ANALYSIS-Brazil may be outgunned in fight to weaken currency

By Reuters Staff
September 10, 2010

By Samantha Pearson

SAO PAULO, Sept 10 (Reuters) – Brazil is locked in a bitter struggle with investors over the value of its currency — a battle it is unlikely to win without major casualties.

The government is increasingly desperate to halt the appreciation of the real, which has more than doubled in value against the dollar since President Luiz Inacio Lula da Silva took office in 2003 and is now, by one measure, the world’s most overvalued major currency.

The currency’s rise is in part a reflection of Lula’s success in transforming Brazil into a darling of foreign investors. Yet what was once seen as a blessing has become a curse, and Finance Minister Guido Mantega warned Thursday that the government will take whatever measures are necessary to keep the real from further damaging exporters.

Meanwhile, the central bank has resorted to unusual, multiple interventions in the market this week to try to keep the real at or above its current level of 1.72 per dollar, near its strongest level this year.

Yet Brazil’s government and monetary authority may very well be outgunned in the near-term by a host of economic fundamentals and one-off events, namely the $65 billion share offering planned by state oil company Petrobras later this month. Analysts say that could unleash further deals and yet another wave of foreign investment inflows.

Continuing to fight the real’s appreciation also carries potential fiscal costs that may prove too much to bear at a time when the government is already ramping up spending ahead of presidential elections on Oct. 3.

In fact, markets are increasingly betting that the government will blink. Wagers by foreign investors on a stronger real reached $14.1 billion as of Sep. 3, according to Brazil’s Banco Safra — not far below an all-time high.

“While most central banks carry a certain clout, markets have a tendency to become a groundswell of opinion backed by real positions, with real risk on the line,” says Andrew Wilkinson at Interactive Brokers.

BRAZIL: A VICTIM OF ITS OWN SUCCESS

Brazil’s combination of robust 7 percent annual economic growth and some of the world’s highest interest rates — the benchmark rate is at 10.75 percent — has made it an irresistible target for foreign investors at a time when most of the world is dominated by low yields and weak growth.

The global growth hunt has also pushed Peru’s currency close to an all-time high and boosted the Chilean peso to its strongest level in eight months.

But the real is the most overvalued of all the world’s major 33 currencies, according to Goldman Sachs. Against the U.S. dollar, the real is overvalued by a whopping 53 percent, it says.

Even the threat of a double-dip recession in the United States seems to have had little effect on the real in recent weeks, says Michael Woolfolk, senior currency strategist at BNY Mellon in New York.

“The Brazilian real is hanging in there — it’s very tough, very strong. It seems to be trading off its own fundamentals rather than international investor risk appetite or the performance of the U.S. economy,” he says.

While the central bank insists that it is not trying to fix Brazil’s currency at a particular level, economists point to 1.70 real-per-dollar as the government’s breaking point.

The central bank doubled its dollar purchases on the spot market last month, buying $3.04 billion, its biggest monthly purchase so far this year. On Wednesday, the bank took the unusual step of calling two, rather than one, auctions — the first time that had happened since May.

The bank did the same thing on Thursday.

Yet, in a potentially foreboding sign, investors have barely flinched. The real closed stronger on the local spot market on both Wednesday and Thursday.

The interventions also carry a heavy cost, adding to Brazil’s growing debt burden. Most of the dollars the bank buys are held in reserve in U.S. Treasuries, which are currently yielding next to nothing. Meanwhile, the bank still has to pay out much higher interest rates in reais.

MIXED RECORD OF INTERVENTION

Brazil doesn’t have to look too far into its own past to see that currency interventions often don’t work out.

Lula’s predecessor as president, Fernando Henrique Cardoso, spent billions of dollars trying to maintain the real’s value when it was loosely pegged to the dollar in the late 1990s. The peg ultimately buckled, causing a traumatic devaluation.

Other countries such as China have got intervention down to a fine art, keeping the currency exactly where they want it.

If the real continues to appreciate, Brazilian authorities could resort to weapons of mass destruction such as raising a 2 percent tax on foreign purchases of bonds and stocks that was imposed last October during another bout of currency strength.

That would help to reduce foreign capital inflows. But it could also scare away the same investment that is helping to plug the country’s gaping current account deficit, which reached a monthly record in July and is a source of growing concern.

Another option would be for the central bank to employ so-called “reverse swaps”, a form of derivative that would have the same effect as buying dollars in the futures market. However, a previous period of swaps between 2005 and 2008 failed to stem a significant appreciation of the real.

The mere threat of such measures has been enough to make some investors wary.

PETROBRAS IMPACT

Diego Donadio, an analyst at BNP Paribas in Sao Paulo, says the possibility of greater intervention is the main reason that he is now advising his clients to buy other currencies instead of the real, such as the Mexican peso.

“There are so many deals in the pipeline, whether they be bonds or acquisitions and the capitalization of Petrobras. But on the other hand the risk from intervention is very high,” he says.

Although many questions remain unanswered about the mechanics of the Petrobras  capitalization, traders expect the deal to lure between $15 billion and $25 billion of foreign investment to Brazil.

Since other local companies have been afraid to come to market in recent months, for fear of being upstaged by the oil giant, a deluge of smaller deals could also follow.

Flavia Cattan-Naslausky, a strategist at RBS Securities is among those who believe the central bank may choose to surrender somewhat to the currency’s rally during this period.

Recent comments from Mantega show “some resignation to short-term appreciation around these large corporate deals,” she says.

(Additional reporting by Silvio Cascione in Sao Paulo. Editing by Brian Winter and W Simon )

((samantha.pearson@thomsonreuters.com; Reuters Messaging: samantha.pearson.thomsonreuters.com@reuters.net; +5511-5644-7736))

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