After some weeks of headline political noise, now involving the former president Lula da Silva, it would not have been a surprise to see Brazilian Real (BRL) exchange rate volatility and depreciation. Yet, that didn't materialize. In fact, the BRL has been in an appreciation trend against the USD since mid January, suggesting that current political changes, on top of being an example for societies all over the world, are not a point of concern for financial markets.
On one hand, the BRL currency has suffered an exaggerated depreciation since mid 2015, overreacting to low commodity prices, China economic deceleration and to the domestic situation of the country itself. On the other hand, flows remain supportive for this currency.
Recent trade balance data released show a growing trade surplus, on the back of falling imports and rising exports. Despite an adverse pricing environment for commodity products, exports are benefiting from the foreign exchange effect along with some degree of product diversification. The current account's deficit is much lower than in the same period last year reflecting the trade surplus and a smaller deficit in services.
Foreign direct investment is also growing from last year, and reached 11 bn USD in January and February 2016, which more than compensated the 6.7 bn USD deficit in the current account. With retail sales contracting around 10% and unemployment at record high levels since 2009, imports should continue to fall, while the weak currency should sustain exports. Despite the environment, international reserve's position is sound and exceeds external debt, meaning that the vulnerability of the country to external shocks is low in fundamental terms.
At the same time, domestic interest rates are an incentive to maintain money in Brazil as long as inflation decelerates. Currently, with inflation expectations trending down on top of low growth and a high budget deficit, the Central Bank's policy may continue to favor growth over inflation control, which could contribute to maintain rates on hold instead of raising them.
In real terms interest rates are very attractive in Brazil with Selic at 14.25% and inflation expectations around 7.5%. The recent numbers released show a deceleration of inflation from the 10% barrier, a trend that if maintained may allow for an increase in real interest rates even with the Central Bank maintaining nominal rates on hold.
In this environment, as long as financial flows remain controlled, there shouldn't be BRL depreciation pressure.
The problem is if inflation doesn't decrease as expected and for the reasons above mentioned the Central Bank remains reluctant to raise rates. That will lead to a decrease of real returns, turning the BRL currency less attractive in relative terms.
Political noise could cause financial outflows and consequently foreign exchange volatility in the short-term, although it hasn't in the last month. Maybe because the current developments are seen as positive, many may believe in an impeachment.
Year-to-date the BRL has gained around 8.5% against the USD, outperforming most Latin American currencies. The exchange rate of BRL against the USD is at September 2015 levels, date when commodity prices fell, concerns about China mounted but above all, when the first rate hike by the FOMC was postponed from September to December. With the softening tone from the FOMC throughout 2016, emerging currencies gained some value.
Nonfarm payrolls and ISM manufacturing regarding the month of March are due to be released on Friday. If as suggested by previous releases of more regional indices, the results come better than market consensus, expectations about a rate hike by the FOMC could be reinforced leading to a strengthening of the USD against other currencies, including the BRL.
This means that the BRL exchange rate is reaching an uncertain point. On one hand, inflation expectations have stabilized, real interest rates remain attractive, international reserves cover in full external debt and trade and foreign direct investment are supportive of the currency. On the other hand inflation is still high and above the central bank's target, financial flows could add selling pressure to the BRL on the back of political noise, which impact on the currency is very uncertain, and international monetary policy could contribute to weaken the currency.
In addition, it is worth considering, given the performance of the export sector and the depression of the import sector, if it is really in the interest of Brazil to bear the consequences of a fast appreciation of the currency, and its impact in the only dynamic sector of the economy - exports and foreign direct investment.
Arguments contributing for a strengthening of the BRL against the USD are more of a structural nature and although contributing to increase the value of the currency in a more permanent way, their influence takes more time to become evident than the factors supporting a depreciation.
Therefore, we can say that fundamentals remain supportive for the long-term, but in the short-term financial outflows may cause currency volatility and maybe some depreciation. Better than expected economic data in USD raises the odds of a FED hike in June which could exert temporary negative influence over the BRL.
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