Brazil Slowdown Likely Just Pause

But the pressure on the Brazilian real poses a challenge for treasurers.

Brazil’s economic growth party has paused, prompting global companies to consider tactical measures to hedge risks, but the long-term outlook for Latin America’s economic powerhouse remains strong.

Srinivas Thiruvadanthai, director of research at the Jerome Levy Forecasting Center, says he expects Brazilian interest rates to continue to fall—ultimately a boon for local businesses—and the real to remain under pressure, even after plummeting 23% against the dollar since June 2011.

“The economy will be under duress this year, but afterward will probably improve,” says Thiruvadanthai, adding that of the major emerging markets, Brazil is probably best placed for a rebound because it’s less dependent on exports than China or Russia and doesn’t have India’s “intractable” inflation.

This week Brazilian President Dilma Rousseff announced a $66 billion economic stimulus package that will focus on improving the nation’s infrastructure.

Although Brazil may be in for a rough patch, international companies don’t appear to have altered their long-term plans for the country. Microsoft announced cloud availability of its Office 365 suite of applications in 40 countries in June 2011, and last summer it was exploring ways to take local payment types in Brazil. The latter hasn’t happened yet, but George Zinn, treasurer at the Redmond, Wash.-based software giant, says the rollout of cloud computing services has continued.

Inflation is a perpetual concern in Latin America. While Brazil has seen a pick-up in price increases since 2010, inflation is nowhere near the heights reached in 2003, and recently it has dipped. Susan Hillman, a founding partner at Treasury Alliance Group, says treasurers at Brazilian companies and the Brazilian affiliates of global companies’ “are outstanding treasury officials,” given their extensive experience dealing with challenging financial environments.

Nevertheless, Brazil’s weakening currency is a medium-term concern. Thiruvadanthai noted that global companies that manufacture and sell in Brazil have revenue and costs in the same basis, leaving them to hedge any profits to be repatriated to the U.S. On the other hand, companies with operations in the U.S. and sales revenue in the weaker real must hedge product costs—a much bigger number.

Winston-Salem, N.C.-based Hanesbrands runs operations in Brazil, but its affiliate there pays in dollars for supplies it purchases from the company’s global supply chain. Hanesbrands Treasurer Donald Cook says the company hedges fluctuations in the real and other currencies by dollar-cost-averaging its foreign affiliates’ purchases of dollars, which smoothes out volatility when they acquire goods from Hanesbrands’ supply chain.

Regardless of currency fluctuations, Brazil poses a challenge because of its duties and protectionist policies. “[The weakening real] makes it difficult to optimize a global supply chain, especially in a rising [U.S. dollar] environment,” Cook says.

Hillman notes that Brazil’s tax on foreign loans, the imposto sobre operações financeiras or IOF tax, was recently raised to 6%, and in June the tax was extended to loans with maturities of up to five years, up from a previous limit of three years, in order to dampen inflows of foreign cash that have caused the real to appreciate. The tax applies to short-term investments as well. “Both borrowing and investing have a downside,” Hillman says.

If the real continues to weaken, Cook says, it may ultimately make sense for Hanesbrands’ Brazilian affiliate to purchase more goods onshore. Hanesbrands’ FX policy does allow it to use derivatives such as forwards and options to mitigate risk, Cook says, but “we have not seen the volatility yet that justifies something different than what we’re doing now.”

A company taking future delivery of either dollars or reais faces an added complication today. Those locking in a forward contact to buy dollars in six months, and therefore holding reais, receive a significantly higher interest rate on that currency than does their counterparty holding dollars in the U.S., where rates are at historical lows. Consequently, banks require the real holder to compensate the dollar holder for that difference.

“So for people long the real and short dollars, this trade is a double whammy because they must pay the forward points that have always been there, and the real has weakened since March,” says Bryan Morales, head of corporate FX distribution at Credit Suisse.

Morales adds that while costs related to interest-rate differentials won’t go away, using options to protect against unexpectedly severe currency swings is more affordable now because their implied volatility is at its lowest point in a year.

A company could buy a U.S. dollar call to protect against rates swinging unexpectedly in the opposite direction, while benefiting from the upside and losing only the premium if they don’t. And since currency options premiums can be expensive, the company could finance the call by selling a U.S. dollar put, limiting its upside and establishing a “collar.”

“So the client has a range of risk he’s willing to take in the middle,” Morales says.

 

For earlier coverage of Brazil, see Currency Flows Reverse, Brazil Signals More Stimulus and
BRICs’ Currencies Seen Sliding.

 

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