Brazil’s Government to Take Steps to Curb Appreciation of Currency

FT: Rousseff to tackle sharp rise in the real
FT: Brazil continues to wrestle with dilemma over interest rates
WSJ: Brazil Rates Are Focus as Inflation Edges Higher
Economist: Waging the currency war

The value of the real, Brazil’s currency, rose 4.6 percent in 2010 after a 34-percent gain against the dollar in 2009. Although the strength of the currency makes buying foreign products cheaper, the appreciation is being blamed for hindering Brazil’s manufacturing competiveness because it makes exports more expensive. While analysts expect a drop in the currency, they warn against expectations of a large decrease in its value against other currencies. Therefore, Brazil must act now to stop the appreciation in its currency.

Issues affecting Brazil’s currency are high interest rates, rising inflation, and high government spending. In the past, Brazil lowered its interest rate to 6 percent during the first term of President LuizInácio Lula da Silva. However, in his second term in 2008, government spending increased dramatically to fight the global financial crisis and continued throughout 2009, causing interest rates to rise. Another cause of the rising interest rates is the country’s low savings rate, a factor that keeps Brazil’s economy dependent on foreign capital.

Although Brazil is currently dependent on foreign investment, the government is taking steps to deter foreign capital inflows. Brazil introduced and then raised a tax on bonds bought by foreigners. While this strategy seems counterproductive, Brazil hopes to decrease the amount of foreign capital in its reserves, thereby decreasing the value of the real and encouraging its exports. Economists warn that this strategy is dangerous if the move discourages foreign investors completely. Instead, they suggest that the government rein in its spending to solve this problem.

Even though interest rates are a prominent issue, the central bank, with de facto autonomy from the government, continues to raise interest rates due to the high inflation and government spending. Analysts expect an increase from 10.75 percent to 11.25 percent after a two-day meeting that ended Wednesday. Although rate increases are normally an appropriate way to fight inflation, some policymakers argue that decreased government spending would be more beneficial. After the presidential election last year, the central bank published a study that found that most economists who had studied Brazil thought that trimming the government budget by one percentage point of GDP would have the same effect on inflation as increasing interest rates by one percentage point.

When she took office on January 1, 2011, Brazil’s president, DilmaRousseff, promised to make dealing with Brazil’s appreciating currency a priority of her administration. Although the government has taken some steps, neither she nor her administration has offered a concrete and long-term plan of how to decrease spending and by how much. Many critics fear that because the majority of her economic advisers came from the previous government, there will not be any real changes.

Although the government introduced capital controls to contain appreciation of the real, the measures will only have a temporary effect. Brazil’s finance minister (whom Rousseff appointed from the previous administration) says the government is decreasing interim budget spending by one third and is planning more cuts to fight appreciation. Many economists say real and lasting budget cuts are necessary.

Discussion Question: Should the Brazilian government address dangerous levels of foreign capital inflows by cutting government spending or by imposing capital controls?