The Brazilian government has been in a “Currency war” for the past years; it has been endeavoring to stop the real (Brazilian currency) from appreciating while not hurting other economic aspects of the country. Interest rates in Brazil have been rising in recent years, which attract large amounts of capital inflows. In the first three months of 2011, Brazil received $35 billion in net inflows—the same amount of inflows as the past year.[1] This condition has been appreciating the Brazilian real relative to the US dollar. As a strong growing economy, Brazil has also been facing high inflation rates, which have become the country’s main economic concern. To curb inflation, the central bank increased interest rates, which drew more inflows of capital[2]. The currency’s uncontrollable appreciation has increased imports dramatically and now foreign goods have grown to be 23% of market sales[3]. At the beginning of this year, Brazil began what are known as “Macro prudential actions”[4]. Such policy consists of: taxing foreign investment, and slightly increasing reserve requirements. The government raised from 2% to 6% the IOF tax on short-term capital inflows[5]. This measure attempts to depreciate the real by making it less profitable for foreigners to make short-term investments in Brazil. At the end of August, the central bank decided to cut interest rates from 12.5% to 12% to depreciate the real[6]. As a result, by October, inflation had risen to 7.31%[7].
The actions of the Brazilian central bank were quite inappropriate for the situation. Having crises with both interest rates and inflation, dealing with them directly would inevitably cause a tradeoff. If the central bank were to lower interest rates to depreciate the real, inflation would rise; if the central bank wanted to decrease inflation, it would have to raise interest rates and the real would appreciate because of a rise in foreign investment. For Brazil to get out of this situation, the government should focus on macro prudential actions. By increasing taxes on foreign investment, the real would depreciate since investment in Brazil would be less profitable. Thus, the central bank is weakening the real without affecting interest rates and raising inflation. By raising the reserve requirements mildly, the central bank is decreasing inflation gradually. The government should start acting on interest rates only once inflation has returned to its central target.
Sources
“BBC News - Brazil in surprise interest rate cut to 12%”, n.d. http://www.bbc.co.uk/news/business-14743866.
“BBC News - Brazil inflation rate climbs after interest rate cut”, n.d. http://www.bbc.co.uk/news/business-15218174.
“Brazil defends macro prudential policies | Emerging Markets”, n.d. http://www.emergingmarkets.org/Article/2795500/Brazil-defends-macro-prudential-policies.html.
“Brazil’s economy: Wild horses | The Economist”, n.d. http://www.economist.com/node/18587335.
“Foreign exchange: Unwelcome appreciation for Brazil | The Economist”, n.d. http://www.economist.com/blogs/freeexchange/2011/04/foreign_exchange.
“Mantega Threatens More Capital Controls to Prevent Brazil Currency Gains - Bloomberg”, n.d. http://www.bloomberg.com/news/2011-01-04/mantega-threatens-more-capital-controls-to-prevent-brazil-currency-gains.html.
“Protectionism in Brazil: A self-made siege | The Economist”, n.d. http://www.economist.com/node/21530144.
[1] “Brazil’s economy: Wild horses | The Economist”, n.d., http://www.economist.com/node/18587335.
[2] “Foreign exchange: Unwelcome appreciation for Brazil | The Economist”, n.d., http://www.economist.com/blogs/freeexchange/2011/04/foreign_exchange.
[3] “Protectionism in Brazil: A self-made siege | The Economist”, n.d., http://www.economist.com/node/21530144.
[4] “Brazil defends macro prudential policies | Emerging Markets”, n.d., http://www.emergingmarkets.org/Article/2795500/Brazil-defends-macro-prudential-policies.html.
[5] “Mantega Threatens More Capital Controls to Prevent Brazil Currency Gains - Bloomberg”, n.d., http://www.bloomberg.com/news/2011-01-04/mantega-threatens-more-capital-controls-to-prevent-brazil-currency-gains.html.
[6] “BBC News - Brazil in surprise interest rate cut to 12%”, n.d., http://www.bbc.co.uk/news/business-14743866.
[7] “BBC News - Brazil inflation rate climbs after interest rate cut”, n.d., http://www.bbc.co.uk/news/business-15218174.
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