Brazil: capital control distortions upon distortions

By Win Thin

With regards to the BRL outlook, it’s about a week later and it seems markets are still trying to fully digest FX measures from Brazil. Before delving into the details, we want to stress that it is very clear that Brazil is moving further and further away from the orthodox model due to its obsession with the strong real. While the IMF said today in its Article IV discussions with Brazil that capital controls are an “appropriate” tool, the agency also warned that they can be “distortionary.” We think that with so many regulatory measures seen over the past year, there are now distortions upon distortions. We are detecting increasing exasperation on the part of investors and banks with the arbitrary nature of these controls, along with the Law of Unintended Consequences. For now, global investors want to stay in the BRL trade, but Brazil policy-makers are really walking on a razor’s edge right now, especially as the global backdrop turns more negative for EM.

On July 27, Brazil’s government created a legal framework that basically gives the executive branch power to take measures on the FX derivatives market, and so Finance Minister Mantega imposed a 1% IOF tax on BM&F (onshore) FX contracts. It also set a maximum potential rate of 25%, leaving the implicit threat of further IOF hikes if the exchange rate does not behave as desired. The result has been elevated uncertainty in the markets and a rush for onshore banks to cover their short USD positions. Furthermore, onshore banks are attempting to replace these USD shorts with positions in the offshore NDF market. However, the offshore NDF market is highly dependent on those same BM&F contracts for execution and hedging and so at this point, there is nowhere to hide. For now, higher transaction costs and lower liquidity seem to be the norm, and wider bid/ask spreads will remain in place in the offshore NDFs.

How confusing are things? So confusing that Brazilian officials don’t quite yet seem to have figured out the full impact of the measures on the wider economy. There are reports that Brazil companies with legitimate hedging needs are complaining about higher hedging costs due to the latest FX measures. It is possible that the authorities will somehow exempt such corporate activity, but it is too early to say. Most recent statement from the government confirms it is “to consider adjustments to tax on derivatives and to help hedgers”. Furthermore, Brazil is reportedly mulling steps to curb vehicle imports, perhaps by raising tariffs. We are entering into a period of heightened regulatory uncertainty, and that is not good for market conditions in either offshore or onshore Brazil markets. We note again that exports/GDP for Brazil is less than 10%, and that the negative impact on the economy from a strong real appears limited.

Despite the dislocations described above, it is noteworthy that spot BRL has seen limited impact and is currently trading near 1.58, with recent weakness driven largely by overall EM softness. Besides ongoing risk from negative DM developments, investors will certainly be nervous of further measures if we trade back below 1.55 towards the 1.5290 low that preceded these FX measures, so we expect choppy conditions ahead. We have in the recent past been confident that the medium-term BRL appreciation trend remains intact. However, our confidence has been dented somewhat by the arbitrary regulatory environment that is developing in Brazil. Our advice to Brazil (and the rest of EM) remains the same: accept the stronger currency, and be careful what you wish for. Continued distortions and policy flip-flops will eventually damage investor confidence, which can have outsized consequences via a plummeting currency. Turkey presents a good example of the risks Brazil faces if policy slippage continues, especially in this current environment where investors are not very forgiving of countries making policy mistakes.