Brazil — Self-Inflicted Conundrum

Wednesday, 24 Apr 2013 08:06 AM

By Ashish Advani

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This week I am in Brazil.

I must say that I am quite impressed with the speed and hustle of Rio de Janeiro. Obviously the beaches are gorgeous. What amazes me is that on a regular working Monday, the beach is filled with people frolicking about and sipping beer. Quite an amazing sight.

Coming back to business, I have been wondering about the direction of business in Brazil. After meeting with a few seasoned bankers and businessmen, I am beginning to recognize the quandary that is plaguing Brazil.

Back in 2011, when President Dilma Rousseff came to power, she carried the vote on the dissent and frustration against the previous government. She had vowed to weaken the Brazilian real due to a misguided notion that a weaker real would reduce inflation and help the nation prosper.

She went about creating harsh taxes on incoming foreign funds. She raised senseless taxes. And she did it again. As a result, investors turned away from Brazil as a choice destination for their cash. She then reduced interest rates to spur business and further drive the rate differential down to work against funds inflow.

While she seemed to win in the short term, the effects of those harsh measures are coming home to roost. As the foreign communities turned away, business slowed down to around 3.5 percent gross domestic product, which is quite anemic for Brazil. Inflation has begun to take root and has crept into daily products.

Shopping in Brazil, I found things to be quite expensive. Asking around, the locals expressed frustration about prices getting out of hand. The official rate of inflation here is 6.5 percent. So even by official means, the growth rate is negative 3 percent. In day-to-day terms, the locals tell me that inflation is near 10 percent or more. Wage growth is not as robust, leading to the people losing wealth and the feeling of well-being.

The government itself has found itself on both ends of the markets. While it has intervened in the currency markets to weaken the real, it has recently also stepped in to support it when it felt that the real is getting too weak. The government seems to have invited this state of confusion about whether they should weaken the real or strengthen it.

Losing the battle to inflation, they announced a surprise interest rate increase in an attempt to mop up surplus cash in the system. Only time will tell if this measure will have the desired effect or not.

Due to the country hosting the upcoming World Cup Soccer and Olympics, we have seen record flows of investments begin to creep into Brazil already. Last year, they had a staggering $65 billion inflow, which is huge by any standards. This year may be even bigger.

What a mess!

While the government is trying to decide on the direction of the currency, the businesses and banks are forging ahead with business. Most banks are predicting a strengthening of the real.

Frankly, in my opinion, a strong currency is a great measure for keeping inflation at bay. In the case of Brazil, this view holds even more so, since the country has a robust and thriving domestic consumption. The recent elevation of China as its largest trading partner, along with the bilateral currency agreement, will continue to place Brazil in a favored status as China moves along.

It is time for the government of Brazil to step aside and let the businesses run at capacity. The real will strengthen in the next several months, albeit at a slower-than-acceptable pace. Consider investing in the currency for the longer-term prospects.

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