Brazil's central bank may be on the wrong side of a multibillion dollar bet in its attempt to slow the rise of the Brazilian currency. The bank has spent about $34 billion (69 billion reais) this year to buy dollars and accumulate foreign reserves in an attempt to prevent its currency, the real, from strengthening to the point where it slows exports and undermines economic growth in South America's largest economy.
That amount nearly matches the $35.1 billion the bank spent in all of 2006. But as has often happened to central banks which have been prepared to bear the cost of currency intervention, the Brazilian real continues to rise.
Despite the bank's almost daily intervention on the spot foreign exchange market in the past couple of weeks, the real jumped about 7.0 percent against the US dollar so far this year to trade as high as at 2.012 per dollar last week, a level not seen since 2001.
"It's a lost war," said Darwin Dib, an economist at Unibanco SA, Brazil's fourth-largest private bank, in Sao Paulo. "This strategy is not sustainable. The market sees that if there are any effects, they will be short-term ones."
For Dib, and other analysts, the central bank's strategy is not sustainable given the record levels of dollar inflows resulting from a booming Brazilian economy, a stockmarket at record highs, and the allure of a benchmark interest rate of 12.5 percent, at a time when global risk-aversion is low.
Brazil had $10.7 billion in net dollar inflows in April, the most ever for a month according to government data, boosting year-to-date inflows of the US currency to $28.12 billion.
The country has already posted a $545 million trade surplus in the first week of May, boosting the surplus for the year to $13.5 billion, implying further repatriation of export earnings and upward pressure on the currency.
"This is a big shift for Brazil and other Latin American countries, from being heavily indebted, running current account deficits, to running a current account surplus," said Clyde Wardle, an emerging markets currency analyst at HSBC Bank USA in New York. "Not to mention that sovereign risk has decreased a lot and the country now may even get an 'investment grade' status."
For many analysts the central bank's wager is bound to be lost, not only because it is fighting against the success of its own government's economic policies, but because the bank is ultimately dependent on the US dollar recovering some ground if the strategy is to be sustainable.
The US dollar lost ground against most major currencies this year, and in April the dollar hit a 26-year low against the British pound, and fell to record low of $1.3682 against the euro.
Many Wall Street firms now predict the dollar may slide even further and test $1.40 against the euro. Even a poll by Brazil's central bank show most economists predict the real could end the year a bit stronger at 2.05 to the dollar. "The weakening dollar plays a part in this equation," said Meg Browne, a currency strategist at Brown Brothers Harriman in New York.
"It's an interest rate differential game. Rates in the US are going down and in Brazil, they stand at about 12 percent: and that's pretty decent." One way for Brazil to diminish the appeal of its currency and the dollar-flows into reais, would be to cut its benchmark interest rates.
But the Brazilian central bank has already been cutting its interest rates. The bank cut its benchmark rate by 25 basis points to 12.5 percent in April and most economists in a central bank weekly survey forecast another 125 basis point reduction to 11.25 percent by the end of 2007.
"The central bank is already cutting interest rates and we are going to see more cuts," said John Welch, an emerging markets economist at Lehman Brothers in New York. "But it's a bit of a Catch-22 for them. If they loosen monetary policy too much, they risk bringing inflation back and all recent indicators in Brazil point to price pressures."
For now, the central bank hasn't given up its fight and last Thursday raised eyebrows when it sold more than $3.1 billion of reverse currency swaps linked to short-term interest rates. It followed the swap by buying dollars on the spot foreign exchange market twice on Friday, which it had not done in years.
The real dipped a little after the heavy central bank intervention, but it resumed its advance on Monday and Tuesday this week, even as the central bank announced it planned to offer another set of $840 million in reverse currency swaps. The real traded at 2.0241 per US dollar in New York.
"The reverse swap was met with some criticism because after all, it runs a check in the market that one day will have to be paid, and most probably, by the central bank," Wardle at HSBC said. "But all the measures seemed to have worked to maintain low volatility, with narrow trading ranges. And maybe, if you think about it, how much stronger the real would be if it wasn't by central bank?"
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