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Exchange rates during the pandemic: The case of Brazil

Updated: Oct 21, 2021

Renato is a guest writer for the Warwick Economics Summit Blog, studying towards a MSc in Economics and Management of Government and International Organizations at Bocconi University.

The atypical economic shock imposed by the pandemic has caused many currencies to depreciate in relation to the American dollar. Brazilian real (BRL) was no exception: in fact, it was subjected to a greater depreciation in comparison with other thirty major currencies ranked by Fundação Getúlio Vargas, a Brazilian well-known university.

Source: Econodados

While comparable emerging markets currencies, such as those from Argentina, Mexico, India, Indonesia, Russia and South Africa, depreciated between 3% and 31% from January to October 2020, the BRL lost 40% of value.

Where free mobility of international capital is established, exchange rates work as a monitor of risk perception, since it is the result of capital flows in search of reasonable adjusted-for-risk profitability. Therefore, one should explore country risk dynamics as a first explanation for exchange rate depreciation. A traditional measurement of country risk is the price of credit default swaps (CDS), an insurance protection against external debt default. International investors buy CDS from insurance companies when they fear debtors - generally countries - are not going to pay them. When a nation’s risk increases, insurance companies charge more for guaranteeing its debt payment, which means that CDS prices are an estimation of country risk.

Among the eight most devalued currencies in the period , Brazilian CDS soared by 149%, the greatest increase in the period, followed by Russian CDS (+121%) and South African CDS (+98%), as the following graph indicates.

Source: Econodados

Adjusting these countries’ external bond yield for their respective risk (in terms of CDS), all return rates remarkably diminished once central bankers around the world have opted to reduce interest rates to stimulate the economy. SInce emerging markets’ rates have not compensated for the increase of country risk, capitals left them, causing their exchange rates to rise. Thus, the reduction of adjusted-for-risk returns is a key factor in explaining exchange rate depreciation.

Source: Econodados, World Government Bonds

Nevertheless, rate reductions explain only partially the BRL devaluation. While Brazil’s returns decreased by 1.5 percent point, Mexico and South Africa’s respectively decreased by 2.6 and 1.6 pp. However, these countries’ currencies have not experienced a depreciation as great as that of the BRL. Thus, it is very probable that Brazilian’s CDS have underestimated the country’s risk.

Indeed, once CDS work as a protection insurance against external debt default, it is not unusual to suggest that they have not reflected all perceived risk of Brazilian economy: its monetary authorities currently own a huge reserve currency stock of US$ 356 billion, which makes them international creditors. The risk of external debt default in this case, thus, is very small, and tends to maintain CDS at low levels.

There must be internal risks not accounted for by the CDS that are instead captured by exchange rate. Typical issues in emerging markets include, among others, uncontrolled inflation, fiscal disequilibrium and political disturbances. In 2020, it appears that only the last two played a significant role in the Brazilian economy.

According to private forecasts collected by the Brazilian Central Bank (BCB), expected inflation was anchored for the following years. Even though wholesale prices increased substantially in 2020 due to exchange rate pass-through and supply-side shocks, retail consumption remained very limited as unemployment reached 13%. Both monetary authorities and private agents perceived these price’s shock as temporary, with no significant impact on future inflation. Thus, uncontrolled inflation risk was minimal and, consequently, can not be considered as a reason for exchange rate depreciation.

By contrast, Brazilian fiscal policy during the pandemic inspired relevant concerns among investors. As reported by the IMF, Brazilian government consumed 8.3% of its GDP up to September 2020 so to support health services and social income. It is by far the greatest fiscal effort among G20 emerging markets, similar to those of advanced economies such as Germany, Austria and the UK.

Source: IMF

When interpreted in the light of fiscal space, Brazilian spending may not appear excessive, as its debt before the crisis was, in terms of GDP, similar to that of the UK and smaller than that of the USA - two countries that spent more than Brazil during the pandemic. In consequence, one could argue that fiscal policy did not cause the exchange rate to depreciate.

Nonetheless, recent studies have suggested that national debts should be compared not in terms of GDP, but in terms of private wealth, as government debts are not sustained by a nation’s one year production, but by its citizen’s stock of financial wealth.

Using private wealth as a comparative denominator, fiscal disequilibrium in Brazil turns out: by 2019, Brazilian government held one of the greatest public debts in the world, which means that its Covid-related spending was expected to have harsher fiscal implications in comparison with other countries that spent the same proportionally to GDP. Therefore, fiscal policy was, indeed, an important cause of exchange rate depreciation.

Source: IMF, Global Wealth Databook 2019

Associated with fiscal disequilibrium, political risk has also impacted exchange rates. A public release of a ministerial meeting in May 2020 revealed a dispute within government concerning fiscal management, between Paulo Guedes, minister of economy, and Rogério Marinho, minister of regional development. The former insisted on fiscal responsibility, while the latter proposed increasing expenditure on infrastructure and universal income. Although President Bolsonaro was elected on a liberal agenda, he achieved a good amount of popularity due to fiscal stimulus; it is not clear yet which side of the dispute he will favour.

In sum, there is evidence to suggest that the massive exchange rate depreciation in Brazil resulted mainly from fiscal disequilibrium and political uncertainty.


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