Brazil’s capital controls and the law of unintended consequences

June 5, 2013

Brazilian economic policy is fast becoming a shining example of the law of unintended consequences. As activity fades and inflation picks up, the government has tried several different measures to fix the economy – and almost every time, it ended up creating surprise side-effects that made matters worse. Controls on gasoline prices tamed inflation, but opened a hole in the trade balance. Efforts to reduce electricity fares ended up curbing, not boosting, investment plans.

Perhaps that’s the case with yesterday’s surprise decision to scrap a key tax on foreign inflows into fixed-income investments. The so-called IOF tax was one of Brazil’s main defenses in its currency war, making local bonds less appealing to speculators and helping prevent an excessive appreciation of the real.

As the Federal Reserve started to discuss tapering off its massive bond-buying stimulus, investors began to flock back to the United States. So with less need to impose capital controls, Brazil thought it would be a good idea to open its doors again to hot money. Analysts overall also welcomed the move, announced by Finance Minister Guido Mantega in a quick press conference on Tuesday, in which he said that excessive volatility is “not good” for markets and that Brazil was headed to a period of “lesser” intervention in currency markets.

So what happened in the first morning after the move?

Volatility spiked, with the real swinging from a 2 percent rise to a 1 percent drop within hours. The central bank came to the rescue, offering to sell as much as $2 billion in derivatives designed to curb currency losses. Although fewer capital controls are usually welcome in the long term, at first they boost volatility. That will only get worse if a U.S. payrolls report due Friday strenghtens the case for tapering off stimulus.

Argue Guilherme Loureiro and Marcelo Salomon, from Barclays:

Zeroing the IOF tax eliminates an important barrier that prevented foreign investors from liquidating local rates positions (as they would have had to pay tax again to push money into Brazil). And the elimination of this barrier should, in fact, increase the volatility of USD/BRL, especially in moments of stress in global capital markets. While the decision to cut the IOF tax helps attract foreign flows, it also will demand more FX intervention from the BCB to dampen excessive volatility.

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