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Last month, Brazil's government surprised the world when it said that it was prepared to lend reserves from the nation's central bank (CB) to help finance the rescue package for the European Union. The Brazilian government would allegedly lend the money through a bilateral agreement with the IMF. A government official said also that, technically, Brazil's reserve levels, which it claims to stand at around US$350 billion, wouldn't change. Instead, they'd just be held at the IMF.

Well, perhaps it is time to explain briefly what these US$350B+ in reserves really mean.

The much touted growth in the Brazilian foreign reserves must be very carefully looked at. Brazil's total debt has grown rapidly since 2007 (see graphic below). This can be explained by the high degree of external financing by the private sector (FDI) and international funds transfer for investments such as the Brazilian stock and money markets. The net assets, in dollar terms, however, are only close to US$50 Billion if one subtracts debt (US$300B) from reserves (US$350B).

Click to enlarge charts

Although about half of the reserves are longer term government debt that will be stable in a financial crisis of some sort, the rest of the reserves can be extremely volatile. In fact, this volatility could be seen clearly this year between last July and October, when the BRL/USD almost touched 2.00 after a massive capital outflow. The CB then intervened and the FX stands at about 1.75 now. Brazil experienced such a scenario (in higher proportions) in 1998 when half of its foreign reserves evaporated in few days, which caused a huge currency devaluation and short-term interest hikes in excess of 40%. Of course, now the country's financial situation is much better than in 1998 when Brazil's CB had a huge net negative assets on its books.

The point of the previous statements is that the Brazilian government might be over-extending itself when it says it wants to aid Europe - these types of statements must always be taken with a grain of salt.

So why is it important to understand the composition of Brazil's reserves? Because it helps investors be more aware about the risks associated with the impact of the current economic uncertainties over the volatility of the BRL (Brazilian Real). As soon as foreign investors holding Brazilian assets (remember those $300B in debt?) become fearful, they tend to sell BRL to cover losses at home, be it in the US, Europe or Japan. For instance, this is exactly what happened when the BRL lost 20% last September alone in a matter of few days. See the BZF chart below, where it shows how the peak of $29 turned into a bottom of $24 in a matter of a few days.

In summary, investors must be careful when investing in BRL assets, considering not only the potential gains of individual local companies or indexes (like EWZ), but also how the currency risks affect your portfolio when a devaluation occurs.

Source: Brazil's FX Reserves: Take Care When Investing In Real Assets