Dollar Appreciation Against The Real Likely To Impact Brazil's Economic Recovery

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Includes: BRZU, BZQ, DBBR, EWZ, FBZ, UBR
by: Global Risk Insights

Internal political uncertainty and U.S. rising interest rates have caused a two and a half year high of the dollar to real exchange rate. The dollar's appreciation, in turn, has caused concern regarding Brazil's economic recovery - which has been driven by its internal market - given its pressure on inflation and the possible decrease in consumption as products become more expensive.

On September 5, the dollar hit a two and a half year high against the real closing at R$4,14 - the highest level since January 2016. Throughout the past few months, the dollar continued to rise and exchange offices were selling the tourism dollar - dollars sold directly to consumers - at R$4,32. Since January 2018, the dollar has appreciated 25% against the real.

International and domestic factors

On the international front, the dollar's appreciation was caused by higher yields on U.S. Treasury securities which rose to 2% and continuous fear of a trade war between the U.S. and its trade partners. Additionally, the Federal Reserve may continue its interest rate increase to contain inflationary pressures due to economic growth - especially in U.S. retail sales. The concern is that an increase in retail sales may increase inflation, and in order to contain this increase, the Federal Reserve would likely increase interest rates even further.

High interest rates in the U.S. - deemed the safest market in the world - have the potential to attract resources from other emerging market countries, such as Brazil.

In Brazil, the appreciation of the dollar can also be explained by the continuous volatility in the presidential polls. Last week, the Superior Electoral Court (TSE) voted to deny Lula da Silva from running under the Clean Slate Law - as of the latest August poll, Lula was polling first with 39%. After the TSE decision, a new poll was published on September 5 without Lula; Jair Bolsonaro is now first with 22%, followed by Marina Silva 12%, Ciro Gomes 12%, Alckmin 9%, and Haddad 6%. Doubt remains as to whether the next government will make the necessary economic reforms to reach fiscal balance.

Alongside the dollar pressure, the Brazilian economy continues to underperform with 1.1% growth so far in 2018. This indicator is far worse than what was expected, causing economists at financial institutions to revise the GDP growth to 1.44% for 2018 - earlier in the year the expectation was 2.70%.

Brazilian Central Bank

So far in order to intervene, the central bank has held a number of foreign exchange swaps, equivalent to the future sale of dollars. In its latest round, on August 30, the total offer was $1.5 billion.

On August 1, the central bank's Monetary Policy Committee (Copom) decided to keep interest rates at 6.5%, signaling caution due to the volatility of the external scenario.

The Selic rate is used to keep inflation within its target to control prices of goods and services - when inflation is low the central bank lowers the Selic rate to boost economic activity, and when inflation is high, they increase the Selic to encourage people to consume less to remove reais from the market (sometimes increasing unemployment). Financial analysts project inflation at 4.16% for 2018.

Despite this volatile scenario, Minister of Finance Eduardo Guardia and Central Bank President Ilan Goldfajn believe that Brazil will not face the same difficulties as its neighbor, Argentina, since Brazil has low levels of foreign debt, high international reserves, opportunities to sell future dollar contracts, and stable foreign investment inflows.

Impact

The dollar's appreciation has a direct impact on the pockets of Brazilians. Uncertainty in the presidential elections polls and a need for security has caused investors and Brazilian tourists to buy more dollars, which in turn increases the price of the dollar even more.

In addition, it causes an increase in prices of goods and service and puts pressure on inflation, as many parts of the final goods are imported using U.S. currency - especially true for the electronics industry as well as food such as bread and pasta since wheat tracks the price of the dollar. In addition, the price of oil is likely to continue to increase due to tensions between Iran and the United States. If the dollar rises too much too quickly, it creates concern of boosting inflation in Brazil - something that if relatively moderate would not be considered too negative given its low 2017 and 2018 rates.

Inflation may also be passed along to products that do not use imported parts as some goods are traded in dollars for export and Brazilian exporters will have to adjust their prices in order to make a profit.

In regards to tourism, the appreciation of the dollar comes with positive and negative effects. On the negative side, vacations for Brazilians looking to go abroad became extremely expensive. On the positive side, international travelers may be attracted to come to Brazil due to its weak real which in turn can boost the tourism industry activity and improve some parts of the economy.

Overall, an increase in the price of the dollar is set to delay economic recovery in Brazil, especially as safe countries like the United States become more attractive to investors.