Consultants' Commentary: FX

T&R presents consultants’ insights on timely topics with this inaugural column: Brazil’s real has the wind in its sails.

The possible benefits of holding Brazilian short-term instruments or Brazilian reais may have been overlooked by treasurers as a result of the perceived contagion risk at the macro level over the past eight months.

During the bout of concern over Europe’s debt problems in mid-September, the real weakened to U.S. $1.95 from U.S. $1.54 in late July. The latest reading at U.S. $1.72 shows considerable potential for the real to appreciate against the greenback over coming months. In addition to the impetus favoring all risky assets (the tide lifting all boats), the Brazilian real has the wind in its sails as the result of other fundamentals.

First, Brazil’s president, Dilma Rousseff, is demonstrating steady resolve to continue the policies and priorities of her successful predecessor, Lula da Silva. These efforts continue to attract institutional funds, particularly to Brazilian equities and infrastructure-related bonds, which also benefited as of December from the elimination of the tax on financial transactions (IOF tax) due from foreigners.

Second, Brazil will be the center of the universe for billions of soccer-loving people throughout the world when it hosts the World Cup in June and July of 2014. This fact may be lost on North Americans, but putting on this event means Brazilians have to be ready to welcome the world as they never have before.

The country is investing in infrastructure and cleaning up the shanty towns (favelas) of Rio de Janeiro, and the process is not always pretty. The occasional pushback from organized crime to these efforts is predictable, but it’s a radically different story from what is happening in Mexico, where drug cartels act with near impunity, much as they did in Colombia before President Uribe took office. Perhaps it would be more appropriate to compare Brazil’s crime reduction efforts to what Rudolph Giuliani did as mayor of New York City.

Third, demand for Brazilian short-term instruments is not limited to foreign institutional funds and hot money. There is a little understood relationship between Brazil and Japan, with tens of thousands of Japanese citizens raised in Brazil living in Tokyo. The appetite for carry trades from Japanese retail investors and traders is well known. Carry trades allow these investors to buy the currencies of countries with high overnight yields and sell currencies with low overnight yields. The latest investment figures show Japanese investors have moved out of euro-denominated positions—to the tune of more than U.S. $10 billion over the past six months—and switched much of that to carry-rich currencies like the Australian dollar. Japanese banks and retail brokers are starting to promote the Brazilian real as a safe destination for such carry trades, particularly as the yen begins to weaken against the U.S. dollar and the Brazilian real continues to gain against the U.S. dollar.

Fourth, Brazilian stock exchange and futures market operator BM&F Bovespa is close to launching a state-of-the-art trading platform (Puma) with help of the Chicago Mercantile Exchange. This multi-million technology initiative, along with measures that enhance direct market access and co-location, is setting the stage for robust liquidity growth from algorithmic traders, which will project Puma’s technology past Brazil’s borders, to the rest of Latin America and beyond.

Despite the bullish outlook for this South American nation, treasury executives should also be aware that Brazilian authorities would prefer to see the real’s appreciation stall. Last week, Brazil’s finance minister, Guido Mantega, and President Rousseff expressed concern over the pace of the real’s appreciation (up 9% relative to the U.S. dollar so far this year). We expect Brazilian authorities to wage a war of words to try to contain the real’s appreciation but seriously doubt they will go as far as Swiss central bank officials, who threatened in 2011 to sell unlimited amounts of Swiss francs to curb its ascent relative to the euro. 

It is too early to know if Europe’s latest (and most credible) effort to deal with the Greek debt problem will prove sustainable. Regardless of what unfolds in Europe, Brazil is moving on. In light of what is taking place in this Latin American giant, it makes perfect sense for corporate treasuries with Brazilian real exposure not to lose too much sleep trying to repatriate such capital if they can avoid it. For those without exposure, gaining some exposure also makes sense, particularly if the liquidity outlook is for six to 12 months out.

 

Javier Paz, a senior analyst at Aite Group, writes about technology, regulatory and business trends from a wealth management perspective.

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