Should we expect an appreciation of the Brazilian Real?

Liseth Galvis-Corfe - 18 October 2018

Brazil, in common with other emerging markets, has suffered persistent capital outflows since the US Federal Reserve started tightening monetary policy. This has worsened in recent months as part of the emerging markets sell-off. According to Emerging Portfolio Fund Research Inc., in the period July-Sep 2018 investors withdrew US$3bn from the Brazil equity market. The Real has depreciated by 17.2 per cent year-to-date in 2018, undermining confidence in the currency. Is the positive currency and equity market reaction to the victory of the right-wing candidate Jair Bolsonaro (46 per cent of the votes) in the first-round elections, merely an expression of relief or is it the signal of better times ahead? The Real appreciated 2.7 per cent between the 5 and 15 of October. In the same period, the Bovespa increased by 1.26 per cent.

The second round is to be held on 28th October and the polls indicate that Bolsonaro is the favourite to win the elections. According to Parana (polling company), Bolsonaro commands 60 per cent support and Fernando Haddad from the left accounts for 40 per cent. If Bolsonaro is elected, and implements his agenda of tax cuts, reform of the labour market, an anti-corruption programme and inflation control, then there are more substantial reasons to project a recovery in the Real (figure 1).  

Bolsonaro has campaigned with Paulo Gaudes, an investment banker, who is the favourite for the position of Minister of Finance. Gaudes is a free-market advocate, promoting the virtues of deregulation, privatisation and decentralisation of the State. These are good signals for financial markets. However, it’s not clear how Bolsonaro will reduce the government budget deficit, one of the biggest concerns for investors.  It has increased from 3 per cent to 7.8 per cent of GDP between 2013 and 2017. Also, it is expected that Bolsonaro will encounter similar difficulties to Michael Temer in finding support in Congress for the reform of the unsustainable pension system. Bolsonaro’s PSL party has a shallow representation – only 52 of the 513 seats in the lower house of Congress, requiring extensive coalition-building. On the other side of the fiscal argument, as part of his campaign, Bolsonaro has promoted measures such as improvements in education, healthcare and security, which would require a relaxation of fiscal policy.  

For capital to return to Brazil it is crucial that the fiscal outlook improves. We expect capital inflows (figure 2) to greet a Bolsonaro victory, the headwind of rising US Dollar funding cost remains.  For the Real, the follow will depend on the urgency of implementation of the reforms. From the perspective of economic fundamentals, the Real has plenty of scope to recover, according to calculations from IIF (figure 3).    

Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Source: EPFR

Figure 3

Source: Institute for International Finance

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