OECD Chief warns of asset bubble forming in Brazil

Sources: Yahoo News (AFP) – Brazil fortunes slump on bubble fears, China tightening / WSJ – US Economist Krugman Expects Asset Bubble in Brazil / Reuters – ECB’s Nowotny warns of emerging asset bubbles / Reuters – DAVOS – Capital inflows to emerging markets rebound – IIF / FT – Fatal Attraction / Lanka Business Online – Fresh Tremors

OECD Chief, Angel Gurria, has joined a growing list of experts who have expressed concern about a potential asset bubble forming in Brazil. In a recent interview on CNBC Mr. Gurria warned that, “There’s a danger of asset bubbles in places like Brazil or places like India and we should be careful.” This statement follows a warning earlier in the week from European Central Bank Governing Council member Ewald Nowotny who said, “There are indeed concrete risks of asset bubbles in many emerging countries, caused in particular by significant inflows of short-term capital.”

The large capital inflows to emerging markets stem from loose monetary policies of Central Banks in the developed world. A side effect of the low rates is the creation of a carry trade strategy that involves borrowing a currency with a low interest rate and buying a currency with a high interest rate. For example, the European Central Bank currently has a target benchmark rate of 1%. Brazil’s target benchmark rate is 8.75%, and experts expect it to rise above 10% during 2010. Investors borrow from the Euro region where rates are low and invest in emerging markets for the higher yield. Along with this carry trade strategy, another factor that has led to large capital inflows is that investors generally view emerging markets growth prospects as significantly stronger than mature economies in the coming years. The combination of the carry trade factor along with growth prospects have led to a high risk of an asset bubble forming in emerging markets.

Central Bankers around the world, alarmed by these trends, have been taking actions to prevent the formation of asset bubbles. Brazil imposed capital controls in the form of a 2% tax on new foreign portfolio investment in late October, 2008 to try to slow down foreign investment in the Brazilian stock exchange. The tax did not appear to have much effect in November, as foreign investor inflows totaled $542 million; however, Brazil’s markets experienced a reversal of fortune during January. Investors pulled more than $500 million dollars from Brazil’s stock market. The stock market fell 4.7% and the real dropped to September 2009 levels. Brazil’s government did not express concerns with the capital outflows during January, asserting instead that any devaluation of the real will strengthen its exports.

Brazil’s economy also depends on China’s monetary policy because China is Brazil’s largest trading partner, accounting for approximately $42 billion dollars of trade last year. China started to tighten monetary policy in January in an attempt to slow down the inflow of hot money into both its real estate market and stock market. If China tightens monetary policy too quickly, Brazil could experience large capital outflows. The resulting swing in outflows from inflows could severely disrupt Brazil’s economy. However, Brazil’s imposition of capital controls in October, along with China’s current monetary tightening could prove to be timed right to stem off the formation of a large asset bubble and the resulting economic disruption.

Discussion Questions:
What steps can Brazil take to diversify its risk of becoming too dependent on China as a trading partner?
Is the January decline a sign that Brazil’s 2% tax on new portfolio investment working in stemming off a disruptive asset bubble?