Brazil launches fresh currency war offensive

By Samantha Pearson in So Paulo

Brazil will no longer play the fool and let its currency appreciate while richer nations gain economic advantage by devaluing theirs, its finance minister Guido Mantega, said this week. It is almost 18 months since Mr Mantega first coined the term currency war, but it appears there is no ceasefire in sight. On the contrary, Brazil has embarked on a new offensive to suppress gains in the real. On Monday itextended a tax on foreign loans for the second time this month. More While analysts still predict a long-term appreciation of Brazils currency, they believe an arsenal of measures from taxes to interest rate cuts could trap it between R$1.75 and R$1.80 per dollar for most of 2012, diverting investor flows to other Latin American assets. The market is beginning to understand that the Brazilian government is willing to pay the price of distortive capital controls and that they are willing to take risks with inflation just to get the foreign exchange rate down, says Tony Volpon, head of emerging markets research for the Americas at Nomura. A weaker currency has gone to the top of their priority list. Yet the governments bellicose rhetoric comes at a time when the real is already relatively weak. After hitting a 12-year high against the dollar last July, the real has dropped about 14 per cent, trading at around R$1.80 on Thursday. One of the main factors behind this depreciation has been a gradual reduction in the real-denominated holdings of Japans Toshin retail funds. Their exposure has dropped from a peak of $108.65bn in July last year to $90.57bn this month, a decline which Mr Volpon says has broken a traditional correlation with consumer confidence data and which may prove structural. As such, some suspect Brazils recent assault on the currency was politically motivated and prompted by the need to explain economic data this month showing the countrys once China-like rate of growth had slowed abruptly to 2.7 per cent last year. President Dilma Rousseff has since entered the debate, promising to do the possible and the impossible to combat the monetary tsunami from richer nations. The introduction of similarly protectionist measures from Chile to Switzerland over the past 18 months, along with tacit approval for capital controls by the International Monetary Fund, has only strengthened Brazils resolve to take action. Given the exceptional circumstances, monetary policy became heterodox on a global scale; almost every country is trying to react to measures taken by central banks, says Antonio Manfredini, an economist at Brazils Fundao Getulio Vargas. The question among traders now is what type of measures could be unleashed next, especially if higher commodity prices push the real towards R$1.70 per dollar, the strongest level the government is expected to tolerate. Brazils high interest rates mean its fixed income market has long been the target of unwanted hot money flows, but these declined after the imposition of a 6 per cent IOF transactions tax on bonds and the beginning of an aggressive easing cycle in August. The problem for the government is that the real now appears to be supported by more desirable flows, mainly foreign direct investment and stock market acquisitions. However, foreign companies may now be funnelling money through their Brazilian subsidiaries as FDI to buy bonds locally without paying the IOF, says Flavia Cattan-Naslausky, foreign exchange strategist at RBS. Data from Brazils central bank seem to support this theory. In January 2011, foreigners spent $2.65bn on Brazilian bonds, but only $638m in the same month this year. Meanwhile, Brazilians poured $1.19bn more into local bonds this January compared with last year. Brazils decision to extend the 6 per cent IOF on foreign loans to five-year maturities this week could help block some of these flows, which may be disguised as inter-company loans, but analysts say further extensions would cripple smaller companies. Similarly, a rumoured tax on foreign direct investment is expected to be pushed aside for less-damaging measures such as an increase in the currency derivatives tax. The relative strength of Brazils economy is expected to support the real. But, if the government continues with its new offensive and succeeds in bringing interest rates down to historic lows, investors have said they may move elsewhere in the region. I would go back to Mexico where the central bank doesnt really intervene and Colombia, a smaller market but one with a better sense of directional trade and less volatility, says Ms Cattan-Naslausky. There are other more transparent trades you can do with fewer risks.

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Brazil extends tax on foreign loans

By Samantha Pearson in So Paulo

Brazil has stepped up its currency war in an effort to revive its shrinking domestic industry by extending a tax on foreign loans. In its third measure this month, on Monday Brazils government broadened the so-called IOF transactions tax on foreign borrowing to cover any debt maturing in up to five years. The 6 per cent tax had originally only applied to foreign loans of two years or shorter and was extended at the start of March to maturities of up to three years. Brazils government has been struggling to halt a flow of money into the country, which has been blamed for overvaluing the real against the dollar and so reducing competitiveness. In particular, a surge in intercompany loans from abroad has raised suspicions that foreigners are using their subsidiaries in Brazil as a vehicle to speculate on the bond market and bypass other capital controls. The finance ministry will continue to look for spaces where short-term capital is moving into Brazil; they will try to penalise this, without putting too much pressure on the more long-term and stable flows of capital, said Marcelo Salomon, an economist at Barclays Capital. With some of the highest interest rates in the world, Brazils bond market has become a target for what Dilma Rousseff, Brazils president, this month branded a tsunami of cheap money from richer countries. Analysts have dismissed previous changes to the tax as relatively ineffective, given that only a small portion of foreign loans mature in two or three years. Mondays move is expected to hit a much wider slice of the market. Its really going to affect small to midsized companies, said Andre Ferreira, director of the Futura brokerage in So Paulo. The bigger ones just go directly to the market and take out loans for five years and one day, for example. The small companies just cant get money with maturities as long as that. After the decree was announced, the real weakened more than 1 per cent to above 1.8 per dollar, its weakest level in two months. Since the beginning of this month, the real has been the worst performing currency among the 16 most traded. Analysts said the government was unlikely to extend the tax, as it could deter long-term capital, but would introduce other controls to defend the unofficial target for the real of 1.7 per dollar. The government has also come under pressure to introduce longer-term reforms to boost industrial production, which fell 3.4 per cent in the year to January, as well as improving its own efficiency and thus giving the central bank more room to cut rates. In the same way that Chvez blames the US for everything that goes wrong in Venezuela, Brazils government always blames the dollar, said Mr Ferreira.