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October 24, 2015

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Hi Noel, thanks for the post. I hear a variation on this comment a lot: "Extensive foreign-currency borrowing by private entities means that a falling real would push Brazilian borrowers into insolvency." The issue is that you haven't had that extensive foreign currency borrowing, or not at least relative to the intl reserves that the Central Bank has built up. If you compare intl reserves to the amount of debt service coming up over the next year (public and private, interest and amortization) you actually have ~$3 of reserves for every ~$1 due. So I get that markets treat Brazilian monetary policy as if they engaged in foreign currency borrowing as they did during previous crises but it's not really true. I'd be very happy to see counter to this point though!

I think that the problem is that the central bank would need to bail out private borrower, which might not be politically tenable. Let's say you have a Brazilian supermarket chain. It borrows in dollars but earns in reales. If the value of the real falls, then they're in trouble, regardless of the size of the central bank's reserves.

The large reserves only help if the central bank is willing to spend them. It can do that in two ways. One, it can use them to buy reales and stop it from falling as much as it would have otherwise. That would give the country more leeway to drop interest rates, but it means that the exchange rate doesn't fall. You avoid the problem rather than solve it. (And you also avoid the benefits of a weaker exchange rate.)

The other way is that it can directly or indirectly help that Brazilian supermarket chain refinance its debt. The most straightforward mechanism would be for the central bank to assume the company's debt: the supermarket chain would owe reales to the central bank and the central bank would owe dollars to the supermarket chain's foreign creditors.

You can make that transaction more indirect, but it still involves a subsidy to entities that have borrowed in dollars.

That seems like it might be problematic, unless I've missed something.

Systemic currency risk is pretty common in developing countries -- I had a ringside seat for the nightmare that was Indonesia in 1997 -- but it's mildly surprising to hear it in the context of a middle-income country where (1) the currency has already lost half its value against the dollar in the last three years, (2) there's been either a trade surplus or a modest trade deficit for all of the last decade, and (3) there are very large foreign currency reserves.

I suppose (3) is irrelevant if the CB /wants/ the currency to fall, but that brings us back to (1) -- why hasn't a drop from 60 cents to 26 triggered a banking crisis; and if it hasn't, why would an additional drop do so?

Noel, we had the conversation about bond prices in Lula's first term, right?


Doug M.

We did have that conversation.

I'm sympathetic to the central bank's worries about further depreciation. Brazilian companies have a lot of dollar debt. (http://www.bloomberg.com/news/articles/2015-09-14/brazil-downgrade-leaves-firms-with-270-billion-debt-hangover.)

At some point the falling real will start to crush them. Where is that point?

The thing is, Federico sent me some data (that I'm going to post) which shows that Brazilian companies have gone to town with hedging their dollar debt against exchange rate risk. And if I understand it correctly, it looks like the central bank is the counterparty. So it is, sort of, taking depreciation risk off the hands of private companies.

The implication, then, is that the Brazilian central bank is more worried about depreciation feeding through into inflation than it is about balance sheet effects. Or it's worried about the long-term: hedges ain't infinite. If the peso falls, at some point companies with dollar debts will need to refinance or default ...

I think Doug's first point (the (1)) is a great one. Of course it's possible that the cash flow problems are just about to show up but given the BRL depreciation most people would have expected to see actual stories of companies defaulting because of FX move and there haven't really been a lot. As for why the BCB isn't cutting rates (which I take to be the question you raise) -- well there's basically two things going on. 1) The BCB is trying strongly to rebuild its credibility as an infl targeter. And based on its own internal models inflation is still expected to be slightly above target over the next 1.5 years. Many CBs would have said, screw it, we're placing more weight on output but the BCB really wants to rebuild credibility. 2) There's a fiscal policy issue. Right now expectations are that the Brazilian govt is the most fiscally profligate govt in Brazil's history (I'm only exaggerating a bit, ask the Brazilians) and that any move to ease monetary policy would be tantamount to the BCB saying that it's going to monetize the infinite desire of the govt to run deficits. So you can see why the BCB is sensitive to that.

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