Thinking About the Real, Given Brazil's New 2% Tax

Investors continue to grapple with the best way to work around Brazil's new 2% front-end tax on foreign inflows.

Understanding that in order to minimize impact, many investors would contemplate holding BRL balances received as proceeds of a sale, a dividend or coupon payment to use to make purchases of other Brazilian assets at some future time, we looked at the volatility of the BRL-USD exchange rate. The implied volatility and the actual weekly range of the BRL suggests that the risk of holding the BRL balances is that the currency movement can in a relatively short period be larger than the 2% tax.

This, in turn, leads to a follow-up question: Is there a guide or tool one can use to help identify the direction of the Brazilian real? What would be useful is some way to identify the underlying trend in the BRL, so that when it is strengthening one might decide to let the BRL balances build, and when the BRL is weakening one might decide to convert the BRL.

Often, moving averages are seen as one type of technical tool that is useful in identifying trends. Of course, the preference is for a simple, straight forward rule. For example, derive a rule that if the dollar is above its 20-day moving average against the BRL, the BRL proceeds are converted on the idea that the BRL is in a downtrend. If the dollar is below its 20-day moving average against BRL, the proceeds are maintained on the idea that the BRL is in an appreciating mode. This is among the simplest approaches. However, there are occasions this year where the dollar rose 5% above its 20-day moving average against BRL.

Another slightly more complicated strategy would entail using two moving averages, a short and long, and using the cross over to decide what to do with the BRL. When the shorter term moving average for the dollar is above the longer term, one would convert the BRL proceeds and allow the BRL balances to build if the shorter term average is below the longer term average.

The trade-offs here are the sensitivity of the moving averages to price swings, how many cross over signals are generated and how many good and false signals appear. The shorter the moving average terms are the more sensitive the moving average is to prices and the more signals are generated.

There are numerous computer programs that optimize moving average cross over signals. While they can be helpful, the problem is that one optimizes the moving averages for some past period (in sample test) and then applies it to the present and future (out of sample), though those moving averages may not longer be optimal perhaps due to a change in the volatility of the market.

For the record, the 20-day moving average of the dollar comes in near BRL1.7375, which is around where it is currently trading. The 5-day moving average is just above BRL1.73.

This note is not meant to propose a particular set of decision making rules, but rather to suggest ways that investors may want to think about whether to convert the BRL proceeds or not, given the new 2% tax.

Disclosure: No positions

Comments

[Mad Hedge F...:]

bcf I’ve got to comment on Brazil’s (EWZ) idiotic move last week to impose a 2% tax on real stock and bond purchases to scare off foreign investors. It’s like firing off an emergency flare in the night and saying “Come and get me.” If any portfolio manager was living in a cave for the past ten years and somehow missed the attractions of investing in an emerging market that exports food and energy, has an appreciating currency, and an almost perfect demographic profile, they can see it now, clear as day. This lunacy reminds me of Malaysia prime minster Mohamad Mahathir’s rantings and ravings about George Soros’s selling of his country’s markets during the Asian financial crisis, when in fact, George was buying. I sympathize with Brazil’s dilemma, similar to those of the Swiss during the eighties and nineties, when the whole world wanted to buy their currency, forcing the government in Berne to drive interest rates to zero, pushing domestic prices through the roof. But this is the price of economic success. Everyone wishes they had Brazil’s problems. Better to just let things be.

Oct 28 04:30 PM

[Bill Charles:]

I totally agree with the Mad Hedge Fund Trader, what an imbecile move with the 2% tax. Most of the time I've lost money in the market is when some stupid politician interfers one way or the other. Geez!!!!

Oct 31 04:40 PM