Brazil & Southern Cone - October 2010 (ISSN 1741-4431)

The Brazilian economic miracle continues apace, with the financial markets barely pausing over the surprise first round election result. Although there are concerns over the statist policy approach expected from the leading presidential contestant going into the second round run-off, the government candidate Dilma Rousseff, arguably, the opposition candidate José Serra represents a bigger unknown.

On 5 October, two days after the first round, the government lifted the tax on financial transactions (IOF) on foreign purchases of fixed income securities to 4.0% (from 2.0%) in an effort to stem the rise in the Real. The currency has surged this year on the back of a weaker US dollar, strong domestic growth and Brazil's commodity export bonanza and on some measures is now the most overvalued currency in the world. It came under additional upwards pressure in September on the back of the record breaking public share offering by the state oil company Petrobras. The central bank dramatically stepped up its US dollar purchases in an effort to cool the Real, to little avail.

Ahead of the 31 October run-off, José Serra argues that Brazil's high interest rates are partially to blame for the strength of the Real. Serra rattled investor nerves earlier this year with a rather non-committal stance on the nominal (but not formal) central bank autonomy. Fiscally conservative, he argues in favour of a comprehensive tax reform in order to lower Brazil's structurally high interest rates and reduce pressure on the Real, allowing for more export led growth and a much needed increase in domestic savings. Yet he also promised to lift the minimum wage 18% in 2011. Arguably, that promise, along with his proposed tax reductions, could risk overstimulating the Brazilian economy, leading to a bubble akin to the one just seen in Western economies.

Dilma Rousseff also argues for tax reform, albeit more limited, but she has been more explicit about leaving monetary policy in the hands of the hawkish central bank. She is also committed to the primary fiscal surplus target of 3.3% of GDP. While there are doubts about the PT government's 'use' of the primary surplus target to conceal an expansionary underlying fiscal stance, Serra is the one that will most need to clarify his economic policy stance in the second round debates.

Brazil fed up with weak global currencies
On 15 September, Brazil's finance minister Guido Mantega criticised Asian economies for deliberately running weak exchange rate policies. The strength of the Brazilian Real is eating away at the balance of payments position, driving up imports and hindering export growth. The trade surplus in the first eight months of 2010 was US$11.67bn, down 41.3% year-on-year.

Japan intervened in the foreign currency market for the first time in six years in mid September, buying US dollars to try to weaken the yen and lower the price of Japanese exports. It followed this up in early October with a cut in the benchmark interest rate to virtually zero. The yen has risen around 10% against the US dollar this year to reach a 15-year high, and Prime Minister Naoto Kan, recently re-elected, is under intense pressure from the local private sector.

Mantega signalled that Brazil “would not keep quiet" in the face of what he called a “currency war", a deliberate policy by Asian governments, as well as the US treasury, to artificially devalue their currencies in an effort to export their way out of the global crisis.

The minister said that there were several options on the table, including the use of the country's sovereign wealth fund to mop up dollars from the Petrobras offering, as well as reverse currency swaps, under which the central bank would buy dollars in the futures market. Under these instruments, the central bank would pay investors the Brazilian overnight interbank rate (10.75%), in local currency and receive a fixed rate in US dollars, an expensive way of sterilising excess dollars.

Its unlikely that the latest rise in the IOF will be enough to stem the Real's strength. As we went to press on 5 October it was at R$1.67/US$,   its strongest level since 2 September 2008 (before the global crisis), prompting the IMF to issue a stern warning that the 'currency war' between Western economies risked derailing the still nascent global economic recovery. Brazil's international reserves were at a record US$278.8bn on 4 October, on central bank figures.

• Petrobras breaks all records
  The Petrobras public share offering on 23 September raised R$120.4bn (US$69.97bn) making it the biggest-ever equity issue. The result surpassed the record established by Nippon Telegraph, which raised US$37bn in 1987; and was also well above the US$22.1bn raised by the Agricultural Bank of China earlier this year. The Petrobras board issued 2,294m ordinary (voting) shares priced at R$29.65 each (US$17.24) and 1,788m preferential (non-voting) shares at R$ 26.30 each (US$ 15.73). The capitalization increased the Brazilian government's capital stake in the company from 39.8% to 48%.