The dysfunctionality of the Real's price is drawing the attention of the markets. We often see in the news that the Real was the currency that had the worst performance on the day compared to the dollar. If this short article were to go dipper on all the issues that influenced this collapse of the Brazilian currency, it would end up becoming a book and there would still be many themes left for a second edition. Anyway, it would be a story full of villains and bad guys, but if I were to choose only one culprit, the leader, who would it be? My choice would be the Brazilian Interest Rate.[1]
Before delving further into the foreign
exchange pillars of this choice, I believe it is important to place some
assumptions about the dynamics of Brazil's basic interest rate, also called
SELIC (Special System for Settlement and Custody in Portuguese). It can be said
that this rate is the amount that the Federal Government pays to those who lend
money to the government through government bonds. Consequently, it is the
benchmark for private financial investments and other market interest rates.
Theoretically, no investment at the national level should pay less interests
than government bonds because the credit risk of the Brazilian State is
supposedly much lower than any private institution. This logic applies to the
national Market level, but not so much to the international market as we will
see below.
Today
Selic is at its lowest level in history at 2%. In short, it means that those
who buy government bonds in Brazil will receive 2% of their capital per year in
the form of interest. In 2016 the rate was 14.25% and since then it has been
decreasing.
This rate of 2% is considered incredibly low because it does not consider inflation, which in the last 12 months was 4.56%[2], so assuming that Brazil is paying negative interest is not a work of science fiction, but it is already a reality. A low Selic rate was the long-term desire of the market as it becomes a driver of national growth[3] but has caused side effects and the rising of the dollar rate is an example of that.
In the national market level, we assume Brazilian bonds as being essentially the risk free assets, but foreign investors do not see it that way. In order to pricing the risk for investing in any country in the world, a default insurance market called CDS (Credit Defaut Swap) was created. In other words, an investor pays a premium to ensure that his investment in a particular country will not be lost if the government does not pay what they should. Due that, this insurance become an indicator of the risks of applying in that country. The higher the value of the "insurance", riskier it is to buy the bonds of that country because the chance of default is bigger. Based on this indicator, investors seek the best investment opportunities around the world. Today Brazil's CDS is at 153 points while other emerging countries like Mexico and Russia are at 81 and 86[4] respectively. In other words, according to this indicator, the chance that Brazil will default today is 88% and 77% higher respectively than Mexico and Russia. Keep that number in mind.
Now, let’s connect all that information together. We already know that interest in Brazil is at 2% and according to the CDS, it is much riskier to invest in Brazil than in the other two emerging countries. But what will be the interest rate for Mexico and Russia? In early February 21 Mexico dropped to 4% while Russia is at 4.25%. To summarize in a quite simple way, the international investor who wants to invest in Brazil pays almost twice as much for insurance and buys an asset with a ROE by half of the others within his reach. Analyzing only from this point of view, it becomes clearer to understand why Brazil is having difficulty in raising dollars on the international market and we get why we are facing an outflow of dollars for other countries on the last year.
This type of investment is commonly known as Carry Trade and consist in investors injecting capital to earn from the sovereign interest rates. Some experts say that this form of dollar inflow is purely speculative and is not healthy for an economy. However, the fact is that the absence of the entry of this resource and the massive exit of those dollars placed here before directly implies the price of the currency, throwing the quote upwards.
Brazil has a long way to go to reduce the CDS and this is the direction they should take in order to solve the Real depreciation for good. The path is already known but is hard to get all the long list of measures checked as done. They include reforms, such as tax and administrative, privatizations, maintenance of the budget for government expenses, etc. However, the interest rate at the current level is also dysfunctional and should start to rise in a short time. This upward movement in interest rates should make the dollar return to a lower level than the current 5.40, but for a greater appreciation of the Real, the above agenda must be achieved.
[1] For some analysts, the high exchange rate is beneficial, especially for Brazil, which is a major exporter of commodities. Brazilian products become more attractive in the international market as the Real loses value and this is interesting for exporters. On the other hand, the high dollar impact on inflation and that is why it is being considered a villain here.
[2] From the website https://www.ibge.gov.br/explica/inflacao.php considering the date to jan 20 to Jan 21.
[3] For example, an industry that is looking to increase its production capability now has access to cheaper loans and can finance the purchase of new equipment and machinery, which in turn will require the hiring of more employees and so on. Another example of how the interest rate at lower levels encourages the opening of new businesses can be seen by the fact that individuals and companies must seek better yield alternatives than government bonds. The opening of new companies is one of the options chosen by individuals who take the money that was invested in the bank and start looking for entrepreneurship as a better source of income for their money.
[4] From the website: http://www.worldgovernmentbonds.com/sovereign-cds/
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