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Dilma's Dilemma Over Weak Brazilian Real

09/29/2015 - 09h04

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JOE LEAHY
FROM "THE FINANCIAL TIMES"

As the Brazilian real came under sharp selling pressure last week, Latin America's largest economy passed a number of milestones.

Not only did the currency break through its record low against the dollar, weakening to an all-time intraday level of R$4.2478, compared with a previous intraday low of R$4.014 set nearly 13 years earlier.

But Brazil's stock exchange, the Bovespa, lost its status as Latin America's largest bourse by market capitalisation to arch-rival Mexico, at about $461bn compared with $476bn.

"The highest value for the Brazilian market was reached in April 2011 when it hit $1,530bn," says Einar Rivero of Economatica, a data service. He adds that in just over four years "the Bovespa has lost $1,050bn".

The question for global markets and policymakers alike is where the bottom lies for the Brazilian real as an austerity programme designed to stabilise the economy runs into political headwinds.

The answer is important not only for Brazil - as the sharp sell-off in the currency last week risked spreading to other emerging markets.

"The Brazilian real remains one of the key indicators for emerging market risk sentiment in the current market backdrop," says Société Générale in a note.

The real's weakness follows a struggle by President Dilma Rousseff to implement a hawkish fiscal adjustment programme to reverse the budgetary largesse of her first term, which ended last year.

She initially promised primary fiscal surpluses - the budget balance before interest payments - this year and next but a sharp recession and resistance in congress have upset her efforts.

Standard & Poor's pounced earlier this month, downgrading Brazil's investment-grade rating, sparking selling of Brazilian assets, which picked up steam last week.

As investors sought to hedge their various holdings, interest rates spiked, with Brazilian credit default swaps pricing in a higher probability of default than those of Lebanon.

On Thursday (24), central bank governor Alexandre Tombini stepped into the fray, reminding investors of the country's large stockpile of foreign reserves at $370bn and his willingness to use them.

Calm returned to the markets with the real falling below R$4 to the dollar. But many wonder for how long.

"In the near-term, it is likely that weakness in the real will persist. In the current environment US dollar/Brazilian real may overshoot to R$4.50," ABN Amro says in a report.

The weaker real raises new challenges for the central bank, most importantly, the prospect of higher than expected inflation.

Yet, in its quarterly inflation outlook, the central bank signalled no further rate increases beyond the present 14.25 per cent level of the benchmark Selic rate. It cited the volatile markets and the weakness in the economy as making it premature to consider further monetary policy tightening.

Instead, it said the key variable lay in the fiscal arena. It was crucial that the government balanced its books.

"In this context, measures that contribute to the timely rebalancing of the public accounts will be fundamental to macroeconomic stability and the recovery of confidence and growth," the central bank said.

The weaker real may also help Brazil in the medium term by further narrowing the current account deficit and making the country's domestic industries more competitive.

Brazil's levels of foreign currency debt, while high enough to concern investors in companies such as state-oil group Petrobras, are not as burdensome as in the past.

"A weaker real will in time help to revive the export sector and close the current account deficit," says Neil Shearing of Capital Economics. "Fast forward to the end of this decade and our sense is that, after several difficult years, a weaker currency will have laid the foundations for steady [if deeply unspectacular] growth."

But that more optimistic view requires one precondition not directly connected to the markets - that Ms Rousseff will be able to avoid a messy and destabilising impeachment process.

Earlier in September, there were signs that congress was ganging up to usurp the desperately unpopular president of her position in office. But as of last week, she seemed to be heading off such moves by incorporating more dissidents into her cabinet.

Capital Economics rates her chances of removal as low. But it will be touch and go. In a report, the research firm charts growth in gross domestic product against opinion polls for Latin American presidents.

In Ms Rousseff's case, her economy is in negative territory in terms of GDP growth and her approval ratings are not too far behind.

Gallingly perhaps for the Brazilian president, the one president whose ratings have held up the best so far in Latin America this year is, yes, Mexico's Peňa Nieto.

Copyright The Financial Times Limited 2015

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