BRAZIL´S OUTSOURCED FOREIGN-EXCHANGE POLICY / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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MAY 10, 2011.

Brazil's Outsourced Foreign-Exchange Policy .
By LIAM DENNING


Brazilian monetary policy is set in Brasilia, right? Try Beijing, Frankfurt and Washington instead. Foreign investors should take note.

Brazil is in a bind. Despite better-than-expected April consumer-price data released last week, inflation of 6.5% is far above the central target of 4.5%. While seasonal declines in food and fuel prices should help over the next few months, core inflation is proving stubborn.


Brasilia is sensitive to this, given a history of hyperinflation. That's one reason for an eye-watering real interest rate of almost 6%. But this attracts foreign speculators. Despite measures against them like targeted taxes, Brazil's currency, the real, has strengthened steadily against the dollar. Exporters are hurting, with the head of Siemens' Brazilian operations warning currency controls might be necessary to prevent "deindustrialization."


Looking at those real rates, though, raising Brazil's cost of capital by enacting currency controls isn't advisable. The country suffers from weak fixed-asset investment already, which worsens inflation via logistical bottlenecks owing to poor infrastructure.


If Brazil remains committed to a flawed policy of targeting both inflation and the exchange rate, it must rely on others to help out. Last week's pullback in risk appetite helped on several fronts. It not only likely deterred some hot-money inflows, but also strengthened the dollar and cooled commodities prices.


Looking ahead, any Greek restructuring crisis also likely would pressure the real as investors bought dollars. Ultimately, though, Brazil needs tighter U.S. monetary policy. A stronger dollar would curb inflationary commodities prices and, by strengthening the dollar-linked yuan, make imports from its largest trading partner, China, less competitive.


It's a risky bet to make. Absent these stars aligning, Brazil's exporters should brace for further pain, and investors for higher interest rates.

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