While visiting Germany in early March of last year, Brazilian President Dilma Rousseff talked about her determination to protect her country's manufacturing sector from the rising real. She apparently thought that the strengthening of the Brazilian currency was caused by a "monetary tsunami" unleashed by expansionary credit policies in the euro area and in the United States. Her administration, grabbing the financial headlines with "currency war" slogans, then went on to weaken the real by buying the dollar.
President Rousseff's German hosts may have shared her misgivings about extraordinarily easy monetary policies, but they might have reminded her that this was necessary to offset an equally extraordinary fiscal tightening, and to pull the U.S. and European economies out of a looming recession. As a trained economist, President Rousseff probably needed no reminder. She certainly knew all that as she undoubtedly understood that a strong and coordinated American and European effort to support their economies and expand world export markets was good for Brazil's sales to the rest of the world.
Brazil, however, was serious about its intention to drive its currency down. In the year to last October, its holdings of U.S. Treasurys rose by $25.8 billion – a sum roughly equivalent to the increase in Brazil's foreign currency reserves over that period.
It is a good bet that this was not the kind of advice President Rousseff got during her visit to Germany – the country with vast experience in managing currency fluctuations, which became the world's largest exporting nation despite the near tripling of the D-mark's value against the dollar between the early 1950s and the time it entered the euro in 1999.
Benefits of a Strong Real
Instances of sustained demand-supply imbalances of a particular currency are always signals of a need for policy change. That is ultimately what currency interventions end up with, despite efforts to "sterilize" their short-term impact. Only an appropriate policy change can restore exchange rate stability.
Selling the real may provide a temporary relief, but it won't shield Brazilian manufacturers from imported products of standardized technology relying on price competition. It would be better to lower manufacturing costs through productivity gains, lighter tax and regulatory burdens and technological innovation.
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Just like Embraer has done – Brazil's world beating company producing short-range aircraft in a market dominated by Airbus, Boeing, Bombardier and now the Russia's Sukhoi Superjet.
A strong real would improve Brazil's terms of trade because foreign demand for its main exports – food, energy and raw materials – is less price sensitive than demand for mass- produced medium- and low-tech products. Brazil is now one of the world's largest exporters of food and agricultural products. World food prices last year increased 9 percent (in dollar terms) while prices of industrial goods rose only about 4 percent.
With its huge oil and gas reserves, Brazil is currently the ninth-largest oil producer in the world, and is on the way to becoming one of the top five in the years ahead. Energy exports will therefore remain a big source of foreign currency earnings, giving a strong upward bias to the exchange rate.
That is a trend that should be welcomed rather than resisted because a strengthening real will help control inflation and create a stable setting for steady and sustainable growth. Indeed, price stability being one of Brazil's old stumbling blocks, a strong currency would be a major contribution to the country's economic stability.
Here is an example. In spite of a virtually stagnant economy, Brazil's inflation in November (the latest observation available) was 5.5 percent, about one percentage point lower than a year before, and still above the official mid-point target of 4.5 percent. The question is: What will happen to inflation once the full devaluation impact is reflected in domestic prices, and once the economy begins to accelerate in the months ahead as a result of stimulus packages, large infrastructure projects (for World Cup in 2014 and Olympic Games in 2016) and record-low borrowing costs?
Obviously, a stronger real would be very helpful.
Learning to Live With a Strong Currency
A gradual tightening of current credit conditions is unavoidable. That could damage growth prospects if all the burden of stabilization were to fall on monetary policy. Allowing a stronger currency, implementing structural reforms to create more competitive labor and product markets and improving infrastructure would better serve objectives of faster and more balanced noninflationary growth.
Some measures along these lines are being taken. President Rousseff continues to consult with business leaders on changes they would like to see, and it is possible that further actions to improve economic efficiency will follow.
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Trade with China and Africa also offer opportunities to support faster growth through stronger exports and more diversified markets for Brazil's manufacturers.
China has been Brazil's biggest trading partner since 2009, investing in energy and mining and buying huge amounts of commodities Beijing needs to modernize its rapidly growing economy. A 60 billion real ($30 billion) currency swap line with China will facilitate bilateral trade and smooth out problems in trade relations. China's commitment to buy more manufactured products from Brazil will also help. A $1.4 billion purchase of Embraer planes is a good start.
Brazil is successfully pursuing closer economic relations with Africa, where its large companies are operating in strategic sectors like infrastructure, mining and energy. Africa is also a growing market for Brazil's exports of food, seeds and farm technology. In addition to that, Brazil is forging its broad partnership with Africa by helping to alleviate the continent's problems of malnutrition and healthcare.
Festival of Soccer, Samba and Sun
In spite of slower than expected growth, Brazil's equity markets continued to improve over the last 12 months, but they still substantially underperformed the emerging markets average. In dollar terms, the Bovespa index was also overshadowed by other major Latin American markets, partly as a result of Brazil's 10 percent currency devaluation.
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While there are concerns about the country's prospect of managing a sustained noninflationary rebound of economic growth, there are no pressing policy constraints because trade and budget balances are currently estimated at about 3 percent of GDP. As in the past, domestic demand will remain the key driver of economic activity. Some help will also come from exports as a gradual strengthening of world economy stimulates demand for Brazil's farm products, energy and raw materials.
And, don't forget, intensive preparations for the festival of "soccer, samba and sun" during next year's World Cup will give a big boost to the economy.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia