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Fighting Brazil's 'currency war'
With an election Sunday, finance officials worry an overvalued real could hurt performance in the fast growing economy.
Last Modified: 29 Oct 2010 16:10
The decreasing value of the US dollar, and other factors, are pushing up the Brazilian real [GALLO/GETTY]

It may be a battle fought with interest rates, monetary manipulation and investment regulation, but the affects of what Brazil’s finance minister calls a "currency war" can cause similar suffering and dislocation to that of a military conflict - where bombs, guns and tanks are the instruments of destruction. 
 
A lesson taught to Brazil - the world’s eighth largest economy - through past experience.
 
Its currency, the real, has risen about six per cent against the US dollar since late June and finance minister Guido Mantega blames America for waging the monetary conflict. 
 
"The problem is serious," says Alfredo Saad Filho, a Brazil expert and professor of development studies at the University of London. "There is a persistent overvaluation of the currency."
 
Paulo Pereira Miguel, the chief economist with Quest Investments, faces the problem on a daily basis.
 
One of his clients owns a factory making armored cars; it’s a good business in Brazil, as high crime rates and persistent inequality mean companies have to spend on security.
 
"The factory needs a lot of steel," says Miguel. "The owner used to buy this steel from Brazilian factories. But [with the rising real] the price of [domestic] steel is above the international average."
 
Now the factory owner is purchasing much of his steel from overseas, because the high real makes imports cheaper. This simple business decision - to outsource industrial production - is a metaphor for the currency issues hitting some Brazilian industries.
 
“The main debate in Brazil is the effect upon manufacturing exports,” says Lia Valls Pereira, chief of the foreign trade centre with the Brazilian Economic Institute, a prominent think tank based in Rio de Janeiro. "The share of manufactured exports in total exports has decreased from 55 per cent in 2005 to 40 per cent in the first half of 2010," she says.

Global power shifts

There are several factors driving the real’s rise. And they are fundamentally intertwined with changing power dynamics in the global economy.
 
This year, the US government is set to run a deficit of $1.34 trillion, according projections from the Congressional Budget Office. To spend so much more money than it earns, America is borrowing from abroad and – essentially – printing money. This causes a decrease in the worth of the US dollar, making other currencies more valuable. 
 
"In Brazil, you don’t see the same massive deficits you are seeing in the West," says Edmund Amann, an economist at the University of Manchester. "At the moment, Brazil has high interest rates and less risk than it used to."
 
Coupled with American domestic policy, low interest rates and sluggish growth rates in Europe and the US, investors are looking to other countries for high returns on their capital. The US federal reserve, has kept interest rates close to zero since October 2008, while Brazil’s central bank has rates above 10 per cent. 

The Brazilian riel has risen six per cent against the US dollar since June [GALLO/GETTY]

"The differentiation of [interest] rates with the US is really dangerous," says Miguel, the investment economist, adding that Brazil’s Asian manufacturing competitors have policy tools available to deal with the issue which are unavailable to Brazil.
 
Despite the currency war causing casualties, or at least amputees in some sectors, Brazil’s economy is booming.
 
"Any talk of winners and losers have to be seen in the context of an economy set to grow 7 per cent next year," says Amann. 

But finance officials still worry about short-term speculative or "hot" capital destabilising the country from abroad.
 
Finance minister Guido Mantega recently announced plans to raise taxes on foreigners investing in fixed income securities from 4 to 6 per cent, in an attempt to stop speculators from driving up the currency. 
 
"Given the high interest rates in Brazil and the low growth in most developed countries, experts in Brazil think that the [tax] measure will have little effect," says Pereira.
 
Election time
 
While analysts debate the merits of high interest rates and speculative taxes, average Brazilians will vote for their new president in a run-off election on Sunday. And, as is typical in election campaigns anywhere, the economy is a major issue.

Dilma Rousseff is running for the governing Workers Party (PT), and she promises to continue the market orientated yet socially minded policies of the popular outgoing president, Luis Inacio Lula da Silva.

Her opponent, former governor of Sao Paulo state Jose Serra from the Social Democratic Party, holds a PhD in economics from Cornell University.

While both parties have courted business and promise an investment friendly climate, Serra has a "stronger underlying belief" in fiscal conservatism, according to Quest Investment’s Miguel.

But a Serra victory, which seems unlikely, would not necessarily lead to lower interest rates and a weaker real. 
 
"If Serra wins, there will probably be more tightening and bringing rates down than under Rousseff," says professor Amann. "But Serra is more market friendly than Rousseff. Investors are going to like that message and that may push up the real."

Like other analysts, Amann isn’t convinced there is much the country’s elected political leaders can do to tame the currency beast. "There would have to be another huge international market shock [like the bust of 2008] and a decrease in commodity prices to bring the currency back down," he said.

Commodities and the 'Dutch disease'

Exports of agricultural products and minerals have driven much of Brazil’s recent growth. But now there is a new kid on the resource block: billions of barrels of black gold - Brazil continues to discover new untapped sources of oil.

"In the long term, this structural shift to becoming an oil exporter, will have quite a bearing on the track of the exchange rate," says Amann.

In September, investors rushed into the Bovespa stock exchange in Sao Paulo to gobble up $70bn worth of shares in Petrobras, the Brazilian energy company who will exploit a massive new oil field off the country’s coast.

"Never before in the history of man have we had a capitalisation of this size," outgoing President Lula boasted at the share sale.

Commodity exports can push up the value of a country's currency, hurting the manufacturing sector  [GALLO/GETTY]

Brazil’s central bank hopes $30bn in direct foreign investment will flow into the country this year, up from $10bn in 2003 when Lula, formerly an anti-capitalist union leader, took office. How times change.

But, primary commodity exports carry a host of challenges: mainly the "resource curse" and "Dutch disease", two reoccurring economic trends in the "history of man" to use the president’s lofty words.

Resource revenue brings quick cash to governments, often fostering corruption, mismanagement, and dis-incentives for creating other businesses, as has happened in Iran, Nigeria and the Democratic Republic of Congo, hence the "curse".

"Dutch disease" refers to a period in the 1960s when the Netherlands discovered petroleum in the North Sea. Money poured into the country and the Dutch currency rose to new heights, making manufacturing exports less competitive and allowing the country to rest on its laurels, using resource revenue to purchase imports.

"A Dutch disease is not a natural outcome," says Miguel. "If the country is ready to hold these [currency] reserves abroad as a sovereign wealth fund, than it doesn’t need to happen."

Managing wealth

Norway, Qatar and other petroleum rich countries stash much of their resource revenues in sovereign wealth funds: massive pools of capital that are invested outside of the country, to protect the domestic economy from overheating from oil cash and to stop the currency from rising too drastically.

Canada, Nigeria and other petro-powers have not been so prudent and squander much of their oil wealth.

If oil is exploited sensibly, there can be broader benefits to the manufacturing sector, says Miguel. "A lot of these oil fields will need equipment and technology to develop" and if Brazil become apt at producing this high-tech equipment, it can export to other regions, he says.
 
Fundamentally, Brazil can’t fight the currency war alone. It is a problem caused by global imbalances, often between China and the US, and it requires international solutions.

The best thing would be a coordinated arrangement to avoid a currency war, says the Brazilian Economic Institute’s Lia Valls Pereira.

She thinks a "Tobin tax [a small percentage charged for market trades] on short term capital inflows" would be a good start.

But despite Brazil’s rapid rise, its strong economy and lively - if imperfect - democracy, it doesn’t fundamentally control the real’s value.

"The main issue is between the US and China," says Pereira. And if today's low intensity currency war is ever to evolve into outright economic conflict, it will be fought between these two inter-dependent, contradictory, powers.

 Follow Chris Arsenault On Twitter: @AJEchris

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