Minutes from the December 7/8 COPOM meeting in Brazil are worth commenting on. The central bank put a lot of weight on its decision to hike reserve requirements December 3, calling it a “fast and powerful” tool to contain domestic demand pressures. Some are taking this as a dovish slant with regards to SELIC rate hikes, but we disagree and continue to look for a 50 bp hike in January. In our view, reserve requirement hikes shouldn’t be seen as a substitute for policy rate hikes, but rather a complement. From what we’ve seen historically in EM tightening cycles, reserve requirement hikes are often the first step in the cycle and are later followed up with policy rate hikes. Can reserve requirement hikes take some of the pressure off of central banks to hike policy rates? Possibly, but we are more bullish on the Brazilian economy and believe that COPOM must continue to hike both over the course of 2011. Brazil price pressures are largely demand driven, in our view, and with the economy continuing to growth above trend (thought to be around 4.0-4.5%), we see fairly aggressive tightening ahead.
We do acknowledge that October data was on the soft side, but with fiscal policy still expansionary and much spending in the pipeline due to the 2014 World Cup and the 2016 Olympics, we think momentum will remain strong in the economy. We can understand why EM policy-makers (not just Brazil) are relying more on reserve requirement hikes, since higher policy rates risks further inflows of hot money and more currency strength. We continue to look for further IOF hikes if the tightening cycle leads to further BRL gains. Despite the recent EM correction, BRL is holding up well and remains smack in the middle of the 1.65-1.75 range seen in Q4. We have been impressed by BRL resilience in general, and foreign investors are likely satisfied with basic BRL stability when collecting interest payments. Further intensification of the euro zone crisis would very likely drag USD/BRL back toward 1.75, where buyers have generally emerged and prevented trading above that level since September 1.
