Brazil’s policy bind. It’s not alone

April 21, 2011

Brazil’s central bank yesterday raised interest rates as expected, though it raised them by a quarter point rather than the half point most analysts had predicted. But rather than indicating the bank has gone soft on inflation, it reflects the quandary that Brazil and almost all emerging economies face: how to fight inflation and keep currencies in check. Even after the smaller-than-expected rate rise, the real surged to a new 31-month high against the dollar. BRAZIL/

Many have resorted to hiking reserve requirement ratios (RRR) to tighten policy – Turkey on Thursday raised RRRs again on lira and foreign currency deposits — but the fact remains that rate rises are inevitable at some point. That expectation makes emerging currencies attractive to foreign capital– just compare the zero interest rates in the United States or Japan with the 12 percent on offer in Brazil.

Meanwhile, economies are suffering, and Brazil possibly more than most. Currency strength may help with inflation but it does mean much domestic demand is being fulfilled by imports, leading to bigger current account deficits. ING analysts suggest Brazil’s industrial production has been stagnant for almost a year but capital and consumer goods imports surged by 40 percent. Productivity gains have seriously lagged the real’s surge. Loose monetary and fiscal policy means these economies are in danger of overheating.

The big hope is that U.S. yields will start rising some time soon and provide some respite. But there is scant sign of that yet, with the dollar hammered to three-year lows against major developed currencies. Against some emerging currencies, the greenback has hit multi-year lows. Many argue that with U.S. rates likely to remain rock-bottom a while longer, the flood of cash into emerging markets will not ebb any time soon.

Relief may not come before 2012, some analysts say. Fed rate tightening should start in 2012, at a time when Brazil might have come to depend more heavily on foreign capital to finance its growing current account gap. That will make the real vulnerable, ING analysts reckon, adding: “Thus we see risk of dollar/real in two years’ time being much closer to 2.00 than the (current) 1.57 levels.”

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