Excellent Timing for Brazil's Double Down

(from my colleague Ilan Solot)

Brazilian officials finally pulled a big rabbit out of their policy hat. The central bank committed to selling up to $500 mln in FX swaps daily and up to $1 bln on Fridays – amounting to around $60 bln. The program will last until the end of the year.

In short, the new measure gives markets a far greater degree of predictability. It marks a departure from the piecemeal micromanaging style of policymaking by Brazilian authorities (and most other EM officials) in reaction to the current selloff. With this facility in place, it has become less likely that the central bank will resort to heterodox/macroprudential measures. For example, some market participates were concerned that the government would have to resort to imposing IOF taxes on outflows – though we doubt such a measure was a real consideration.

We think the measure could help bring a moment of detente to the dramatic price action in Brazilian markets – though much will depend on the Fed tapering story, of course. Another bout of EM selling would very likely hit the real again, despite these new measures. 

Also, today’s BRL gains come amidst a steadier backdrop for EM FX overall and better risk sentiment – INR is up 2%, for example. Still, USD/BRL is well off its high near 2.4550 to just under 2.4000 in spot as we write this. In addition, fixed income markets also reacted positively with rates falling as much as 22 bp across the swap curve. 

 Stabilizing FX has become a necessary condition to create a degree of predictability for the rest of the central bank’s tightening cycle (currently pricing in some 150 bp of additional hikes). BCB meets next week and is expected to maintain the 50 bp pace of hikes, despite recent BRL weakness.

Separately, we find it notable that the central bank’s interventions remain squarely focused on the forward markets. This seems to indicate that the pressure is coming largely from hedging demand – or at least that’s how the central bank perceives it. This would mean that most of the current BRL is coming from corporate sector’s hedging needs or meant to offset FDI exposure. 

 Instead, spot transactions would be more common in the case of repatriation of funds by foreign investors divesting from equity and fixed income markets in Brazil. This view would be consistent with anecdotal evidence that global investors have been underweight Brazilian assets for some time already.

In addition, the focus on swap interventions instead of spot may also reflect some reluctance by the Brazilian government to sell FX reserves. There has been a lot of discussion of late about the impact of selling of FX reserves by EM countries. A recent article in the Financial Times cites research pointing to an $81 bln decline in emerging market reserve holdings in the May to July period, presumably to fund direct FX intervention. 

The data indicates that this is roughly 2% of the developing countries currency reserves. Some countries, obviously, have seen a larger decline in reserves. Indonesia, Turkey and the Ukraine have drawn down 13.6%, 12.7%, and 10% of their reserves respectively over in that three month period of May-July.