Latin Finance - July/August 2011 - 26

central bank policy

New Tools for Old Problems
by Vincent Bevins

razilian authorities have been resorting to less conventional methods to tackle rising prices as a way to avoid strengthening the real through rate hikes. This is uncharted territory and arguably a risky venture for a country that has a history of hyperinflation. Markets are not necessarily convinced the plan will succeed, but understand the need for a broader set of monetary tools. Brazil has long been attacking its serious inflation problem with serious interest rates. The hyperinflation that plagued the country in the 80s and 90s was brought down with a new currency, the real, as well as sky-high rates. Fifteen years after the “plano real” was put into effect, the nation still has some of the highest real interest rates in the world, posing problems for local long-term investment, though inflation has been under control for some time. But as last year’s rapid economic growth raised the spectre of overheating, and inflation slowly broke the central bank’s official upper 6.5% limit, the government has not been content to rely solely on interest rate hikes to fight it. Starting in December of last year, Brasília has employed a set of measures, collectively described as “macroprudential,” alongside its traditional monetary policy. This involved raising banks’ capital and reserve requirements in December last year, then again in January. By February, reserve requirements on term deposits were increased to 15% from 13%. The most recent action came in April, when the government doubled a tax on personal loans, to 3% from 1.5% a year. Initially, some investors thought this a risky strategy, one less serious than traditional interest rate policies and with unclear consequences for financial market participants.

Faced with an over-valued real the Brazilian government is relying on a wider set of ‘macro-prudential’ measures to fight inflation.
because such measures are still relatively misunderstood and underestimated, they are not always as effective at controlling inflation expectations. This was born out at the beginning of this year, when hikes in the Selic, Brazil’s base overnight rate, translated directly into expected inflation expectations changes, while the macro-prudential moves did not. “When you move interest rates, expectations react quickly, but this hasn’t been the case with macroeconomic measures,” says Loes.” In Brazil, for example, capital adequacy measures have never been used for this specific goal, though in practice they have a dampening effect on real demand, Loes adds. In addition to the difficulties posed by high rates for local long-term investment in infrastructure and manufacturing, the strength of the local currency is cause for considerable concern. There is still a huge rate mismatch between Brazil and the US and Western Europe. Brazil has real interest rates hovering around 6%, while real rates in many developed countries are close to zero. This has led to strong inflows, pushing the real up to worrying levels for the government. Rita Mundim, an expert in capital markets at the Fundação Dom Cabral, a center for executive and company development, believes policy shifts reflect the declining power of the bank lobby. “The main lobby in Brazil has always been the bankers’ lobby, and now the

Policy to impact investors: Loes Despite such doubts, most investors and experts within and outside Brazil consulted by LatinFinance say that the macro-prudential approach is likely to remain part of the central bank’s policy tool set. André Loes, chief economist at HSBC in São Paulo, expects interest rates to be the main tool used to battle the current inflation crisis, but the broader macroprudential strategy will become more important going forward. Because growth in demand in the Brazilian economy is driven to such a large extent by loan book expansion – now leading to fears of a credit bubble – these types of measures can in theory be quite effective in fighting inflation. However, detractors argue that

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July/August 2011

Latin Finance - July/August 2011

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