Brazilian Real Depreciates 6.8% in One Day

In early October, after the real-to-U.S.-dollar exchange rate jumped 19% in three days, the Central Bank stepped in to defend the currency and the price of the dollar came down 12% in the following four days. The depreciation is mostly the result of external and exogenous conditions in world markets rather than significant changes in the Brazilian economy. Commodity prices have finally peaked, and the expectations of lower future foreign-exchange revenues are associated with a weaker real. Additionally, the U.S. dollar is recovering ground against other world currencies, and the real is not an exception. As of 22 October, the U.S. dollar was worth 2.38 reais.

Central Bank Intervention

On Monday (20 October), Central Bank president Henrique Meirelles informed Congress that so far in October, the bank has intervened in the foreign-exchange market through different channels for a total of US$22.9 billion. Among others, direct purchases on the spot market amounted to US$3.2 billion, with swaps of US$12.9 billion, and lines of credit for (international) trade of US$1.56 billion.

From a longer-term perspective, Brazil enjoys a solid external position, driven not only by robust growth in exports but also by foreign investment. A massive inflow of foreign capital has led to the appreciation of the Brazilian real, from 2.65 reais:US$1 at the end of 2004 to its current levels. Foreign-exchange reserves more than doubled in 2007 from an already-high base. At the end of 2006, international reserves amounted to US$85.8 billion, whereas on 22 October 2008, they totalled US$201.7 billion. The central bank has spent over US$3 billion defending the currency stability of the currency rather than the value itself; it was clear that at 1.80 reais:US$1 the currency was overvalued and the government was helping certain industries in the export sector to defend their competitiveness (help comes in the form of subsidised loans and tax breaks).

Outlook and Implications

The short-term outlook for the Brazilian real is one of high volatility, imposed, to a large extent, by a highly uncertain international financial scenario. The collateral effects of the U.S. sub-prime mortgage crisis continue to shake world markets, and it is likely that bad news regarding large U.S. financial institutions may not yet be the last. Given the overvalued nature of the Brazilian currency, the international crisis may bring a correction. Although only partial, this means that the depreciating trend observed since the beginning of September 2008 may continue. This year, Brazil is expected to post a current-account deficit in the balance of payments for the first time since 2002. Nevertheless, the deficit will be more than offset by foreign direct investment and other capital inflows. Thus, the country is expected to gain reserves overall. The recently awarded "investment-grade status" by Standard & Poor's and Fitch will help avert massive capital outflows from the country. Nevertheless, if this were to happen, Brazil enjoys ample foreign-exchange reserves to cope with the problem. It remains to be seen whether more market turbulence in the United States and other major markets translates into a flight-to-quality scenario, wherein capital will flow out of Brazil, or juicy returns on high interest rates in emerging markets attract more financial investors.

Overshooting Likely