Despite recent appreciation, the Brazilian Real stands at record high levels against the USD, and even considering the situation of Brazil, these levels find little support on fundamental grounds. Nevertheless, the credibility of the government and public sector policy could be penalizing going forward. Not so much for the international environment.
On the external sector front, Brazilian fundamentals are improving. Data show that except for year 2014, the Brazilian trade balance has been in surplus since 2001 and is likely to continue improving on the back of a weak currency. Quantities of goods exported are still growing despite a challenging economic environment while imports, which typically present an erratic pattern, are less likely to expand when the currency is weak.
It is evident that there is a shift in the composition of exports in the last 10 years away from machinery and transport equipment to commodity products like food and live stock and raw materials. Within these categories, it is also evident there is a substantial increase in the weight of exports of cereals, seeds and grains and mining products, contributing to some concentration of exports (24% of total exports in 2015). China gained substantial share in Brazil exports in the last few years, but trade relations have been in the two ways around with China also having increased substantially its share in Brazil imports. In net terms, exposure has increased materially but not as much as when looking at export data on a standalone basis. Moreover, when excluding China, the commercial balance would still be positive by $13.3B, instead of $19.7B when including it (2015 data).
Despite relevant exposure of Brazil to the commodity cycle and to China, commercial flows should be supportive of the currency at these levels, as even without those items, the commercial balance would still be in surplus. The weak currency should continue helping the export sector in general going forward, which is positive to compensate the negative effects from China's deceleration and lower commodity prices.
One factor contributing to the depreciation of the currency is the current account, which remains negative on the back of service related outflows. However, when including foreign direct investment in Brazil, the flow turns positive. The latest data suggest that foreign direct investment is compensating the current account deficit which should contribute to revert the net external financing needs experienced in 2013 and 2014 (but not in 2015 despite the challenging environment).
If commercial flows continue to support the demand of BRL, financial flows remain negative, with December being an especially challenging month, consistent with the sharp deterioration of the currency in the end of the year. It is interesting to see that it was also in December that net demand for BRL explained by commercial activities exceeded the net supply explained by financial activities.
It is financial flows, not commercial flows that are explaining the depreciation of the currency. More than the negative effect that lower commodity prices or a China deceleration may have in the Brazilian currency, which as mentioned previously are not causing the external balance to reach negative territory, it is expectations about the future that are causing financial outflows by investors and prompting them to sell.
In my view, concerns with Brazil are exaggerated due to a lower effect of commodity prices and China demand in the economy than many perceive, and consequently, the soundness of the country's external position. Proof of this is the buildup of foreign exchange reserves in the last few years and the nearly irrelevant amount of usage to support the BRL by the central bank. Currently, the central bank has $356.4B of reserves, down from a peak of $373B in 2012. Most of the depletion was explained by the external financing needs inherent to the current account deficit of 2013 and 2014, a situation which is reverting. The central bank also started 2016 with relevant intervention, by historical standards, in the foreign currency markets, an action only possible because of the high level of reserves.
The reserve position also exceeds the external debt position, if excluding intercompany loans. The private sector represents 85% of the debt in foreign currency, when including intercompany loans, which can be a sign of external vulnerability, but it's not a reason per se for the BRL to depreciate, at least in the short term. For example, the Brazilian financial sector, which is very sound, represents 45% of the external debt, excluding intercompany loans. The reserve position is enough to pay total external debt coming due until 2021. The interest rate environment is also supportive for the currency, as 10% inflation compares with nominal local rates at 14.25%, leading real rates well into positive territory.
This leads to the conclusion that the depreciation of the BRL has been caused by the credibility problem of the country, both due to public sector management and corruption cases as well as by uncertainty about global monetary policy.
Brazil's budget balance is well into deficit (10%), despite the still relative soundness of the primary budget balance when compared to other Latin American countries, and there is no evidence of a change going forward. In addition, to reduce interest payments in the locally issued public debt, the central bank didn't raise rates in the last meeting, which given inflation levels, could place the central bank's independence at stake.
As Brazilians come back from the carnival period, more noise regarding Dilma's impeachment may come to light, and with elections only due in 2018, if Dilma stays in power, Brazil will hardly improve its credibility. On the other hand, if Dilma is impeached, although it would be positive in the longer term, absence of a credible replacement would add to further noise in the short term.
The current financial market environment is questioning the effectiveness of zero policy interest rates worldwide, while at the same time the Fed seems to be afraid to proceed with the normalization of its rates in light of financial instability and a still strong USD.
As mentioned in my previous article, What's Next For Euro/Dollar Monetary Policy?, additional easing from the ECB would have the effect of an additional rate hike in the US, which wouldn't make it necessary for the Fed to raise rates in December 2015.
If the Fed, in fact, doesn't continue with the hiking cycle, which in the current environment it may not, that will be supportive for the foreign exchange market in general by devaluing the USD and supporting emerging currencies, including the BRL. Otherwise, if the Fed continues to normalize rates during the year, emerging market currencies have priced in that event in the end of 2015, and with local central banks raising rates, that wouldn't be a material effect over emerging market currencies.
In this environment, we can say that: (i) the external sector fundamentals in Brazil are supportive of an appreciation of the BRL, as the trade balance and the current account net of foreign direct investment have returned and should continue in positive territory (an accumulated effect of a weakening BRL since 2011), (ii) the international reserve position is very comfortable and inhibits refinancing risk well into 2021, and (iii) the Fed policy in the short term and a global easing monetary policy stance are also supportive of emerging market currencies' appreciation.
On the other hand, Brazilian institutions' credibility is not good, including the central bank, which is an additional concern; the fiscal position is negative with no prospects of improvement in 2016, and uncertainty about inflation control could pressure the currency.
In relative terms, the environment should remain challenging for emerging markets in general for the rest of the year, and Brazil doesn't seem to present a case strong enough to make a difference. In a more favorable international environment, I don't expect the BRL to outperform its Latin American peers, but I also don't see much room for further depreciation as fundamentals point otherwise.
Catalysts for a material currency appreciation could be a change in the government and public policy or a more aggressive tightening stance by the central bank, which would be positive for the credibility of the country. Both seem unlikely in the coming months.
I think the BRL is peaking against the USD, but a material short-term appreciation is unlikely. Could be attractive for longer-term positions, i.e. beyond 2016.
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