers have been jawboning recently about the relative weakness of the greenback, the Brazilian government took decisive action this week. How so? The Brazilian government has imposed a 2% tax on all foreign portfolio investments in its country. This extremely aggressive move has had an immediate impact on its currency and equity markets. The Financial Times provides further insights on this dramatic development in writing, Brazil Taxes Foreign Portfolio Flows In Bid To Stem Exchange Rate Rise:

The imposition of taxes on international financial flows has symbolic significance for emerging market investors. Malaysia, blaming foreign speculation for destabilising its economy, imposed capital controls to prevent a run on its currency in 1998 during the Asian financial crisis. Chile maintained controls on capital inflows for many years but has now suspended them.

The real fell to R$1.71 against the US dollar on Monday from its intra-day high of R$1.70 and dropped below R$1.74 yesterday during morning trading before rallying slightly. The main stock market index fell by 4.1 per cent.

Brazil emerged from a short recession in the second quarter. It is expected to post marginal economic growth this year and 5 per cent or more in 2010.

Edemir Pinto, chief executive of the BM&F Bovespa, Brazil’s futures and equities exchange, said foreign investors might now prefer to buy Brazilian companies’ US-listed American Depositary Receipts, which would not be affected by the tax.

“The Brazilian market was one of the first to recover this year and was on a fantastic growth path,” he said.

“About 70 per cent of shares in IPOs are bought by foreigners. So we didn’t expect the government to take this drastic measure.”

To the extent that investors have had exposure to foreign markets and have recognized substantial positive returns, I extend my congratulations. That said, be mindful that emerging markets are fraught with risks and volatility not commonly seen in the United States. This ‘real’ity check by the Brazilian government is ‘real’ evidence of that.

Navigate accordingly.


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