1. Brazil has been trying to curtail capital inflows. Why is capital flowing into Brazil? What does this
do to the Exchange rate? Why would the Brazilian authorities care? What might they do about it?
What are the policy consequences of their actions? Trace through the ramifications of whatever
policy is chosen
Many developing countries including Brazil have reaped handsome rewards from surging capital inflows in
recent years. This is widely regarded as a very welcome phenomenon, raising levels of investment and
encouraging economic growth. However, surging capital inflows can also be something of a double-edged
sword, inflicting rather less welcome and destabilizing side effects, including the tendency for the local
currency to appreciate in value, undermining the competitiveness of export industries and potentially giving
rising to inflation. The major contributing factor to inflation is that the capital inflows result in a buildup of
foreign exchange reserves. As these reserves are used to buy domestic currency, the domestic monetary
base expands without a corresponding increase in production: too much money begins to chase too few
goods and services.
The combination of expected reduced depreciation with high interest rates in relation to the interest rates in
the United States and other developed economies attracted capital inflows to Brazil. The situation has also
been further exacerbated by relatively high domestic rates that have induced banks to incur open foreign
exchange positions by financing local currency lending with foreign currency borrowing. Even when the
rules limit their foreign currency position, the banks still become indirectly exposed to the risk of
devaluation. Additionally, when using exchange rate as a nominal anchor that leads to high interest rates
combined with little immediate prospect of devaluation encouraged domestic enterprises to take up foreign
currency-denominated loans.
In light of a persistently weak dollar, driven by loose US fiscal policy and minimal expectations of Federal
Reserve rate increases this year, Brazil has been forced to take tough measures of its own to dampen
inflows that have sent the real soaring. This has led them to introduce a combination of macro policies
(monetary, exchange rate policies and fiscal policies) to reduce the impact of capital inflows.
Banco Central do Brazil (BCB) has had limited scope to control inflation via conventional monetary policy
without spurring further yield-hungry buying of the real. The US dollar has weakened consistently against
the real since the onset of quantitative easing in the US, falling from an October 2008 peak of R$2.46.
Brazil’s base rate already stands at 12.25%. Its inflation is on track to hit 6.6% this year, according to
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2. Goldman Sachs’ projections, second regionally only to Argentina. Next year’s forecast is scarcely better at
6.5%.
The Brazilian government has not been relying on lower interest rates to discourage the inflow of portfolio
funds. Instead, it has introduced IOF taxes on financial transactions, short-term loans and issuance of
securities. It is now charging a 6 percent levy on international debt sales and loans with an average
minimum maturity of up to 360 days, after having tripled a tax on foreigners’ purchases of fixed-income
securities in October 2010 in a bid to stem the appreciation of the real. However, this move was evidently
not as successful as intended. The Brazilian government reported that the inflows in the first quarter of
2011 were actually 42% higher than the inflows for all of 2010. It is also not clear whether increasing the tax
to 6% from the previous 5.38% will necessary have the desired effect.
Other Brazilian measures include steps taken to manage the credit growth in an effort to ease domestic
demand and prevent overheating, by increasing reserve requirements as real credit growth has been
expanding at the rate of 14% in Brazil.
In March 2011, the BCB extended its IOF tax (payable on foreign transaction inflows) to include external
loans shorter than two years. In April, the same levy on consumer credit was doubled from 1.5% to 3%.
The IOF is levied on all direct foreign investors into the country and all foreign financial institutions must
register foreign investor accounts, which are subject to the tax. These policy measures are not unusual and
Brazil has made frequent use of non-conventional tightening since 2008, with a focus on macro-prudential
policies – especially on credit cards and consumer loans. In June, the government raised the minimum
monthly repayment on credit card debt from 10% to 15%. Taxes on credit card expenses were raised by
4% in March to 6.38%.
The inflow of short-term capital has encouraged credit growth and, consequently contributed to money
supply growth and inflation. In spite of various macroeconomic measures to spur growth and tame inflation,
Brazil’s economy stalled in the third quarter of 2011 as the euro zone debt crisis dragged on global demand
and the country’s increasingly indebted consumers retreated after nearly three years of buoyant spending.
In view of the concerns about the global financial turmoil, Brazil’s central bank has cut interest rates three
times since August 2011. The government also announced a slew of tax breaks last week to support
consumption, reprising policies in the wake of the 2008 financial crisis. Early this year, the central bank
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3. hiked the interest rate five times by a total of 1.75 percentage points to alleviate the overheating of inflation
before it reversed course in August.
Finally, the biggest challenge remains for the Brazilian government is to curb spending and keep interest
rates at a moderate level by regulating monetary policy without stoking inflation. The trade and the linkage
between emerging markets in Asia, Africa and Latin America are rising exponentially which creates a
special kind of opportunities for emerging market’s companies to invest in Brazil or Brazilian multi-national
companies being elsewhere. However, the biggest problem is really about the mechanisms of bringing in
the long-term funding in lieu of short-term funding that is available around the world into Brazil to take
advantage of its well developed capital markets and stock markets. With Brazil’s current conducive market
conditions, this may be achieved by structurally creating a new debt market for domestic companies in
Brazil to attract long-term investments.
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