SAO PAULO/RIO DE JANEIRO, Nov 11 (Reuters) - Brazil's high and rising interest rates are likely to keep attracting bond investors next year despite the country's struggle with a deteriorating budget, high inflation and low growth.
Foreign investors have snatched up a heavy $6 billion worth of Brazilian debt per month, on average, since policymakers removed some capital controls in June and the U.S. Federal Reserve signaled it would take time to wind down its bond-buying program, which has boosted demand for emerging-market assets.
That appetite is set to continue at a solid pace despite a recent currency drop, a weakening in Brazil's fiscal performance and risks of a downgrade to its sovereign credit rating, although it may moderate in coming months.
In a break from recent years, when Finance Minister Guido Mantega erected capital controls to stop inflows from distorting the economy, policymakers are now welcoming foreign money as they try to smooth out the currency's recent weakening trend.
Even when the Fed eventually starts slowing down its asset-purchasing program, analysts and investors say Brazil may avoid a reversal of capital flows as it offers one of the highest returns for an investment-grade debt issuer.
"I'm not particularly worried about having a position in Brazil. Bond yields are high, both historically but also compared to other countries in emerging markets," said Jan Dehn, head of research at Ashmore, a fund manager dedicated to emerging markets with $78.5 billion under management.
While other emerging markets such as Mexico have recently loosened monetary policy, Brazil has raised its benchmark Selic rate by 2.25 percentage points since April to the current 9.5 percent, becoming one of the highest in the world.
The rate is widely expected to return to double digits as soon as this month as the central bank tries to curb inflation, which has remained uncomfortably close to the official target ceiling of 6.5 percent even as economic growth disappoints.
Dehn said recent sell-offs in Brazilian markets, usually caused by hedge fund selling and pessimistic local investors, often create an opportunity for institutional investors to buy.
In the latest of those sell-offs, yields paid on long-term contracts of interest-rate futures jumped after Brazil posted a primary budget gap of 9 billion reais ($3.85 billion) for September, the largest in nearly five years.
"If you compare Brazil to a lot of other countries, it's actually less negative than people think. I'm actually even a little positive," Dehn said, arguing that President Dilma Rousseff will likely make sure the economy remains stable next year before October presidential elections. Risks of a debt default are also seen as low.
One of the recent policy shifts that made Dehn more optimistic was the government's June decision to scrap the so-called 6 percent IOF tax on foreign purchases of local debt.
The tax was Brazil's strongest barrier to foreign inflows, introduced during the height of what Mantega dubbed a "currency war" that was damaging local industry.
Since its removal, monthly inflows to local bonds and other fixed-income instruments soared to $6 billion a month from just $800 million during the first five months of 2013, on average.
Foreigners bought a net $7.2 billion in September alone, a record high, pushing foreign holdings of government debt to 17.2 percent of total outstanding debt, from 14.4 percent in May.
Pent-up demand from investors who stayed out of Brazil to avoid the IOF tax explains part of the sharp rise, and suggests the current rapid pace of inflows is likely to moderate.
Still, net foreign investment in Brazil's debt could reach $20 billion next year, one of the highest levels since the real was introduced in 1994, said Carlos Kawall, chief economist at J. Safra and a former Brazilian Treasury secretary.
"Foreign holdings of Brazilian debt can go as high as 20 percent next year," he said.
The main risk to that scenario is a volatility spike in the exchange rate, or in the local interest rates yield curve.
Instability has already been a drag on the carry trade, a risky strategy in which investors borrow in low-yield countries to leverage their gains in high-yield currencies such as Brazil's. Carry trade investors need some stability in the currencies they play with, as hedging those operations is often too expensive.
If the recent deterioration in Brazil's fiscal policies leads to even stronger market swings, then institutional investors could start to have second thoughts too.
But for now, investors and economists interviewed by Reuters consider that fiscal deterioration concerns have mostly been priced into risk premia, as well as fears of a credit downgrade by at least one ratings agency next year.
If that holds, more dollars should pour into Brazil again once interest rates peak, forecast Siobhan Morden, head of Latin America strategy with Jefferies in New York.
"The fact that foreign holding of local fixed income is going higher means that there is conviction that we're at the end of the (monetary tightening) cycle," she said. "Once the central bank signals that they have concluded, that could be a catalyst (for) more inflows."
($1 = 2.3367 Brazilian reals)
(Editing by Brian Winter and Krista Hughes)