April 20111 Edmar L. Bacha BRAZIL’S CURRENT MONETARY POLICY DILEMMAS Edmar L. Bacha Bank of Israel...

April 2011 1 Edmar L. Bacha

BRAZIL’S CURRENT MONETARYPOLICY DILEMMAS

Edmar L. BachaBank of IsraelApril 14, 2011


• Brazil’s macroeconomic policy framework

• Central Bank status and functions

• Economic policy performance

• Current economic conditions

• Monetary policy objectives and dilemmas with use of overnight interest rate and FX spot market intervention

• Search for ‘unorthodox’ policy instruments: credit restrictions, capital controls, and more diversified FX intervention

• Evaluation of current ‘unorthodox’ policies

SUMMARY


Macroeconomic policy framework since Jan’ 1999

• Inflation targeting (currently, 4.5% ± 2.0%)

• Floating exchange rates (w/regular CB FX intervention)

• Primary (ex-interest) public sector surplus (2011 target, 3% GDP)


Digression on Central Bank’s status• The CB is an autarky linked to the Ministry of Finance. But the CB Governor is a

cabinet level position since 2004, and, thus, responds directly to the President of the Republic. His appointment is approved by the Senate

• CB directors (7 to 8) are normally selected by the CB Governor in agreement with the Finance Minister. Subsequently, they are appointed by the President of the Republic, once approved by the Senate. CB Governor and directors can be freely dismissed by the President of the Republic

• Currently, the CB Governor and all directors are career civil servants. In previous years, at least some of them were selected in the local financial market or academia

• The yearly inflation target range is set for two years ahead by the Monetary Council, composed by the Finance Minister, the Planning Minister, and the CB Governor

• The CB’s Monetary Committee (≈ CB board) is responsible to maintain inflation on target. It meets every 45 days to set the SELIC (overnight) interest rate target for the subsequent period

• The CB operates in the FX market through electronic auctions open to authorized bank dealers


Economic policy performance

• Inflation: target range and actual 12mo inflation

• Wages and Unemployment

• Exchange rate (BR$/USD) and CB foreign exchange market interventions

• Current account deficit, capital inflows and international reserve accumulation

• CB international reserves

• Primary public sector surplus

• Public sector debt/GDP


Inflation

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: IBGE

IPCA inflation vs Central Bank target


Wages and Unemployment

5

6

7

8

9

10

11

12

13

14

2002 2004 2006 2008 2010

Unemployment rate and NAIRU - % - SA

Brazil’s NAIRU ( non-accelerating inflation rate of unemployment) at close to 7.5%

6.3

7.5

Real Wage Bill Index – Mar-02=100 - SA

90

95

100

105

110

115

120

125

130

135

140

2002 2004 2006 2008 2010

Source: IBGE; Itaú


1.5

1.8

2.0

2.3

2.5

2.8

3.0

3.3

3.5

3.8

-3700

-3200

-2700

-2200

-1700

-1200

-700

-200

300

800

1300ja

n/03

mar

/03

mai

/03

jul/0

3se

t/03

nov/

03ja

n/04

mar

/04

mai

/04

jul/0

4se

t/04

nov/

04ja

n/05

mar

/05

mai

/05

jul/0

5se

t/05

nov/

05ja

n/06

mar

/06

mai

/06

jul/0

6se

t/06

nov/

06ja

n/07

mar

/07

mai

/07

jul/0

7se

t/07

nov/

07ja

n/08

mar

/08

mai

/08

jul/0

8se

t/08

nov/

08ja

n/09

mar

/09

mai

/09

jul/0

9se

t/09

nov/

09ja

n/10

mar

/10

mai

/10

jul/1

0se

t/10

nov/

10Ja

n-11

BR

L / U

SD

(-) l

iqui

dity

inje

ctio

n /

(+

) liq

uidi

ty d

rain

ing

FX swapForeign currency loansSpot intervention (including fowards, since Jan-11)Redemptions of the dollar-linked debtAverage exchange rate (RHS)

Daily average US$ mn

Exchange rate and CB intervention

Source: BCB; Itaú

BCB’s Intervention in the FX market


Balance of Payments (US$ bn)

Source: BCB

-24.2 -23.2

-7.6

4.2

11.7 14.013.6

1.6

-28.2-24.3

-47.5

22.026.5

7.94.3

-9.4 -9.7

16.9

85.9

31.2

71.0

96.6

-2.3

3.3 0.38.5

2.2 4.3

30.6

87.5

3.0

46.749.1

-60

-40

-20

0

20

40

60

80

100

120

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Current Account Capital Inf lows International Reserves Accumulation


International Reserves

316

1.63

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

0

50

100

150

200

250

300

350

2001 2003 2005 2007 2009 2011

International Reserves (USD Bn - Right) Reserves/Imports Ratio (Lef t)

Source: BCB


Public sector primary surplus

Source: National Treasury, Itaú

1.6%

2.8%

0.5%

1.5%

2.5%

3.5%

4.5%

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Recurring Primary Fiscal Balance Central Bank's Primary Fiscal Balance

% GDP


Public sector debt/GDP

40.6

55.9

35

40

45

50

55

60

65

70

2006 2007 2008 2009 2010

Net Debt Gross Debt

Source: BCB, Itaú

Total Public Debt: Net and Gross (% GDP)


Current economic conditions

• Overheated economy • Inflation rate: high and rising

• Very high real interest rates

• Very appreciated currency

• Dependence on commodity-related exports

• Rising current account deficit


Overheated economy (growth of domestic demand)

3.7%

5.4%

7.8%

8.7%

4.3%

-2%

0%

2%

4%

6%

8%

10%

2000 2002 2004 2006 2008 2010 2012

Source: IBGE, Itaú

Domestic Demand (12 Months)


-20%

0%

20%

40%

60%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

...backed by strong growth of government spending and public banks’ credit expansion

Outstanding Loans (YoY)Total Government Expenses (inflation adj. 3-month YoY %)

Source: BCB, Itaú

Private Banks

Public Banks

7.4

0

4

8

12

16

20

2004 2005 2006 2007 2008 2009 2010

\


Inflation rate: high and rising (headline and ex-food and beverages)

Source: IBGE, Itaú

IPCA Index (12 Months)

17.2%

6.3%

5.0%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

IPCA ex- food and beverages IPCA

Itaú Forecast

5.9%


-10

0

10

20

30

40

502T

-96

4T-9

6

2T-9

7

4T-9

7

2T-9

8

4T-9

8

2T-9

9

4T-9

9

2T-0

0

4T-0

0

2T-0

1

4T-0

1

2T-0

2

4T-0

2

2T-0

3

4T-0

3

2T-0

4

4T-0

4

2T-0

5

4T-0

5

2T-0

6

4T-0

6

2T-0

7

4T-0

7

2T-0

8

4T-0

8

2T-0

9

4T-0

9

2T-1

0

4T-1

0

High real interest rates (Brazil’s and World’s, since 1996)

World

Brazil

Source: Itaú


Very appreciated currency (Big Mac X-rates)

Difference to the US Big Mac (USD)

Big Mac Index 2010

Source: The economist

Country DollarsSwitzerland 6.78Brazil 5.26Euro Area 4.79Canada 4.18

Japan 3.91United States 3.71Britain 3.63Singapore 3.46South Korea 3.03South Africa 2.79Mexico 2.58Thailand 2.44Russia 2.39Malaysia 2.25China 2.18

Israel 4.17

-2 -1 0 1 2 3 4

China

Malaysia

Russia

Thailand

Mexico

South Af rica

South Korea

Singapore

Britain

United States

Japan

Israel

Canada

Euro Area

Brazil

Switzerland


Dependence on commodity-related exports

21.7%

18.0%

10.8%8.5%

7.5%

6.8%

6.6%

20.1%

Main Brazilian Exports - 2010

Iron Ore & MetalsOther

Meat

Sugar and Ethanol

Machines, Equip. Incl. Electrical

Soya Complex

Transport Equip.

Oil, Fuel andChemicals

Exports (USD bn – 12M)

Source: MDIC

76

128

149

49

7061

0

20

40

60

80

100

120

140

160

1999 2001 2003 2005 2007 2009

Commodities

Non-commodities


Rising current account deficit

2.3

2.7

3.5

2.32.4

2.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2008 2009 2010 2011 2012

Current Account Deficit (12M)

Foreign Direct Investment (12M)

% GDP

Source: BCB; Itaú

Forecasts


Current monetary policy objectives and dilemmas in the use of the Selic interest rate

• Main current policy objective is to cool off the economy to bring inflation back to target

• Problem is that fiscal stance and public banks’ credit expansion provide little help to the CB

• Raising an interest rate that is already very high is costly and induces further exchange rate appreciation

• CB as a consequence is following a gradual path of interest rate tightening, hoping to bring inflation to target by 2012


Gradual monetary tightening

8

10

12

14

16

18

20

22

24

26

28

2000 2002 2004 2006 2008 2010 2012

Itaú Forecast

Source: BCB; Itaú

Selic Target Rate

12.25%

11.50%11.25%


Current monetary policy objectives and dilemmas in the use of FX spot market intervention

• Second objective is to prevent FX volatility resulting from ‘speculative’ capital flows – while supposedly not intervening to avoid FX fluctuations related to ‘fundamentals’

• (Regressions of the BRL/USD on the CRB commodity price index, the 10y Brazil’s CDS spread over Libor, the DXY index of the dollar against major currencies, and the lagged BRL/USD, yields good statistical results)

• This is the FX intervention objective as seen from the CB’s perspective. The Finance Ministry is also concerned with the negative impact on manufacturing of ‘fundamental’ X-rate appreciation ( because of ‘deindustrialization’)

• Problem is that sterilized intervention in the FX market is very costly (because of very high domestic interest rates)


Current search for ‘unorthodox’ monetary policy interventions-I • Control of domestic demand through restrictions on domestic

credit expansion, introduced as ‘macroprudential measures’ (Dec’03, 2010)

• Higher reserve requirements on bank deposits (from 23% to 32% on CDs, and from 51% to 55% on demand deposits)

• Higher capital charges on banks’ consumer credit w/maturity over 2 years


Current search for ‘unorthodox’ monetary policy interventions-II• Fighting FX appreciation through capital controls and more diversified FX

market intervention

• Tax on ‘speculative’ capital inflows (Oct’4 2010: IOF tax up to 4% on fixed income flows from 2% previously; Oct’18, 2010: IOF tax up to 6%, including margin on derivatives)

• Restrictions on local banks short spot FX positions (Jan’6, 2011: max exposure, $3 bn)

• Intervention in the future FX market (reverse swaps reinitiated on Jan’ 13, 2011)

• Intervention in the forward FX market (starting from Jan’25, 2011)

• CB FX acquisition for the Treasury (Oct’5, 2011: extension of foreign debt prepayment coverage to 4y from 2y previously) and for the Sovereign Fund (not yet activated)


Interventions had little effect...


...or did they have some?

Extended UIP

Source: BCB; Itaú

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2006 2007 2008 2009 2010 2011BRL Dynamic Forecast Static Forecast


Evaluation of current ‘unorthodox’ monetary policy stance on demand control• Gradualism in interest rate tightening prolongs inflationary spell and

reinforces semi-dormant indexation mechanisms

• Restrictions on credit expansion should be designed to ensure financial stability, nor to control domestic demand, as they result in higher distorting bank spreads

• It’d be much better to give the monetary authorities power to control the expansion of subsidized credit expansion by the public banks (30% of total)

• Economic policy requirements for a lower real ‘equilibrium’ interest rate remain a highly contested academic topic. But a lower public debt and a longer-term commitment to low inflation (as signaled by a more independent CB) would help


Evaluation of current ‘unorthodox’ monetary policy stance: X-rate policy

• Preventing FX appreciation is self-defeating because it gives speculators a ‘one side bet’, induces Brazilian firms to borrow abroad, and dampens the FX-channel of inflation control

• Interventions in the spot market are very costly to have effective FX impact. Marginal gains of operating futures and forwards seem limited

• ‘Soft’ capital controls tend to be by-passed in Brazil’s highly sophisticated financial market

• ‘Hard’ capital controls seem inconsistent with Brazil’s increased openness and need for foreign capital

• “Leaning against the wind" (not fixing) may be a good reason to intervene, if there is uncertainty on the future course of ‘fundamentals’ (like commodity prices). Except for this, it seems better to let the X-change appreciate /fluctuate freely to contain speculation, foreign borrowing, and inflation

• Abundant international reserves may later be used to smooth the required X-rate devaluation, when-and-if a sudden stop of capital inflows occur


Thanks for helpful discussions to Darwin Dib, Marcio Garcia, Sergio Goldenstein, Ilan Goldfajn, Eduardo Loyo, Alkimar Moura, and Livio Ribeiro. Thanks to Natasha Daher and Italo Franca for research assistance. Graphs 5-12, 14-20 and 26 prepared by the economic team of Banco Itaú Unibanco. Graph 25 prepared by the economic team of Banco BTG Pactual.

TODAH RABBAH

April 20111 Edmar L. Bacha BRAZIL’S CURRENT MONETARY POLICY DILEMMAS Edmar L. Bacha Bank of Israel...

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