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Brazil Faces Interest Rate Paradoxes


  • pg 1

Brazil Faces Interest Rate Paradoxes

  Lars Pedersen
  Senior Economist—Latin America Research, (212) 823 3420

Brazil has introduced innovative policies to hold down a rising                                    Display 1
                                                                                                   Brazilians Borrow Foreign Exchange
currency while keeping interest rates high to battle inflation. But
                                                                                                                         Loans to Brazilians
as often happens in policymaking, the law of unintended conse-                                      USD Billions                                     BRL per USD
quences has reared its head...creating opportunities for a new                                       80
                                                                                                                                       Brazilian Non-Banks
                                                                                                                        Brazilian Banks                       3.0
segment of investors.                                                                                60
                                                                                                     50                                                       2.5
Like many emerging nations, Brazil has           higher rates. With US and Japanese rates
                                                                                                     30                                                       2.0
struggled to manage its local credit             still near zero, high and rising interest rates
markets, fiscal spending and inflation           in Brazil are luring a broad range of inflows                         BRL/USD                                1.5
                                                                                                     10                (Right Scale)
pressures in the shadow of extremely low         from both local and foreign investors.                0                                                      1.0
US interest rates. To help contain inflation,                                                              04     05      06     07     08    09    10
Brazil has raised its rates from already high    This huge rate gap creates an incentive for
                                                                                                   As of September 30, 2010
levels, but this has created complications—      many market participants within Brazil and
                                                                                                   Source: Bank for International Settlements and Bloomberg
it’s made Brazil more attractive to outside      beyond its borders to borrow as much as
investors, which tends to drive up the           they can in US dollars and lend as much as
value of the real.                               possible in Brazilian reais. This incentive       Display 2
                                                 will be present until the risk of losing          Rate Gaps That Attract Global Capital
Brazil’s Attractive Interest Rates               money from a decline in the real out-                                      Rates in Brazil
Brazilian interest rates were already very       weighs the available return advantage.
                                                                                                    % Annual Rate
high—near 10.75%—even before inflation                                                              50
picked up. With the recent policy                For years, Brazil has used massive                                            Bank Lending: Trade Bills
decisions, rates are headed for a much           currency-market intervention to counter
higher range: 12.5% to 13.5%, depend-            the inflows attracted by its inordinately            30
                                                                                                                                    BRL 3mo. Non-Deliverable
ing on the maturity of a given bond.             high interest rates. But this aggressive             20
                                                                                                                                    Forward Rate
                                                 intervention also prevents the currency                                                           Selic Rate
Policymakers have discussed alternatives to      from rising to unsustainable levels, which
interest-rate hikes in an effort to rein in      actually reduces the risk of a sudden drop            0
                                                                                                                                               USD 3mo. Rate
domestic demand and slow inflation. This         due to a correction in the currency’s value.              2008                 2009             2010
dialogue culminated in modestly tighter          This makes lenders feel relatively safe in
                                                                                                   As of December 31, 2010
fiscal policy and several measures intended      accessing high returns in Brazil, so the
                                                                                                   Source: Banco Central do Brasil and Bloomberg
to tighten the availability of private credit.   intervention paradoxically attracts still
But these alternatives have been late in         more inflows.
arriving, requiring at least somewhat
The Interest-Rate Paradox Illustrated           In a series of surprising measures last year,
Here’s one easily documented case of this       Brazil’s outgoing finance minister, who has        Display 3
paradox: For some time, banks outside           since been reappointed, tried to disrupt           The Latest Wave: Brazilian Bonds
Brazil, which we assume lend to Brazilian       these flows. He first increased the Imposto                  International Bonds Issued by Banks
residents in US dollars and other devel-        sobre Operações Financeiras (IOF) tax on                                 (USD Billions)
oped currencies, have contributed to large,     foreign fixed-income investment into
                                                                                                               3Q–4Q, 2010          Jan 2011
unstable lending cycles in response to          Brazil. That measure was largely irrelevant
Brazil’s unusually high interest rates.         to forward contracts, which are essentially          Rank
                                                risk-transfer agreements with little cash               1      7.94 Russia       2.93 Brazil
For example, from 2006 through 2008,            involved. But it triggered a brief mini-panic           2      6.04 Brazil       0.52 Colombia
these banks reported a sharp upturn in          to unwind these positions. After the IOF                3      4.58 India        0.51 Russia
their lending claims on Brazilian residents     tax measure failed, a punitive reserve
                                                                                                        4      3.96 S. Korea     0.50 S. Korea
(Display 1, previous page). Most of the         requirement was levied on banks’ short
                                                                                                        5      2.54 Qatar        0.50 Kazakhstan
resulting currency risk was presumably          dollar positions, which had been used to
                                                                                                        6      1.75 Turkey       0.50 Turkey
taken by local corporate borrowers.             absorb the risk brought in by forward-mar-
                                                ket investors.                                          7      1.50 Singapore 0.30 Ukraine

As the real started to fall under selling                                                               8      1.35 Thailand     0.26 India
pressure in 2008, borrowers began to            By impeding arbitrage in the banking                    9      1.25 China        0.21 Argentina
unwind their foreign-exchange risk in what      system, this measure decoupled the real’s               10     1.22 Argentina 0.10 China
appeared at the time to be a currency           forward value from the value suggested by          As of February 10, 2011
                                                                                                   Source: Dealogic
crash. Along the way, Brazilian banks re-       differences in US and Brazilian interest
duced their dollar exposure suddenly, even      rates. The decoupling grew particularly
as local companies continued to increase        pronounced in October 2010. In early
their offshore funding. Since early 2010,       2011, the gap amounted to an interest-          Brazilian corporations at annualized rates
offshore banks have begun a new cycle of        rate shortfall of 2% to 3% for forward-         as high as 40%.
lending to Brazilian banks, with the inflows    market investors (Display 2, previous
pushing the real back up to levels that         page).                                          Here’s how the strategy works: A Brazilian
have provoked massive intervention and a                                                        company can borrow in US dollars and
range of new policy measures.                   Local Borrowers Exploit a Gap                   then convert or hedge those funds into an
                                                The experiments of Brazilian policymakers       equivalent funding position in the Brazilian
Forward-Market Inflows Surge                    trying to control the forward-currency          real. For example, $1 billion in proceeds
Foreign investors have also taken interest.     market have triggered another unintended        from issuing dollar-denominated one-year
They can easily deploy a strategy by which      consequence—new inflows, this time from         bonds can be used to purchase Brazilian
they purchase forward contracts that            local businesses trying to take advantage       reais, which can be exchanged for dollars
commit them to sell foreign currencies (the     of this same gap from a different angle.        one year later when the bond has to be
US dollar, in this example) in exchange for     They see an opportunity to issue bonds in       repaid.
Brazilian reais at a future date specified in   foreign developed-market currencies and
the contract.                                   then buy reais with the proceeds.               During that year, the company has $1
                                                                                                billion cash in Brazilian reais at its disposal,
Forward contracts are priced to reflect the     These businesses are responding to a            and it can lend that money out. If the
huge premium of Brazilian rates over US         perverse side effect of Brazil’s energetic      forward contract rate for the Brazilian real
rates—to keep the market in equilibrium,        policy intervention in forward markets.         includes an abnormal discount for Brazilian
investors must deliver more reais per dollar    Policymakers, by reducing the discount in       interest rates, that discrepancy actually
when the contract settles than is called for    forward contracts, have lowered the cost        makes it cheaper, in currency-hedged
by the current exchange rate. As long as        for domestic entities to issue bonds            terms, for the Brazilian borrower. The net
the real doesn’t fall as far as is implied in   abroad—once currency hedging is taken           result: Brazilian banks end up with cheap
the contract, the foreign investor profits.     into account. These entities can then turn      funding at the expense of foreign investors
                                                around and lend the funds to domestic           in forward-currency markets.

                                                                                                FEBRUARY 11, 2011 ECONOMIC PERSPECTIVES
Brazilian banks have, unsurprisingly,                     the total sold in the entire second half of                other borrowers have taken their turn. The
reacted by borrowing heavily in global                    2010 (Display 3, previous page). And                       bottom line is that the dislocation
bond markets. They recently hit global                    the January issuance dwarfs the amounts                    introduced in Brazil’s forward-currency
markets with a wave of bond issuance to                   issued by banks in other countries by a                    market by aggressive policy intervention
tap into this cheap source of funding.                    huge margin.                                               will make bank funding cheaper and allow
                                                                                                                     even greater domestic lending—not
Brazilian bank sales of bonds in interna-                 Brazil’s state-owned energy company,                       necessarily the preferred result for a
tional markets during January 2011 alone                  Petrobras, has also stepped in to take                     country battling to control inflation.n
amounted to US$2.9 billion—almost half                    advantage of this anomaly, and a host of

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                                                                                                                    FEBRUARY 11, 2011 ECONOMIC PERSPECTIVES

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