REPEAT: Real's Future Fair Value In Brazil Congress' Hands
By MICHAEL CASEY
Dow Jones Newswires
NEW YORK -- In its first few days as a free-floating currency, the Brazilian real has seen plenty of what the previous managed exchange rate regime sought to avoid: volatility.
Now, its up to the market to find the currency's so-called "fair value." And while a vague consensus seems to gather around a figure of BRR1.5500 to the dollar, only the boldest pundits make near-term real forecasts with conviction.
High interest rates - made even higher by an increase in the Brazilian Central Bank's interbank lending rates Tuesday - will put upward pressure on the real at the same time that concerns over political opposition to a government austerity program will work in the reverse. Ultimately, the picture will remain unclear, analysts say, until Brazil's government overcomes Congressional resistance to enact key reforms.
In a staggered devaluation that culminated Monday with the formal announcement that the real would float freely, the currency has fallen about 25% against the dollar since its trading band was initially widened Wednesday. The real found some support in the Sao Paulo stock index's 33% surge Friday to close in Rio de Janeiro at BRR1.4300 to the dollar, but on Tuesday afternoon it is trading at BRR1.59.
Those hoping for an end to such gyrations will have to wait, analysts say. There are simply too many unknowns in a situation that offers no historical experience upon which to value the real.
"This currency is only a couple of days old," said Andrew Chaveriat, technical analyst with Paribas in New York. "The market is going to have to try and feel this one out."
The real's fair value will ultimately rest on the market's assessment of Brazil's financial authorities and their respect for the new market-based system, analysts said.
Traders "have to see how dirty a float it will be," Chaveriat said. He argued that the Brazilian Central Bank's assertion Monday it would intervene in currency markets "occasionally" to contain "brusque movements in exchange rates" remains an essentially ambiguous statement that can only be clarified by putting the central bank to the test.
But it's not just the central bank that is under market surveillance. Arguably, the government - in particular, the Brazilian Congress - holds the real's future in its hands.
Floating the currency has taken pressure off foreign reserves previously needed to protect it, but Brazil's finances will remain in poor shape unless the country makes good on its promises to rein in spending, economists say.
"What is important is the government's ability to move toward deficit reduction and containment of inflation," said Lisa Finstrom, currency analyst with Salomon Smith Barney in New York.
Until it demonstrates such commitment, confidence will remain low, in which case the only way the real can attract capital is through high interest rates, analysts say.
But rates need to come down if Brazil's struggling economy is to recover. Moreover, while tight monetary policy can help prop up a currency in the short-run by making the yield more attractive to depositors, it can work against it in the long-run by undermining confidence.
"High interest rates are a sign of a weak situation, not a strong situation," explains Marc Chandler, a New York-based independent global market analyst. "They have to have high interest rates to compensate for the risk of not attracting capital."
That's why the most important event for the real in the near-term is a Congressional session running Tuesday and Wednesday, when legislators will vote on reforms to the country's indebted pension system and will consider a proposed new financial services tax.
Both measures are aimed at meeting fiscal targets drawn up last year with the International Monetary Fund as part of a $41.5 billion multilateral financial bailout program.
If they are passed, and the IMF shows its appreciation by advancing its next disbursement of aid, economists expect an inflow of foreign capital to boost Brazilian debt instruments and put downward pressure on market rates. While the recent rallies in Brazilian stocks were a welcome sign of improved domestic investor sentiment, the government must wait for an indication that foreign investor confidence has improved before it can lower official rates, they say.
Thankfully for holders of reals, the executive arm of government seems determined not to preempt the fiscal reform process. Finance Minister Pedro Malan defended Tuesday's "temporary" increase in interest rates and President Fernando Henrique Cardoso has implored Congress to vote on the reforms. He declared Monday that the free float means "we need to quickly effect fiscal adjustment."
In addition, Malan told journalists after a meeting with IMF officials Monday that the change in foreign exchange policy reduces the need for more emergency international funding. Analysts said the statement would help diffuse fears over a potential rift with the IMF.
During the Asian crisis in 1997 and 1998, countries that appeared to embroil themselves in disagreement with the IMF saw their currencies battered. The Indonesia rupiah was the case in point.
Whether Brazil faces a similar fate is unsure. Confidence not only requires cooperation from Brasilia, but also flexibility from the IMF, says independent analyst Chandler.
Fortunately, the IMF seems to have learned lessons from its Asian experience and is now not married to the principle of defending a currency at all costs, he said.
"But they still seem to be pinning their hopes on higher interest rates to attract capital," Chandler added, arguing that the IMF will need to concede a rate cut some time in the future.
In all, it's about the confidence of the foreign investment community, both in Brazil itself and in the IMF's ability to successfully walk the fine between the need for economic restructuring and the pressures of realpolitik.
The problem is that confidence can be undermined not only by either party, but by extraneous events that put investors into a risk averse mode. Brazilians will well remember the hammering their asset markets got in the fallout from the Russian financial crisis last year.
For the moment, all seems calm on the global stage. But that can change, warns Salomon Smith Barney's Finstrom.
"If there is a deterioration of U.S. or Japanese economies, the (real) may depreciate even more," Finstrom said. "The response in the currency over the past week has been to domestic variables ... from here we will be caring more about the global situation as a whole."
-By Michael Casey; 201-938-4384
-(michael-j.casey@xcor.dowjones.com)
-Marianne Sullivan in New York contributed to this article.
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