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By Jules Koifman

On Wednesday evening, Brazil’s central bank,
Banco Central Do Brasil, announced an interest rate increase of 50 basis points, raising its overnight lending rate (Selic) from 10.75% to 11.25%. This move was widely expected by the Brazilian market and caused the Bovespa (an index of around 50 stocks traded on the São Paolo exchange) to fall on Wednesday 1.21% from Tuesday’s close. The rise in interest rate is predicted to be the first of many in a pattern of tight monetary policies forecasted. In a country where the government aims to protect domestic industries, tightening monetary policy is a dilemma.

Click to enlarge:

bovespa.png

Brazil has recently been faced with rising inflationary pressures along with many economies worldwide, including the United States and China. Its inflation rate reached 5.91% in 2010, a significant increase from 4.31% in 2009, and considerably higher than the government’s target of 4.5%.

On January 1st, Brazil’s new president, Dilma Rousseff came into power with the promise of lowering interest rates. She has now been caught by increasing commodity prices, inflation and growing consumer demand. For example, Brazilian retail sales in November were up 9.9% from the year before, showing robust signs of recovery and powerful growth in the economy. Brazil’s government expects 2011 GDP growth to be 5.5%, down from the 2010 estimate figure of 7.5% (the actual statistic is not yet available). But this kind of growth comes with a price: Along with inflation, the Brazilian real has gained 30% over the greenback since 2009.

Unlike other BRIC nations and emerging markets, Brazil’s reliance on exports is actually quite low. Brazil’s exports only total 11.3% of GDP (as of 2009) while those of China are 26.7% of Chinese GDP (2009). This means that the Brazilian government has a reason other than export development for being concerned with its appreciating currency. Rousseff, as well as her predecessor Luis Inácio Lula da Silva, belong to the left-wing Partido dos Trabalhadores, (Workers’ Party) which greatly supports the domestic manufacturing sector. In order to promote domestic products instead of imports, the real’s value needs to be kept low.

However, increasing Brazil’s key interest rate to 11.25% makes investing in the country very attractive to foreigners. As of Wednesday, a 1-year Brazilian government bond yields 12.52% while the American equivalent yields a mere 0.25% and the U.K. will yield 0.77%. Far better than other interest rates available around the world (albeit for more risk than the major developed economies). International investors buying reals to invest will certainly drive the currency up in value. Brazil’s nominal interest rate of 11.25% represents a very attractive real rate of around 5.5%.

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brazilbonds.png

Chart Source: Bloomberg

A higher real will make imports less expensive for Brazilians, giving them more incentive to purchase imported goods rather than domestically-produced Brazilian ones. The principally affected group is therefore the domestic manufacturing sector- the very sector the government aims to protect.

Brazil therefore faces the dilemma of protecting itself from inflation or protecting its domestic manufacturing sector. If the central bank does not continue increasing interest rates, the economy faces the risk of overheating, perhaps launching it into a crisis. On the other hand, if monetary policy is tightened too much, in addition to domestic lending being curbed, foreign investors will put upward pressure on the real.

Short term solution?

A common criticism of the Banco Central’s monetary policy is that it is only effective in the short term. To sustain Brazil’s economic development in the long term, a strong long-term economic plan is needed. The Brazilian government has recently been increasing government spending, which some economists claim to be a significant source of the inflation the country faces. Thus, the chief concern is that fiscal and monetary policies are conflicting.

Furthermore, the inflation problem has been exacerbated this month by the country’s heaviest rainfall since 1967. Rain has flooded roads and destroyed crops, forcing food prices up 17% in Q1. Vegetable prices jumped 60% this month and production of lettuce, broccoli and other produce has plummeted. In Rio de Janeiro, grocery stores and restaurants have experienced food shortages.

Because of aggressive growth and fiscal spending, several economists claim Brazil is blowing a bubble that will soon burst. It has had periods of robust growth followed by periods of rapid decline before. Controlling inflation through interest rates is a dangerous affair that will appreciate the real and hurt domestic industry. Brazil’s government is faced with a very difficult and pressing issue that must be resolved.

What do you think is the best policy option for Brazil?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Will Brazil's Monetary Policy Tightening Help or Hurt?