Brazil: at risk of losing currency war?

Carnival is finally over and it’s time to get back to work for many bleary-eyed Brazilians. For Guido Mantega, the country’s finance minister, that means plotting the next move in his beloved currency war.

The Brazilian real broke the closely watched level of 1.65 per dollar last week, prompting speculation that new measures could be announced as early as today to curb the currency’s appreciation.

For a country that complains so loudly about foreign exchange manipulation, Brazil has already introduced an impressive array of intervention measures itself: dollar purchases on the spot market, forward and reverse currency swap auctions, a tax on foreign purchases of local stocks and bonds, another tax on derivatives margins and reserve requirements on banks’ foreign exchange positions.

But there are still some options left:

The government could raise the so-called IOF tax on foreign bond purchases beyond the current 6 per cent. However, inflows into the bond market have actually slowed recently and any further hikes may not only scare away pesky speculators but also those coveted long-term investors. Brazil could even hike the IOF tax on stock purchases from the current 2 per cent but that may make less sense. Aside from the impact it could have companies’ funding, foreign investment into Brazilian stocks during January this year was only about half of what it was in 2010.

Quarantine measures are also a popular bet. Investors would have to leave money at the central bank for a certain period of time or incur a fine for early withdrawal – a measure reminiscent of Chile’s ‘encaje’ system of the 1990s.

Then there are the ‘small print’ options. For example, investors could be required to put down more collateral before they trade in the futures market. The possibilities are endless here, as Mantega once warned rather gleefully. Such measures have often been effective precisely because they have caused so much confusion in the market that investors sell on the uncertainty or even decide to shift their portfolio to a more straightforward trade in the region.

But whatever the government and/or the central bank decides to do, the result will inevitably be the same. After a knee-jerk reaction, a little chaos and lots of grumbling, investors will return to the market. As long as Brazil keeps raising interest rates, giving foreigners some of the biggest returns in the world for relatively little risk, Mantega is fighting a losing battle.