Brazilian Real getting less weak, but it’s not strong yet

This article originally appeared in The Brazilian Report (April 24, 2022).

Exchange rate forecasts are famous for putting economists to shame. While predictions about the Brazilian Real — a notoriously volatile currency — are a particular type of sadistic joke. So it’s not much of a surprise that we market economists got them wrong once again.?

So far in 2022, the Real has strengthened significantly against most of its peers and the U.S. Dollar. It is up almost 30 percent relative to an index of major emerging market currencies and around 15 percent against the greenback.

Rewind to the beginning of the year, and the median forecast according to the Central Bank’s Focus Report (a weekly survey with top-rated investment firms) expected the USD-BRL rate to hit 5.60 by the end of this year. Virtually none of the respondents expected the currency below BRL 5 to the dollar; my own forecast of BRL 5.20 : USD 1 was one of the few betting on a stronger Real, and even that is now off by more than 10 percent.

Curiously, economic models using variables such as commodity prices, interest rates, and country risk had been showing that the Real was extremely cheap for several months, but foreign flows — loosely defined as the sum of the current account balance and investments in the country — were missing. Until very recently.?

In October last year, for the first time since 2013, 12-month cumulative net financial flows to Brazil turned positive, with the trade balance posting robust surpluses since 2016.

During that long period, more than USD 300 billion in financial flows spilled out of the country. On top of that, more recently, exporters seem to have chosen to leave a large chunk of their trade proceeds abroad, adding another USD 50 billion to a foregone flows account.?

How the Real got back on its feet

Many “waves” of outflows combined to explain such a huge hard currency hemorrhage. First, foreign investors have been cutting their holdings of BRL-denominated securities since late 2015, when the country lost its investment-grade status among leading credit rating agencies.?

The share of foreign holders of Brazil’s outstanding domestic sovereign debt collapsed from 19 percent to less than 10 percent. In that same period, the weight of Brazilian shares in the widely followed MSCI Emerging Markets Index narrowed from around 11 to 5.8 percent.

Second, Brazilian companies heavily indebted in foreign currency — notably government-controlled oil giant Petrobras — became aggressive dollar buyers in order to repay their creditors abroad. Petrobras is expected to finish its multi-year deleveraging program by the end of 2022, having reduced its gross foreign debt by more than USD 60 billion since 2015.

Third, since 2020, following the plunge in domestic interest rates to 2 percent, Brazilian savers stepped up their currency diversification, sending more money abroad than at any point in more than 20 years.?

Interest rate differentials between Real- and Dollar-denominated bonds that used to be in the high single digits collapsed to almost zero (not to mention the poor performance of the local equity market compared to buoyant U.S. shares), making investments in foreign securities relatively more attractive.

In 2022, Brazil was back to having the highest real interest rate among major emerging markets (by a large margin), favorable terms of trade (boosted further by the war in Ukraine), and cheap asset valuations.?

That combination, plus the reversal of unfavorable seasonal effects (December is usually a month of large outflows, with multinational companies sending out profits and local banks adjusting the hedging of their offshore branches’ exposure) brought back the elusive foreign flows.?

Up until March 11, year-to-date inflows added up to more than USD 10 billion. New figures have yet to come to light, due to a strike among Central Bank workers. The S?o Paulo stock exchange reports BRL 66 billion in foreign net purchases of Brazilian equities up to mid-April.

Will the trend continue??

I will stick to my year-end BRL 5.20 : USD 1 “guesstimate,” and for several reasons. At around BRL 4.80 to the U.S. Dollar, the Real no longer looks obviously undervalued. In inflation-adjusted terms, it is still weaker than its long-term average (of around BRL 4), but, in my opinion, the upcoming election season and the lack of competitive candidates openly defending pro-market agendas calls for some sizable risk premium.?

Furthermore, interest rate differentials will start to narrow soon, with Brazil set to call an end to its rate-hiking cycle earlier than most other countries. Finally, average flows (especially in trade) tend to get scarcer in the second half of the year, particularly once the annual soybean crop is almost completely sold. Further terms of trade gains seem less likely from already historically high commodity prices.

To sum up, a confluence of factors finally aligned over the past few months and the Brazilian Real regained some ground. Fundamentally, it was much harder to justify a BRL 5.80 : USD 1 exchange rate than the current market quote.?

Now that the misalignment is corrected, the Real’s fate should be once again linked to its usual determinants.?

The Brazilian Real is back to its status as a high-yield, commodity-linked currency in a country known for its messy politics. It may look attractive now, but interest rates, commodity prices, and political winds tend to move fast.