Friday, April 8, 2011

Brazil Gives In to Surging Currency

Brazil Gives In to Surging Currency

By JOHN LYONS And TOM LAURICELLA

SÃO PAULO—Brazil appears to be waving the white flag in the currency war.

After months of tough talk to speculators and other governments driving up the Brazilian real, Finance Minister Guido Mantega seems resigned to the fact that there is little he can do to contain the currency's meteoric rise.

The currency climbed through a key barrier of 1.60 per dollar Thursday, a day after Mr. Mantega unveiled the latest in a string of controls designed to slow the real's climb. It was trading at 1.59 to the dollar late in the day, up more than 40% since late 2008.

.As Mr. Mantega announced the controls, investors were surprised to hear him acknowledge that there are legitimate reasons for the real to rise.

Some of the gains are "inevitable, because the real is a stronger currency, and the economy of Brazil is stronger than other economies, so there is an attraction and a security," Mr. Mantega told reporters in Brasilia on Wednesday as he announced an extension of a 6% tax on locals who borrow abroad—an effort to keep dollars out of Brazil.

That is a big change from his confrontational statements of last September, when he warned currency traders that the government would draw on "unlimited resources" to buy dollars and keep the real from rising. "We will not lose this game," he said at the time. The real has gained 8.5% against the dollar since that Sept. 15 speech.

Mr. Mantega declared that Brazil was in the cross hairs of a "currency war," where rich countries like the U.S. keep their currencies weak, artificially pumping up currencies in the developing world.

The Brazilian real is rising as foreign money pours into the South American nation from investors optimistic about the country's growth prospects, as well as those hoping to cash in on its 11.75% overnight interest rates, among the world's highest.

Those high interest rates have made Brazil a key global destination for the so-called carry trade, where investors borrow money in countries like the U.S., where rates are low, and deposit it in Brazil where rates are high, pocketing the difference.

One reason Mr. Mantega may be changing his tune on the currency is inflation. Some observers say Mr. Mantega may be starting to see a stronger currency as an inflation bulwark because it reduces the cost of imported goods.

Brazil's inflation rate rose 6.3% in March, officials said Thursday, well above the annual target of 4.5%. While the single-digit rate is still low for a country that had four-digit hyperinflation as recently as the early 1990s, Brazilian officials are increasingly focused on keeping it in check.

Late Thursday, Mr. Mantega unveiled a new tax on credit-card purchases designed to damp consumer demand and inflation.

Guido Mantega, finance minister of Brazil, seen above in August, now appears less than eager to roll out more heavy-handed capital controls. In part, that is because such measures can have painful side effects on business in Brazil, such as putting the brakes on the kind of long-term investment that Brazil needs.

.The challenge of rising currencies has been something that emerging-market countries have been battling to an increasing degree over the past year. But there are signs some are becoming more accommodative to stronger currencies.

"We've seen countries resist the appreciation of their currency, and as a result, they have an inflation problem," says John Baur, a portfolio manager at the Eaton Vance Global Macro Absolute Return Fund. "Now we're starting to see countries give in on the currencies and decide it's more important to fight inflation."

Investors note that some of the cash pouring into Brazil hasn't been the kind of speculative "hot money" that the capital controls are designed to fight, but instead is so-called foreign direct investment, which is longer term and unlikely to be withdrawn quickly.

"Ultimately, the flows that are causing the currency appreciation are helpful to Brazil and indicative of their success," says Sara Zervos, a portfolio manager at OppenheimerFunds. "It not hot money, it's long-term foreign direct investment—and that's the kind of flows that Brazil wants."

Since October, Brazil has tripled a tax on foreign investment in local bonds, while also taxing locals who borrow abroad.

Mr. Mantega is even taxing shoppers who use their strong currency to purchase goods outside Brazil, to urge them to shop at home.

Mr. Mantega now appears less than eager to roll out more heavy-handed capital controls. In part, that is because such measures can have painful side effects on business in Brazil, such as putting the brakes on the kind of long-term investment that Brazil needs.

"Given the level of [longer-term investment] flows that are headed to Brazil, it seems the only thing the real can do is appreciate," Mr. Baur says.

The $7.6 billion Global Macro fund has about a 3% stake betting on a rise in the real, although he says there are growing risks to the Brazilian economy from a significantly stronger currency.

Write to John Lyons at john.lyons@wsj.com and Tom Lauricella at tom.lauricella@wsj.com

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