Brazil’s currency conundrum

One priority for Brazil’s President Dilma Rousseff as she visits China this week will be the country’s strong currency, the real.

Brazil is caught in a dilemma on its exchange rate. It blames loose monetary policy in the US for unleashing a flood of liquidity onto international markets that has strengthened the real against the dollar, making Brazilian manufactured exports uncompetitive. Meanwhile, cheap Chinese imports, helped by an allegedly under-valued renminbi, are pouring into Brazil, hurting the domestic manufacturing sector.

All of this is contributing to over-heating in the economy, with some economists now predicting that inflation could test the government’s target range this year of 4.5 per cent plus or minus 2 per cent.

At 11.75 per cent, Brazil’s benchmark interest rate is already one of the highest in the world. To avoid raising it further, the government has unleashed a torrent of capital controls and tax measures in recent weeks.

In the fourth of four such moves within two weeks, the government on Thursday tweaked an earlier measure by extending taxes on foreign borrowing to loans with maturities of up to two years as well as doubling the tax on domestic consumer credit.

“They’re trying a bit of everything to see what works: a little bit of monetary policy, taxes, fiscal measures,” said Alberto Ramos, an economist with Goldman Sachs.

But analysts warn that the country will not be able to address both inflation and the currency at the same time. Worse, with the introduction of ad hoc controls, it is running the risk of causing long-term distortions to the market and making Brazil’s already unwieldy tax system even more complicated.

“The problem is that many of the measures are unprecedented; no one knows what kind of effect they will have,” said Flavio Serrano, senior economist at Brazil’s Espirito Santo Investment Bank.

Analysts say that if Brazil wants to keep inflation low, as well as attract the foreign investment it needs to develop its natural resources and also to prepare to host the World Cup in 2014 and the Olympics two years later, it will ultimately have to make a choice: tolerate higher inflation or learn to live with a stronger currency.

Indeed, Finance Minister Guido Mantega on Friday indicated for the first time a willingness to tolerate a stronger real if that would help contain inflation.