What was once the darling of the currency investment world, the Brazilian real, fell from the graces when we saw heavy political interference in 2011.
In the past few months, I have written about Brazil. I have written about the need to attract foreign currency inflows. In the next four years, Brazil will face a trifecta of world events — World Cup Soccer in 2014, Olympics in 2016 and the rapidly expanding economy and middle-class people consuming and expanding their lifestyles.
In 2011, when Dilma Rousseff won the presidential election, she vowed to weaken the Brazilian real to help the people with the high inflationary pressures. She was successful in meddling with the free markets and enforced draconian measures to control the soaring real. The current team of the president and finance minister have de facto “pegged” the real to a rate of 2.0 to the U.S. dollar. While this peg is not official, the finance minister is often quoted as saying that the government will do what it takes to keep the exchange rate here.
While inflation has remained within the top end of the acceptable range of the targets, it is beginning to inch up and I am seeing inflation pressures pick up. One of the major reasons inflation dropped back in 2012 was the mandated cuts in electricity prices. This drop in electricity rates boosted disposable income to the households, which will lead to higher inflation as time progresses. So we did see a short-term dip in inflation, but a stronger inflation push is already being observed.
If the exchange rate is maintained around the current 2.0 levels of the real/U.S. dollar exchange rate, Brazil could see inflation at about 6.5 percent. If the exchange rate drops to 1.8, inflation could drop to about 5.25 percent, and a further dropping of the exchange rate to 1.6 real/U.S. dollar could see inflation declining to 4.75 percent bringing the rate to the middle of the target rate for inflation.
Given that the central bank is juggling a number of objectives other than inflation (such as growth and the level of policy rates), I think the government is most likely to use a mix of real appreciation and non-rate instruments to keep inflation in check for 2013. This could involve the real being re-pegged to 1.90 or even 1.80 to the U.S. dollar. So we can see a 10 percent increase in the real exchange rates in the next few months.
I fully expect to see further retractions to the draconian taxes imposed on the currency inflows into Brazil that started in 2011. Not only is inflation higher than acceptable, the country needs foreign capital to flow in and help fund the various construction activities and heavy investment in infrastructure that needs to happen for the 2014 and 2016 games.
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