Has the Brazilian FX market lost its swing?

October 31, 2012

Tiago Pariz in Brasilia also contributed to this post.

Brazil’s Trade Minister Fernando Pimentel was the latest authority this week to fire warning shots in a resurging currency war. The government is “focused” on keeping the real at its current level of 2 per U.S. dollar, he told journalists after a meeting with fellow ministers and businessmen.

Using market rules, we are going to try to keep (foreign exchange) rates steady every time the currency is under attack.

These words came days after Finance Minister Guido Mantega admitted Brazil now has a “dirty-floating” regime. “We cannot continue watching as others take ownership of our market and bring down our industry,” he told a local newspaper.

That doesn’t mean creating a formal framework to return to a fixed-rate regime, as Brazil had in the 1990’s. But just how dirty is this new regime? The exchange rates speak for themselves. Compare the real with the Chinese yuan:

Brazil was a paradise for hot money until a few years ago, paying sky-high interest rates for relatively low-risk bonds. Massive inflows turned the real into the world’s most overvalued currency last year, according to the Economist’s Big Mac index.

Fast-food sandwiches became exorbitantly expensive, as did salaries and raw materials, killing many industries unable to compete in a world with low appetite for manufactured goods.

Mantega’s currency war walled in the foreign exchange market with taxes and other sorts of capital controls. The central bank also did its part, soaking up excess dollars and slashing interest rates ten times in a row over the past year. The real weakened more than 8 percent this year, and the industry has given signs that the worst may be finally over. But Brazil’s flexible currency regime, which helped it leave behind years of high inflation, also took a direct hit.

High inflation may force the Brazilian government to give up the battle next year, some analysts say, in case authorities want to keep interest rates at record lows. A heavy-handed currency policy may not even be so necessary if the industry finally picks up.

But for now, it seems nobody is going to see any big swings in the real.

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