WRAP:Brazil Free Float Praised,But Fiscal Questions Linger
Dow Jones Newswires
NEW YORK -- Brazil's central bank gave the market what it wanted when it confirmed Monday it was sticking with a free-float foreign exchange regime, which should stanch the hemorrhaging of international reserves.
But while its decision to free the real (BRR)($1=BRR1.43 at Friday's close) lifted one big question on investors' minds, analysts say worries remain over whether Brazil's executive can push long-promised fiscal reforms through Congress.
"In general this (free-float) system has a lot of advantages," said Mauro Schneider, chief economist at ING Barings in Sao Paulo. "But I think that Brazil has still got to do a lot of homework on the fiscal front to reap more advantages than disadvantages from this system."
As reported, Brazil's central bank said early Monday it would continue with the free-float regime it adopted on an ad hoc basis Friday, after markets responded unfavorably to Wednesday's widening of the real's trading band.
The central bank added Monday it would reserve the right to intervene in the foreign exchange market "occasionally and in limited form with the goal of containing brusque movements" in the real.
"It is the best option under the circumstances," said Janet Krengel, an emerging markets economist with Merrill Lynch in London, of Monday's move, which had been widely predicted. "Any attempt to reinstitute the band for the system will only be tested again fairly soon."
Set free, Brazil's real continued to weaken Monday, trading at BRR1.55 per dollar at midsession after ending Friday at BRR1.43/dollar. The currency had ended Thursday at its band ceiling of BRR1.32/dlr, after weakening 8.2% on the heels of Wednesday's adjustment in the band.
Sao Paulo's key Bovespa stock index, meanwhile, was 7.4% or 497 points higher to 7,244 at midsession after a historic 33% rally Friday that followed a series of sharp declines.
Currency traders in New York said reaction to Brazil's official floating of its currency would be muted Monday as participants await the reaction of the U.S. stock market, which is closed Monday in observance of the Martin Luther King Day holiday.
Analysts said the policy decision - made public after senior Brazilian government officials huddled over the weekend in Washington with U.S. and multilateral counterparts - should ease pressure on the country's reserves.
Brazil's net foreign exchange outflow Friday totaled $318 million - down sharply from the $4 billion that fled the country in the four previous sessions when the central bank was still defending the real. Some $45 billion has flown out of Brazil since the start of August, cutting reserves to about $30 billion, according to market estimates.
But foreign exchange analysts on Wall Street are now training their eyes on Brazil's political process, where a package of fiscal reforms has been delayed and some states are pushing hard to renegotiate debt payments.
Confidence levels could get a boost if Brazil's Congress can pass two hotly contested measures Wednesday to reform the pension system and introduce a financial services tax - two moves that would help the country reach fiscal targets hammered out with the International Monetary Fund as part of a $41.5 billion multilateral bailout program.
But analysts warn confidence could sink further if Congress balks at some of the cost-cutting measures and more state leaders join Minas Gerais Governor Itamar Franco, who rocked markets earlier this month when he declared a 90-day moratorium on debt payments to Brasilia.
In the best-case scenario, Brazil's central bank would find room to reduce interest rates - one of the government's stated intentions - without putting the real under pressure.
"They are going to have to get some confidence in the policy side and some stability in the currency side and once those two things are in place, then maybe you can get some lowering of interest rates," said Andrew Chaveriat, analyst with Paribas in New York.
Lower interest rates are seen as essential if Brazil's economy is to escape serious recession. Interest rate futures maturing in February were carrying annual rates of 32.25% Monday, down from 32.75% at Friday's close - and one currency trader in Rio de Janeiro predicted they could fall to between 20% and 25% when Brazil's monetary policy committee meets Jan. 27.
Others are more sanguine, however, citing the need to avoid a sudden sell-off in the currency.
"I think they are just going to take their time here and keep rates at attractively high levels," Chaveriat said.
A weaker real could raise the specter of inflation - something that had been banished under the trading band regime - and hurt growth prospects. Last week, Merrill Lynch said it expected the Brazilian economy to contract 4.4% in 1999, after having predicted only a 1.5% contraction earlier.
Aside from the fundamentals, however, it will be global investor perception that holds the key to Brazil's near-term future.
"To the extent that the international community comes out with a strong endorsement of this policy is critical at this juncture," said Joe Petry, Salomon Smith Barney's chief Latin American economist in New York.
As reported, IMF Managing Director Michel Camdessus on Monday said he was very satisfied with weekend conversations between Brazilian Finance Minister Pedro Malan and the IMF. But he also appeared to turn up the heat on the domestic political front, saying he welcomed the Brazilian government's "reaffirmation of fiscal consolidation as the foremost priority."
Projections for the real's near and medium-term performance were mixed, according to traders and analysts.
In morning trading in New York Monday, one-month non-deliverable forward contracts for the real were trading at around BRR1.5460 to the dollar - very close to spot market rates being quoted in Rio de Janeiro.
One New York-based foreign exchange broker said there is so much uncertainty surrounding the future performance of the newly floated currency that the NDF market is simply following the spot market. Demand has been focused on one-month contracts, rather than longer-dated contracts, for the same reason, the broker added.
Merrill Lynch is meanwhile forecasting that the real will end 1999 at BRR1.60 to the dollar.
"We think there is a good chance that it (real) can stabilize around current levels in the short term, but once the inflation impact is felt we would expect it to slip further," said Merrill's Krengel.
ING Baring's Schneider also predicted the real would continue to trade around recent levels - as long as there is no upheaval on the political front.
Marc Chandler, a New York-based independent market analyst, also warned that signs of a protracted political dispute over funding and interest rate policy could weigh on the real.
He said the break Monday above BRR1.50 to the dollar was a breach of a "key threshold level" that portends further volatility in the currency before it finds a fair value.
Brazil's central bank has meanwhile been mum on what guidelines it will use in determining whether to intervene in the foreign exchange market to contain "brusque" movements.
Central Bank President Francisco Lopes said upon his return to Brazil from Washington Monday that the bank hadn't set specific limits for when it would intervene, the news agency Estado reported.
He did say that Monday's intraday exchange rate, quoted at BRR1.52/dollar at the time, was within expectations, according to Estado.
-Dow Jones Newswires reporters in Sao Paulo, Rio de Janeiro, Brasilia, New York and Washington contributed to this article.
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