The Fed vs. Brazil’s Reformers

The Federal Reserve announcement that it is set to create some $600 billion in new reserves is less than two weeks old. But the hum of Ben Bernanke’s helicopter can already be heard overhead here, and it is scaring more than a few market-minded reformers who have spent the last 15 years trying to set a new course for Brazil’s oversized, corporatist ship of state.

When Mr. Bernanke looks down from his money-spraying whirly bird, he no doubt sees a 185 million-strong nation of rising middle-class consumers who are armed with a muscular local currency, the real. If Americans won’t return to their shopping-mall madness of pre-2008 and investors remain on a capital strike due to President Obama’s hostility toward business, why not call on Brazilians, along with Asians and Europeans, to take up the consumption slack?

That’s the idea behind pumping more dollars into the world economy. It is supposed to weaken the value of the greenback, strengthen foreign currencies, and thereby make U.S. exports more attractive to the nouveau riche in countries like Brazil.

Yet this country is still far from the emerging market miracle that the strong real suggests. While it is true that many Brazilians are infinitely better off today than a decade ago, it is also true that the landscape in South America’s largest country remains dotted with political and economic landmines. Adding dollar weakness to an already fragile mix of protectionism and populism here raises the odds against further reform progress and could even fuel setbacks.

The Fed pretends that it is creating dollars in order to stimulate domestic demand. But the new reserves are unlikely to sit in U.S. banks waiting for a resurgence of U.S. growth. Instead they will pour into commodity markets. One place they are likely to end up is here, where a boom in oil, mining and agriculture today seems to spell opportunity.

Brazil’s President-elect Dilma Rousseff may be pressured to respond to U.S. monetary easing with more protectionism and higher taxes.

As investors sell dollars and pile into the currencies of commodity-exporting nations, those monies appreciate. This is enriching for the locals, who earn, save and spend in this higher-value coin. But the shift in exchange rates also makes exports dearer for their trading partners. In trade talk this effect is commonly referred to as lowering competitiveness. Brazilian Finance Minister Guido Mantega may be famous for tagging the Fed’s dollar blitz as the “currency wars,” but the bank’s actions are more aptly described as a trade war.

Over time, a country that devalues its own currency destroys its competitiveness because local producers face rising input costs and consumers lose purchasing power. But in the short run it is the trading partner that suffers as its products become less affordable in currency-depreciated markets. Chilean Economy Minister Juan Andres Fontaine recognized this last week when he noted that although the soaring price of copper in dollars is making the country richer, it is also pushing up the value of the peso and making Chile less competitive abroad. He urged local producers to “get cracking” to increase productivity and promised that the state would do its part to lower the official barriers to competitiveness.

Here in Brazil, it’s hard to see how the real won’t continue to strengthen in the near term. As the dollar price of Brazilian commodity exports heads north, more greenbacks will flow into the country, increasing the demand for the real and its price.

Brazil’s central bank has been trying to prevent an appreciation of the real by accumulating dollar reserves and then shrinking domestic credit. But this process of “sterilization” is expensive. Yale-trained Brazilian economist Raul Velloso told me in an interview here that sterilization cost the government 1.4% of GDP in the past year, more than was spent on health care or infrastructure development.

Despite this, the real still rises. Brazil’s commodity sector is world-class. But with a tax burden of 35% of GDP, onerous regulations and high trade barriers, manufacturers are already internationally uncompetitive. The Fed’s launch of a trade war is likely to make things worse: Producers are bound to cry foul and demand that the government respond with subsidies and more protection.

Meanwhile, as President-elect Dilma Rousseff of the leftist Worker’s Party (PT) prepares to take over in January, PT policy makers are eyeing the high costs of sterilization and also of populist transfer payments that, according to Mr. Velloso, now cover some 50 million people. Not surprisingly they are talking about increasing taxes. If all that’s not bad enough, it is worth recalling that asset/credit bubbles have a habit of bursting. Former central bank president Arminio Fraga reminded me in an interview here that the ratio of household debt-to-income has risen sharply—to 35% by the end of last year from 18% at the beginning of 2005.

There was a time when U.S. economic leadership carried weight in this part of the world. Looking at the mess the Fed is handing Brazilian reformers, it is clear those days are over.