Self-inflicted ‘sudden stop’? Brazil blocked by its own currency war trench

February 25, 2013

In times of currency wars, it’s best not to shoot yourself in the foot. By imposing several capital controls in the past years, Brazil might have tightened monetary policy right when the economy started to falter, Nomura’s strategist Tony Volpon wrote in a research note on Friday.

Brazil’s mediocre economic growth in the past two years has been a mystery, indeed. Some say it has been due to the global slowdown – which contrasts with steady growth elsewhere in Latin America. Many others blame Brazil’s several supply bottlenecks. But then, why don’t businesses see them as an investment opportunity?

The missing link, Volpon argues, has been the imposition of capital controls. Inflows dropped suddenly, reducing the supply of cheap foreign money available for banks and companies. So, even though the central bank cut local interest rates ten straight times to a record low of 7.25 percent, money supply growth has actually slowed since January 2012.

It sounds like a paradox, but you read it right: Brazil may be in the middle of a long monetary tightening cycle despite all massive efforts to revive the economy.

“That growth has faltered after one year of the devaluation is, we believe, proof that the credit and expectation channels have been much more important than the level of the exchange rate for investments, and ultimately the self-inflicted ‘sudden stop’ contributed to the severe growth slowdown that continues to afflict the Brazilian economy today,” wrote Volpon.

When some of the measures were announced, the central bank itself acknowledged that they would impact credit supply. But the government has hoped that a weaker exchange rate would buoy manufacturing output, a strategic sector in a continent-sized country tired of living from commodities revenues.

With market analysts expecting a gradual recovery in industrial output this year, it seems unlikely the government will give up on currency controls. It is also debatable whether other variables – such as a souring investment climate due to frequent government intervention – has not had a bigger impact over business investments.

However, in days when even the International Monetary Fund says temporary capital controls may be useful, Volpon’s study offers some food for thought about the unintended consequences of capital controls. The deeper the trenches, the harder may be to move yourself forward through the battle lines.

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