No more currency war. Mantega dumps the IOF

June 5, 2013

Brazil’s finance minister Guido Mantega, one of the most shrill critics of Western money-printing, has decided to repeal the so-called IOF tax, he imposed almost three years ago as a measure to fend off  hot money flows.

Well, circumstances alter cases, Mantega might say. And the world is a very different place today compared to 2010. Back then, the Fed was cranking up its printing presses and the currency war (in Mantega’s words) was raging; today the U.S. central bank is indicating it may start tapering off the stimulus it has been delivering. Nor is investors enthusiasm for emerging markets what it used to be.  Brazil’s currency, the real, is plumbing four-year lows against the dollar and local bond yields have risen 30 basis points since the start of May. Brazil’s balance of payments situation meanwhile, is deteriorating, which means it needs all the foreign capital  it can get, hot money or otherwise. And currency weakness spells inflation — bad news for Brazil’s government which faces voters next year.

The IOF did work — Brazil’s local debt markets received just over $10 billion last year, Bank of America/Merrill Lynch calculates — a third of 2010 levels, and much of the cash that was already invested, preferred to stay put (given the IOF is paid upon exiting the country).

So will Mantega’s latest gambit work? So far, the real’s reaction has been muted and some analysts even reckon on short-term losses as funds that were staying in to avoid paying the 6 percent levy, are now free to leave.

Analysts at BofA/ML estimate a 2 percent currency benefit versus the dollar as well as a bond rally as real yields for foreigners will now be higher. Brazilian global bonds (denominated in reais but listed and traded overseas) however could lose out — these enjoyed a surge in demand as investors tried to get exposure to the currency without paying the IOF. BofA-ML reckon yields here could rise as much as 150 bps.

Ultimately though, all will depend on — the Fed. Societe Generale analysts say the real reaction could come on Friday when U.S. jobs data might show if the U.S. recovery is indeed gaining traction. They write:

The IOF tax removal may have had a small impact, but is not dwarfing the overall market dynamics of recent weeks….Should payroll employment surprise to the upside, markets will likely solidify expectations for a near-term deceleration of Fed asset purchases, putting high-beta EM currencies under considerable pressure and pushing up on long-end yields.

But if repealing the IOF proves ineffective, Mantega’s bid to boost the real could run into trouble. The central bank has signaled it is not about to expend its reserves in propping up a currency, which like all its peers, is basically up against the Fed’s might. If the real does not falling more than its emerging market peers, Brazil may just have to live with it, deputy central bank governor Aldo Mendes told reporters yesterday.

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