Currency crisis in sight

By PAULO NOGUEIRA BATISTA JR.*

The combination of the worst crisis in our history and the worst government in our history exacerbates all economic problems and increases the country's vulnerability

The Brazilian, used to having bad and even terrible news, is no longer surprised by anything. A new crash in the country, caused by exchange rate strangulation, would be one of the many disasters of recent years. The risk exists. Brazil has sold a considerable volume of international reserves since mid-2019, around US$ 50 billion. Despite this, it was unable to avoid a sharp depreciation of the Real.

Where does exchange rate pressure come from? It is not the current account of the balance of payments. It tends, on the contrary, to improve. With the economy in a deep recession – GDP is projected to fall by 6% or more in 2020 – demand for imports collapses. As imports fall much more than exports, the trade surplus increases considerably. Other components of the current account balance of payments also improved, including international travel and profit and dividend remittances. The combination of recession and exchange rate depreciation is producing, as it usually happens, a rapid adjustment of current external accounts.

The problem lies in the massive net outflow of capital from the country. Since the final decades of the last century, the balance of payments situation in countries like Brazil has been predominantly determined by international capital movements. The current account remains relevant, of course, but what really matters is the evolution of the capital account.

The outflow of capital, which began in 2019, worsened with the arrival of the pandemic. The problem arises for many emerging countries, not just for Brazil. Every international crisis generates risk aversion and flight to safer ports. And the current crisis is the most serious since the Great Depression of the 1930s. But in our case there are two aggravating factors.

First, a crisis of confidence in the country. The growing perception, in Brazil and abroad, is of serious incapacity and unpreparedness of the government. The tumultuous and incompetent reaction to the challenge of the public health crisis eliminated any hope of minimally effective government management. Brazil has become, in less than a year and a half of Bolsonaro's government, a world example of economic and political disorder. Therefore, the risk in operations with the country increased and many investors decided to look for other paths.

This exit movement was also stimulated by the – correct – decision of the Central Bank to reduce the Selic rate. Since the middle of last year, it has been perceived that inflation projections and the weakness of the economic recovery recommended a reduction in the basic rate. With this decrease, however, the differential between internal and external interest rates narrowed, making investments in reais less attractive for investors compared to other destinations. This second factor joined the crisis of confidence in the government to induce capital outflows. It is not by chance that the real has been one of the most pressured currencies in recent months.

What to do? The Central Bank has instruments to deal with exchange rate pressure. The main one is the high stock of international reserves. Despite the recent loss, the country still has US$ 340 billion. The Brazilian position, in this regard, is better than that of other emerging countries – Argentina and Turkey, for example – which did not accumulate sufficient reserves and were more vulnerable to balance of payments problems. Argentina, still in the Macri government, had to turn to the IMF. Thanks to the reserves accumulated since 2006, in the Lula and Dilma governments, Brazil is able to defend itself on its own and does not need to seek external financial assistance in Washington.

Another advantage is the floating exchange rate regime, established in Brazil after the 1998-1999 exchange rate crisis. This flexibility allows exchange rate pressure to be absorbed, in whole or in part, through the depreciation of the real against foreign currencies. If Brazil had operated under a fixed exchange rate regime and had tried to avoid depreciation, the Central Bank would have been forced by capital outflows to sell a much larger volume of international reserves, creating a high-risk situation for the country.

Currency depreciation, always reported in a lamenting tone, has its positive sides for the economy. By stimulating the competitiveness of exports and making imports of goods and services more expensive, it favors the adjustment of the balance of payments in current transactions. Helping sectors that export and those that compete with imports in the domestic market, it contributes at the same time to sustaining the level of economic activity and employment.

Furthermore, one should not lose sight of the fact that the depreciation of the real also favors the public accounts. This is because the government is, by a large margin, a net foreign currency creditor, that is, its foreign assets considerably exceed its liabilities in foreign currency or indexed to foreign currency. The combination of lower domestic interest rates/currency depreciation thus provides very welcome relief to fiscal accounts heavily pressured by the 2020 crisis.

Wouldn't these positive aspects of the exchange rate depreciation, however, be eclipsed by its inflationary impact? Under current circumstances, with the economy in free fall, the problem does not arise, at least in the short term. With idle capacity and high unemployment, the pass-through from the exchange rate to the general price level is limited. Inflation is under control and has even been below the target target pursued by the Central Bank. The biggest risk today appears to be deflation. Currency depreciation helps offset this risk by raising prices in Reais of tradeables, goods and services traded internationally.

This does not mean, of course, that the Central Bank can simply ignore the real's depreciation and operate in pure textbook floating mode. In the midst of a serious economic and political crisis such as the current one, there is a threat that, after a certain point, the fall in the national currency will start to feed on itself, becoming a spiraling depreciation that would destabilize the economy.

To ward off this threat, we still have high international reserves, which can be used to counteract the depreciation. In certain circumstances, the Central Bank may resort to the sale of foreign exchange swaps, which allow it to meet the demand for hedging and stabilize the market without compromising the level of reserves. Indexed to the dollar, but settled in reais, currency swaps are a complementary instrument available to the Central Bank to operate in the foreign exchange market without resorting to international reserves.

Summary of the opera: the situation is difficult, but the country has mechanisms to deal with the pressure on the capital account and avoid exchange rate strangulation. The central problem, in this area as in others, is the lack of a minimally organized and reliable government. The combination of the worst crisis in our history and the worst government in our history exacerbates all the problems and increases the country's vulnerability.

*Paulo Nogueira Batista Jr., an economist, was vice-president of the New Development Bank of the BRICS in Shanghai, and executive director at the IMF for Brazil.

Originally published on the magazine's website Capital letter.