The Brazilian real has been one of the strongest performing currencies year to date alongside the Angolan Kwanza and the South African Rand. The currency has appreciated some 20% against the US dollar during the first quarter –a rise which magnitude has surprised many observers. What lies behind this strengthening cycle and is this good news for the Brazilian economy?
Since the start of the year, the Brazilian real has benefited from at least three tailwinds.
Firstly, the rise in the price of industrial metals, agricultural products and energy has tended to favor net commodity exporters, such as Brazil. As a result, there has been a rise in equity inflows into these markets to take advantage of this cyclical factor. During the first quarter, this has translated in the case of Brazil in a 15% rise in the country’s main stock index.
Secondly, Brazil has benefited from a rebalancing act in the market. Earlier this year this was linked to the adjustments that followed the correction in the price of tech assets in the United States. More recently and more importantly, the inception of the war in Ukraine has led investors to rebalance their portfolios at the expense of Russia, certain countries in Central Europe highly exposed to Russia, and to a lesser extent Turkey. These movements of capital have ended up benefiting other economies, including Brazil.
Thirdly, and this is point that is tied to the two previous ones, when we look at the universe of emerging markets, and in the context of the generalized acceleration of inflation, Brazil – in comparison to some of its peers that are also net commodity exporters – stands out by the fact that it also offers investors positive real interest rates. As a reminder, over the past year monetary authorities have hiked rates 9 times with a policy rate moving from 2% to 11.75%. When we take this rate and deflate it by inflation expectations over the next 12 months, we end with a notable positive differential, an occurrence which we do not encounter in many other economies. This situation favors carry trade strategies, whereby investors borrow funds in countries where the cost of credit is cheap (as is the case in the US or Europe, where real interest rates are negative) and then invest these funds in countries which offer yields in real terms that are attractive, as is the case in Brazil.
In sum, these three factors have contributed to the rise in portfolio inflows by non-residents into Brazil. And when we look at the foreign exchange transactions -- whether they are for commercial or financial purposes – we see that market participants have been net purchasers of real over the first quarter to the tune of about USD 9 billon – which represents about USD 3 billion more than for all of 2021 combined.
Is the strengthening of the currency good news for the Brazilian economy?
Yes, insofar as it helps to tame down imported inflation and to that extent, it helps to protect Brazilians’ purchasing power, which, in addition, will stand to benefit from a new fiscal support package announced by the authorities over the past few weeks.
Nonetheless, its effects on inflation dynamics should not be overstated. First, because its contribution to the variation in the price index is not as significant as, for instance, a change in administered prices. Also, because the current crisis affecting fertilizers – a direct consequence of the war in Ukraine – is contributing to hiking the price of food, an element which weighs heavily in the spending basket of Brazilians. Finally, we cannot rule out a possible reversal of the currency’s trend: contrary to what we have witnessed over the past few years, the currency appears to be more responsive to external drivers but as the general elections approach in October 2022, the currency could end up reacting more strongly to domestic factors, as there are still pending concerns relative to the future orientation of economic policy, but also uncertainties over what will happen to existing fiscal rules, and question marks related to Brazil potentially facing a more prolonged period of slow growth and high inflation. All these considerations could impact the market’s perception of Brazilian risk and ultimately weigh on the currency.
