Brazil takes steps to slow currency appreciation

Sources:
Reuters - IMF says Brazil capital tax not enough on its own
Reuters - Brazil open to extra measures after new inflows tax
Financial Times - Brazil imposes tax on foreign investments
Financial Times - Brazil sets 2% tax on capital inflows
Financial Times - Fatal Attraction

On Monday, October 19, Brazil announced a 2% tax on new foreign portfolio investment. Brazil’s move was a response to its currency, the real, appreciating 36% against the dollar this year. Although foreign direct investment is down 56%, foreign portfolio investment is up nearly 159%. Currently, Brazil has one of the strongest IPO markets in the world; however, foreign investors purchase 70% of the IPO shares. The 2% tax will not apply to Brazilian companies’ U.S. listed American Depository Receipts. The tax only applies to foreign portfolio investment and does not affect foreign direct investment.

As recently as Friday, October 16, Brazil denied that it would impose any capital controls on investment. Several market commentators stated that the move damages Brazil’s credibility. Brazil’s economy has benefited from its predictability and accountability in monetary policy. Although Brazil asserted on Friday that it would not impose the tax, it appears that Brazil spread rumors before deciding to impose the tax to gauge how the market would react. After the announcement of the tax, Brazil’s currency dropped from R$1.70 to R$1.74 on Tuesday and its stock market index fell by 4.1%.

Brazil’s tax represents both a political as well as a monetary move. Labor Unions and manufacturing companies have pressed Brazil’s political leadership to take measures to stop further appreciation of the real in order to keep Brazil’s manufacturing base competitive. This tax should temporarily slow down further appreciation of the real. Although commentators assert that the tax will not have a lasting affect on further currency appreciation, the tax might work because it signals Brazil’s willingness to take measures to prevent further appreciation of the real as well as asset bubbles. Brazil’s Finance Minister, Guido Mantega, asserted that this tax was the first step towards preventing further appreciation of the real and that Brazil would take additional measures if necessary.

Brazil’s economy and stock market have recovered faster than much of the developed world. The credit crisis has not hurt Brazil as bad as other countries because Brazil’s economy is fairly closed. Exports only comprise 15% of Brazil’s economy and it has not relied on foreign credit. Brazil’s action signals that it is worried about a potential bubble in its currency hurting its economy in the future. Brazil is taking an active approach in attempting to prevent an asset bubble because asset bubbles and volatile capital inflows traditionally impede economic development in developing countries.

This is not the first time that a developing country has imposed a tax on investment flows. Malaysia imposed capital controls on its currency during the 1998 Asian financial crisis in order to try to prevent a run on its currency. Brazil’s tax is a preemptive move to try to prevent a financial crisis from ever developing, whereas Malaysia imposed capital controls in order to try to prevent further damages to its economy during a financial crisis. Brazil hopes that this move will help prevent a speculative bubble that could eventually lead to a run on the country’s currency, similar to what happened in Malaysia.

Discussion Questions:

Should Brazil impose capital controls on its economy or should it take a more laissez-faire policy?

Will other developing countries follow suit and impose capital controls?

Does this move cast doubt on the notion that developing countries desire to end the Dollar as the World's reserve currency, as the dollar would likely further depreciate if was replaced as the reserve currency?