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| Guido Mantega, Brazilian finance minister |
International investors are outraged over Brazil’s “currency war” with the US and Europe, after Brazil’s latest attempt to manage its currency – by extending the IOF tax on all foreign borrowings – fanned speculation it will pursue a tighter control over capital inflows in its economy.
However, the lack of reinstatement of the scrapped IOF tax on international investment in Brazilian equities in early December, which was largely to blame for the heavy fall in the Bovespa in 2011, does provide a shred of relief for some market players.
On Thursday, Brazil’s finance minister Guido Mantega revealed that the so-called IOF tax would extend the 6% financial transactions tax to foreign loans with maturities of up to three years, instead of two-years. However, he did emphasize that the measure would have little effect on the market because the average maturity of Brazilian bond placements abroad is usually longer than three years.
The initial aim was to prevent flows of money into the country, and thereby lower its currency valuation. But speaking to Euromoney before Thursday’s announcement, some analysts believe it has had the opposite effect and has, at times, prevented the depreciation of the currency.
“The flows diminished after the IOF tax was introduced but the interesting thing was the way it behaved during the time of the tragedy in Japan,” says Javier Murcio, deputy fixed-income portfolio manager at BNY Mellon’s Standish.
“There was a belief that Japan would have to repatriate capital, and Japan over the last few years has been a major investor in the local market. Ironically, the perverse result was that the IOF served as a way to keep capital in the country because being a high-quality name and double-digit returns in an appreciating currency made being in Brazil very attractive. So, Japanese investors maintained their capital in Brazil because the IOF tax meant that if they left it would be more costly to go back in.”
The extension of the IOF tax for foreign fixed-income professionals is unlikely to change international investor sentiment that Brazil’s macro-prudential approach is creating an imbalance in the economy, and that is the point that needs to be addressed.
“If Brazil wants to be a real-world country, it should do real-world things and that includes not jerry-rigging your currency,” says Jim Craige, international fixed-income investor in Brazil and manager of EM fixed income funds at New York’s Stone Harbor Investment Partners. “It keeps interest rates higher, it restricts the fully functioning of their capital markets – it’s an unfortunate distraction and it is very expensive for them.”
Foreign direct investments in Brazil rose to $67 billion in 2011, from $49 billion the previous year, according to Brazil Central Bank (BCB) data. In a presidential decree, Mantega said that “when the real appreciates, it reduces our competitiveness. Exports are more expensive, imports are cheaper and it creates unfair competition for businesses in Brazil.”
Steffen Reichold, chief economist at Stone Harbor, says aside from the huge expense incurred by building dollar reserves of more than $350 billion, the prevention of its currency appreciation is damaging the economy’s long-term development.
“If the currency appreciates, one side-effect is lower inflation in the system, which in turn enables interest rates to fall,” says Reichold. “It’s an expensive place to do business and a free market economy eventually sorts itself out and they should be willing to do that.”
In the year to February 10, FX inflows reached $14.4 billion, according to data from HSBC, and led to the appreciation of the real close to the floor of its unofficial band of R$1.70 to R$1.95 to the dollar.
On February 15, the Ministry of Finance and BCB announced the creation of a technical group “to assess and propose measures that stimulate a balanced and safe growth of the derivatives market in Brazil”.
The group is also monitoring derivatives exposure of financial institutions and corporates.
The HSBC report says: “The group attests to the government’s intention to increase monitoring and regulation in FX markets. In addition, recall that, in July, the Exchange Commission was granted enlarged powers to amend regulations affecting FX regimes. Precedent shows that the authorities are intent on limiting FX activities deemed to be speculative in nature. We view the intervention deterrent as a credible one at this point.”
Nick Chamie, global head of emerging markets research at RBC, agrees: “While the [BCB] has been absent from the FX market for months, as we approach the 1.70 barrier we expect the BCB will once again reintroduce its regular USD-buying auctions. Other measures to stem BRL appreciation, including reverse repos or tax/regulatory changes, will be re-employed if USD/BRL slides into the 1.65 to 1.55 range.”
As well as possible new taxes on FX derivatives, equities bankers who had been pleased to see the scrapping of the IOF tax on international investment in Brazilian equities in early December have feared it might return.
“The Brazilian government will toggle [the IOF tax on equities] when they see a need to,” says one ECM banker, who believes any re-introduction would damage the rally in the Bovespa, which has risen 17% this year. “It was a very strategic move that they lowered those taxes. It’s not a co-incidence that the market rallied.”
Some bankers also believe the IOF was part of the reason the Bovespa fell so heavily last year.
“An important element was that the offshore investors saw the IOF to be punitive, and they thought they were better off selling and watching the market go down – they didn’t play it down,” says one. “They waited for the bottom to come back in and that probably meant the bottom ended up being lower than it otherwise would have been.”
