Brazil’s high inflation, waning growth and troubled government finances have concerned credit analysts’ for some time. Moody’s is the latest ratings agency to act on Latin America’s biggest economy, knocking it down a notch to Baa3, its lowest investment grade rating, in August.
The move came after President Dilma Rousseff slashed the government’s primary surplus target to 8.747 billion reais ($2.5 billion), a roughly 87% decrease from the original 66.3 billion reais target, in June. Finance Minister Joaquim Levy pointed to a decline in tax revenues as the main cause for the adjustment.
Rousseff also cut $8.6 billion reais in government spending. The move in fiscal policy comes as the central bank’s monetary policy committee has been aggressively hiking interest rates to combat inflation.
Socking away foreign currency reserves, strengthening the financial system with a move to Basel III rules and tackling inflation should strengthen the country’s defenses, Luiz Awazu Pereira da Silva, deputy governor of Brazil’s central bank, tells LatinFinance.
Brazil’s latest approach to monetary policy is two-fold. On the one hand, the central bank has been looking to get on the offensive when it comes to anticipating externalities and their potential impacts, according to Pereira. But on the other, much of Brazil’s monetary policy is an extension of coping with the global financial crisis and its consequences.
Regardless, short-term pain for long-term gain is crucial for understanding the policy shifts. “Once you are adjusting, perseverance is of the essence because policies take time to produce their intended effects. That’s exactly what we’re doing this year,” says Pereira da Silva, who is due to begin a five-year term as deputy general manager of the Bank for International Settlements on October 1.
In his final months at Brazil’s central bank, where he has been since 2010, Pereira da Silva spoke to LatinFinance about central banking in Brazil and Latin America. This is an edited transcript of the conversation.
LF: During the past 20 years, the Brazilian economy has experienced some volatility. What is your take on the current situation in light of your experience during all these years in Brasilia?
LP: Policy-making is a lot of art with a bit of science. It consists of understanding political economy constraints and combining them with sound analytical judgment to identify where to improve policies by continuously adjusting and reforming. Once you are adjusting, perseverance is of the essence because policies take time to produce their intended effects. That’s exactly what we’re doing this year.
In 2015, Brazil is undertaking a classical adjustment process to reduce macro imbalances in its fiscal and current accounts and the adjustment is working. Inflation is high due to a relative price adjustment in early 2015, but monetary policy is addressing its second round effect to put inflation on target by the end of 2016 and anchor expectations. Initial results are showing we’re on the right track, but as with any country and any adjustment process, there are ups and downs. That’s why, despite these ups and downs, we preserve a cautious optimism in Brazil because we’ve seen all sorts of crises, always recovered, and managed to enhance our potential.
The Brazilian experience might be useful to illustrate how we strengthened our policy framework to face the global financial crisis and its consequences. First, we kept an independent monetary policy and acted with determination to address domestic inflationary pressure coming from external exuberance. Second, we reinforced the robustness of our Basel III-compliant financial system to tame the rise of excessive financial risk. Third, we added macro-prudential policies to avoid excessive domestic credit growth. Fourth, we used foreign exchange interventions to smooth volatility and provide forex hedges to our domestic firms. Finally, now that we are approaching the prospects of a forthcoming rate rise in the US, we’re further tightening our fiscal and monetary policies.
LF: How will Brazil be able to absorb the change in US monetary policy? Will higher US interest rates mean capital outflows and exchange rate volatility? What is being done to mitigate the impact of this potentially destabilizing measure?
LP: Brazil has been preparing itself for changes in global monetary conditions that we knew would come. We are now entering the, hopefully, final phase of the global financial crisis where we expect episodes of greater volatility in the wake of normalization of monetary policy rates especially in, and beginning with, the US.
Whether one anticipates a [US Federal Reserve] rate-hiking scenario similar to 1994, which was less orderly in terms of how short-term rates transmitted to longer-term rates, or 2004, which was more orderly, and irrespective of the important efforts by the Federal Open Market Committee to communicate its policy stance and prepare markets as well as it could, the textbook recipe is to strengthen policies. And our framework is precisely being strengthened on both the fiscal and the monetary front. We also have a solid financial system, with an intrusive supervision with the relevant and timely information about vulnerabilities so that the regulator can act preemptively.
Finally, while keeping the floating exchange rate regime as a first line of defense, it is useful to smooth excessive exchange rate volatility that can affect financial stability. In Brazil, we have many well-tested tools, including our strong derivative market to provide hedges to our private sector, and this will allow us to sail through the monetary policy normalization period.
LF: How vulnerable is Latin America to rising US interest rates, the China slowdown and low commodity prices? Is there enough regional central bank policy coordination?
LP: The recent slowdown in China, together with the growth in global supply led to the fall in commodity prices in recent years, a movement that has intensified since mid-2014 and is also propped by the rise of the dollar. Lower commodity prices affect emerging market economies (EMEs) through different channels, positively and negatively depending on specific macroeconomics and trade positions, through changes in the terms of trade, capital flows and fiscal revenues. Currently, commodities represent on average more than 50% of the total exports of Latin American countries. The recent downward movement in commodity prices has been a vector of a temporary slowdown in economic growth, and revisions of public finance and also external account positions in Latin America.
Prospects for monetary policy normalization in the US have strengthened the dollar and weakened Latin America’s currencies, raising financial market volatility since mid-2014. From July 2014 to July 2015, the dollar index appreciated about 18%, while the CRB Index fell about 20%. Note that from the standpoint of market expectations, most of the adjustment in commodity prices and also on the exchange rate of the dollar have already happened.
All EMEs and Latin American countries in particular, had experienced in the past these swings in market sentiment and forex rates and therefore, prudently have accumulated high levels of foreign currency reserves that help mitigate the spillover effects of the normalization of monetary policy by the Fed and the deterioration in the terms of trade due to falling commodity prices.
In Brazil, foreign currency reserves increased to $370 billion in 2014 from $32.4 billion in 2000; in Mexico, to $190 billion in 2015 from $35 billion in 2000; in Colombia, to $46 billion in 2015 from $9 billion in 2000. In addition, most Latin American countries have relied upon flexible exchange-rate regimes and deeper financial markets, which allow firms to access hedge mechanisms more easily in order to mitigate exchange-rate risk. In addition, many EMEs, and Brazil is a case in point, have strengthened their policy frameworks to sail through these events. Finally, the Fed has highlighted that the adjustment of its monetary policy will likely take place gradually and that will help contain shocks in financial markets and avoid excessive capital flow volatility.
LF: Would you say that the current external environment is a positive or a negative for Brazil? What are the most important factors?
LP: All EMEs will have to adapt to what seems to be the end of the commodity super-cycle and the beginning of monetary policy normalization in the US. As I said, policy-making is a permanent process to continuously adjust and reform under evolving constraints. China’s growth is converging to a new “mean” due to a model shift. But growth in the post-global financial crisis global economy, new EMEs and other advanced economies are still in need of commodities. So, I expect at some point a stabilization of commodity prices where Brazil has still innumerous comparative advantages even at lower levels for international prices.
Nevertheless, we are also looking to open up our markets, gain competitiveness in other exports and increasing total factor productivity in Brazil. Monetary normalization in the US comes on the back of a growth recovery there, and the spillover to Brazil would probably outweigh some negative effects from, say, episodes of financial volatility. LF