Brazil Monetary Policy Uncertainty Continues

by Win Thin

Brazil press is reporting that President-elect Rousseff won’t ask central bank chief Meirelles to stay on after she takes office January 1, and repeats earlier speculation of changes to the economic team.  We have been warning for quite some time that markets were too complacent about political risk under Rousseff, and we continue to think we are likely to see a shift in Brazil risk assessment in the coming months.  If Meirelles were to be replaced, we think it would be taken very negatively by the markets.  Lula correctly kept a hands off approach to monetary policy during his administration, but markets will need confirmation from Rousseff that she will do the same.  Remember, the central bank does not have legal independence but has enjoyed practical independence under Lula and before that under Cardoso.  Ultimately, we believe Rousseff will maintain orthodox policies, but uncertainty will likely weigh on the Brazil outlook near-term.

In our view, Brazil needs higher interest rates, not lower, as momentum in the economy remains strong.  Market is looking for 12% rates for end-2011, up from 11.75% last month.  We think markets are underestimating tightening potential, and think that rates could move as high as 12.75% next year.  That is likely to lead to more adjustments in the IOF tax, as the market appears to be in a sort of “equilibrium” with policy rate at 10.75% and IOF tax at 6%.  Fiscal policy remains very accommodative, and there is also spending in the pipeline due to the 2014 World Cup and the 2016 Olympics.  As such, the brunt of the adjustment is likely to be borne by monetary policy.  Market is looking for growth to slow to 4.5% next year from an expected 7.6% this year, but we think the risk is for something closer to 5.5%.  With trend growth for Brazil thought to be around 4.0-4.5%, that’s why we think tightening will end up being more than expected in 2011.  Mid-November IPCA inflation out this week is expected to show a rise in the y/y rate to 5.3% from 5.0% in mid-October.  

For now, USD/BRL remains range-bound in the 1.70-1.75 area.  We continue to believe that other measures will be rolled out on any significant break towards 1.65.  As a result, we think that the year’s low around 1.6440 is unlikely to be tested anytime soon given the increased Brazil risks, and so BRL may have to weaken a bit more above 1.70 before more bargain hunters emerge in force.  Markets will look to see how the new cabinet shapes up for clues  to policy, with a focus on whether Finance Minister Mantega returns and also if other well-respected officials such as Meirelles, Bernardo and Palocci will remain market-friendly influences on the administration.