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BRAZIL: NEW PRESIDENT, OLD CHALLENGES
Can she Beat The Brazilian Heat?
Dilma Rousseff takes over a Booming Economy, but can she keep The Brazilian growth clock ticking Amidst Rising Inflation and Skyrocketing Interest rates?
Issue Date - 03/02/2011
 
As 63-year-old Dilma Rousseff took over as Brazil’s first woman President from her extremely popular predecessor Luiz Inacio Lula da Silva on January 1, 2011, she vowed (during her inauguration) to cut taxes, rein in public spending & control inflation. She repeated almost exactly the same points on which she had stressed on during her statesmanlike victory speech on October 31, 2010. “But can she?” is the question that many have started asking now, not only in streets of São Paulo, Brazil’s financial capital, but across the globe.

Reason: Challenges galore! While Brazil’s economic growth is expected to slide to 4.5% in 2011 (from an enviable 7.6% in 2010), inflation at 5.91% continues to be well above the government target of 4.5%. In fact, inflation in Latin America’s largest economy is already running at a six-year high, with food prices rocketing to 10% in 2010. And with memories of dreadful hyperinflation in initial years of this decade (see chart) still alive in the minds of Brazilians, new President Rousseff surely wouldn’t allow this plague to return to destroy Brazil’s impressive performance.

No doubt, the most logical move for Rousseff would be to boost interest rates. But then, Brazil’s interest rate, at 10.75%, is already among the world’s highest and raising them further would only give foreign investors yet another reason to buy its currency – the real – that has soared almost 35% against US dollar since the start of 2009. This directly points towards Rousseff’s other big task – to cope with the rising strength of the real.

With interest rates at all-time lows in much of the developed world, the 10.75% return on benchmark 10-year government bonds is attracting funds from all across the globe. Foreign investors have poured over $110 billion into Brazilian debt & stock in the past two years, which has lifted the real astronomically. Considering this Goldman Sachs has recently dubbed real as the world’s most overvalued currency. This not only puts Brazilian exporters on the backfoot, but also hampers the economy’s growth in the long term.

 
Though Rousseff wants the benchmark interest rate fall to 2% in real terms (interest rate minus inflation), doing that without scrapping the inflation target would require much tighter fiscal policy. To stop the real’s appreciation, Rousseff will either have to raise the tax on capital inflows, or will have to lower the rate of return on government bonds. However, the first option, raising the tax on capital inflows, has not worked so far for the Brazilian policy-makers. In fact, in the last one year, Brazil has raised the tax three times to 6%, but all in vain. The 10% spread between the Selic, Brazil’s reference rate (which is at 10.75% at present), and the Fed’s discount rate (at 0.75%) remains profitable even with a 6% tax on inflows. What’s more? Brazil’s treasury too is losing about $24 billion every year as it sells Brazilian bonds to foreign investors while investing the proceeds in dollar instruments yielding 10% less return.

In such a scenario, the only option left with Rousseff is to lower the Selic as it would narrow the spread between Brazilian interest rates and other global interest rates thereby decreasing its attractiveness and in turn curbing the excessive money supply in the system. While Banco Central do Brasil didn’t respond to the queries sent by B&E (till the time this magazine went to print), Eugenio J. Aleman, the US based Senior Economist at Wells Fargo agrees to the logic as he tells B&E, “Brazil cannot grow on a sustained basis with interest rates that are higher, in real terms, than in many other countries. Today’s Brazilian real interest rate is positive and very high, and this high real interest rate can create serious problems for the Brazilian currency as it attracts large amounts of short term investment, or what is called portfolio investment, that tend to worsen the appreciation of the Brazilian currency.”

Even Alfredo Coutino, the US based Director at Moody’s Analytics is of the same opinion as he tells B&E, “Brazil’s central bank should cut interest rates next year to slow the currency’s revaluation, rather than increasing them.” “But how?” This still remains the big question. In fact, considering the current pace of inflation, many economists even expect a 50 basis points rise in the benchmark Selic rate in January 2011 itself, and a further 2-3 such rises during the year.

Further, how can one forget the recent bailout of Brazil’s leading bank, Banco PanAmericano, (on November 9, 2010) which exposed cracks in a system? Several believed it to be one of the most solid financial systems among emerging markets, and as such now requires an overhaul. No doubt, Brazil’s economy grew at its fastest pace in last 15 years in 2010, but it was powered, to a large extent, by a rapid expansion in consumer credit. In fact, Brazil has recorded a whopping 400% increase in consumer credit over the last eight years, with the total value of outstanding loans reaching $440 billion (October 31, 2010).

          

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