Brazilian real fair value

Thursday, April 26, 2007

Well, the champagne corks have popped. Of course, it was equity people doing most the partying, as the Dow Jones (why does anyone follow this index?) broke 13,000 for the first time ever yesterday. The currency folks’ champers went flat pretty quickly, as EUR/USD could only manage to hit the previous all time high to the very pip. Six months after the euro’s previous foray to 1.3667 against the dollar, it was trading below 1.20. Sadly for EUR/USD longs like Macro Man, the same trend has unfolded in the hours since EUR/USD traded above 1.3660 yesterday.

The last twenty four hours have seen some interesting facts emerge. First, the global growth story remains fairly intact and upbeat. In addition to solid sentiment readings in Germany and France, the US saw much better than expected durable goods data for March. Equities predictably had a ball.

However, signs of unease amongst beneficiaries of global activity appear to be growing. The Norgesbank surprisingly left rates on hold yesterday. While the attached statement suggested that the trajectory of monetary policy has actually not changed, that the bank failed to deliver a widely anticipated tightening perhaps indicates that they don’t want tightening financial conditions to bind too tightly while uncertainty remains.

Even more interesting was the RBNZ, which ratcheted rates to 7.75% but noted that kiwi strength was both “excessive” and “unjustified.” Leaving aside the obvious correlation between New Zealand’s nominal rates and currency strength, the language in the statement was significant because it repeats the criteria that the RBNZ has previously set for intervening in the currency market. As such, the statement must surely be taken as a shot across the bows of the market that further kiwi strength might see the RBNZ taking the other side of the trade. This morning, the NZD has broken an uptrend line against the dollar- could the little old kiwi be the catalyst for a correction in risk assets? Stranger things have happened. (Macro Man cannot help but note the irony of the RBNZ complaining about currency strength on the same day that news of a trade SURPLUS for March was released.)

Another central bank peeved at domestic currency strength is that of Brazil. As USD/BRL approaches its own version of “the deuce”, Bacen has stepped up its presence in the currency market and threatened to ease rates more aggressively. This prompted Macro Man to wonder about the degree of legitimate BRL overvaluation, which will ultimately dictate the success of Bacen’s intervention campaign.

A few years ago, Macro Man had played around with some PPP-style valuation models for Brazil, saved them into a spreadsheet, and then promptly forgot them. Essentially, he calculated a basic purchasing power parity for USD/BRL. Unsurprisingly, this simple model did not do terribly well in identifying an ex-post equilibrium for USD/BRL, and currently pegs fair value for the pair at 2.73. However, he also adjusted this basic calculation to account for terms of trade shocks; this model appeared to do a somewhat better job of identifying ex-post equilibrium levels for USD/BRL.

This work was carried out in late 2004; at the time, this adjusted model pegged fair value for USD/BRL at 2.66, modestly below the prevailing spot level of 2.90. Imagine Macro Man’s surprise, therefore, when he updated the work and found the TOT adjusted model had more or less tracked the USD/BRL spot rate over the past couple of years, currently assessing fair value at 2.07.
Doh! Although Macro Man has done fairly well out of Brazil (in his real job) over the past couple of years, he generally assume that the real was growing more overvalued below 2.40 and sized positions accordingly. Even more intriguingly, the size of the over/undervaluation according to the adjusted PPP model seems to bear a pretty reasonable relationship to the delta of Brazil’s trade balance. For the past year, the model has suggested that the real has been more or less fairly valued- and the trade balance has flatlined.

What are the implications for Bacen and its intervention policy? Well, for the last couple of years, they have been leaning into the wind, trying to stem a fundamentally justified appreciation of the real. However, barring a further positive terms of trade shock, a move in USD/BRL below the deuce will finally bring the real into overvalued territory. Not only should this begin to impact the trade account, but it also raises the likelihood that Bacen intervention tactics could finally gain some traction. Coupled with its evident resolve to accelerate rate cuts and go for growth, this suggests to Macro Man that fixed income and particularly equities are likely to be superior Brazil plays than the real. He will therefore trudge to the back of the queue of those waiting for a dip to enter these trades.

Posted by Macro Man at 1:03 PM  


Any comparable views of the Turkish lira that you are willing to share? Overvalued? Like the long end as a rates play (//ing Brazil)/ hedge the currency risk even if that position has negative carry given the shape of the lira curve?


Anonymous said...
1:15 PM  

My sense is that USD/TRY is modestly undervalued (e.g., the TRY is modestly overvalued.)

However, given that the USD is definitely undervalued against Europe, and that half of Turkey's trade is with Europe, I don't necessariy think that the lira is that far away from fair value- though I admittedly have not run the numbers on it.

When USD/TRY blew up from current levels in 2006, bear in mind that EUR/TRY was 1.60 rather than 1.80...

Macro Man said...
1:30 PM  

Dear MM,

If Brazil is purchasing so much dollars , is it doing in the sterlized manner ? otherwise wouldn't Money supply and Inflation Skyrocket ?

How long can you sustain these STERILISATION costs ?

How are they managing the USD depreciation ? (ie, India has 200 bn reserves and USD depreciated by 5% over last 10 bn gone with the wind ? )

Anonymous said...
2:15 PM  

Bacen does face sterilization costs when they intervene in the cah market, which is one of the reasons that they've taken some of the intervention off-balance sheet by re-introducing reverse currency swaps.

Macro Man said...
2:52 PM  

If by sterilization costs you mean the interest differential between dollars and reais, then the costs incurred when the Central Bank operates with reverse swaps (which are swaps in which the Central Bank pays the Selic rate and receives the depreciation of the Real plus a spread close to the short American rate) are identical to those incurred when it buys "hard" dollars...

Anonymous said...
10:46 PM  

I want to second "anonymous" on the cost of reverse swaps. I think the key is that Brazil is still willing to "buy" insurance -- i.e. reserves. 2002/03 isn't that far off, and Brazil's reserves to GDP ratio is still modest (a bit over 10%) tho now rising very fast. Until fairly recently, Brazil's treasury bought $ (raised by selling domestic debt and then using the real to buy $) and used them to buy back brazil's external debt, which helped to contain the sterilization costs incurred by the central bank and reduced the int. rate differential (it was the gap between brazil's local currency debt and brazil's dollar debt, which carried a spread over treasuries). the scope for doing is now limited tho, so more of the costs are incurred by Bacen and, perhaps more importantly, reserves are reaching levels where the incremental value of more insurance is falling (i would argue rapidly) while sterilization remains expensive.


Anonymous said...
11:35 PM  

My understanding is that while the swaps do reflect the interest rate differential between the $ and BRL, they are kept off balance sheet and thus to do not entail ths issuance of sterlilization bills (which need to be rolled over. So while they may entail a loss, it is not a 'sterilization cost' per se.

However, I haven't looked at the 'plumbing' of this stuff terribly closely, so I could be wrong. In any case, one could easily argue that it is semantics to differntiate betwen losses from sterilization bills and losses from negative carry on off balance sheet swaps.

Macro Man said...
8:48 AM  

The reverse swap contract is a standard swap contract with daily margin adjustments, registered on the BM&F (the Brazilian Futures and Mercantile Exchange) as an OTC contract.

It leaves the Government as exposed to currency movements and the Selic rate as if actual reserves had been bought. When the contract expires presumably the other side will want to renew it or sell dollars, so it will be as if the government had just sold these reserves back to them.

The rollover cost of sterilization is the increase in risk premium related to issuing bonds? In that case this seems really a minor problem today, especially in comparison to 2002...

Lastly, remember that the Central Bank doesn`t really "conceal" its exposure when it works with the spreads... In 2002 it introduced them because it just didn`t have enough dollars to meet the demand, but started reporting public debt statistics "after swaps", that is, showing its real exposure.

Avinash Goldfish (the 9:46 "anonymous")

Anonymous said...
2:47 PM  

Avinash, I believe you are Brazilian, n'est-ce pas? Is there any sense in Brazil of the cost of Bacen intervention being onerous, or is it the case that defending domestic exporters is a benefit that more than outweighs the cost?

Macro Man said...
2:55 PM  

Yes, I'm Brazilian -- sorry if I didn´t mention it, I just don´t like bragging...

The costs of the reserves are seldom mentioned in the public debate, partly because the insurance growing reserves are thought to offer -- and not their effect on the exporters health -- is still perceived to outweigh these costs. We, as a country, still tend to see it as hard-fought-for "freedom", and not as the side-effect of high interest rates and excess liquidity...

The exporters' situation is being looked after with blunter instruments, like the raise, this Wednesday, of import duties on textiles from China...

There are some who say the Central Bank have an FX reserve target of 140 billion dollars... That would fall in line with the renewed recourse to the swaps, and we'll soon see if that is the case (reserves were at 120 billion as of Wednesday).


Anonymous said...
4:00 PM  

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