Should the Central Bank Exchange its Currency Swaps for Reserves?

BRAZIL ECONOMICS - Report 01 Oct 2015 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

Interventions in the foreign exchange market are a controversial subject. While small interventions trying to dampen excessive volatility are one thing, heavy interventions to change the level of the exchange rate, when the economy is suffering from extreme macroeconomic imbalances, is quite another. The Brazilian economy is in a situation of fiscal dominance and by no means has the tranquility that would be necessary for a policy of changing from currency swaps (the stock of which now stands at over US$ 100 billion, and has a high cost) to selling reserves (which would decline by the same magnitude).

In this work we show that against a backdrop of a sharp currency depreciation movement, although those swaps greatly raise the cost of the net public debt (via its implicit interest rate), they only affect the level of the gross debt, and not its cost (the implicit interest rate remains unchanged). With an exchange rate of R$4.00/US$, the decline of the gross debt by exchanging the totality of swaps for reserves would be 7% of GDP. The conclusion is that exchanging swaps for reserves would bring a very small alleviation – virtually negligible – in the primary surplus necessary to stabilize the debt/GDP ratio, and hence would not make a considerable contribution to the fiscal policy effort.

Under normal circumstances, selling reserves is an instrument that can be used. But Brazil today is far from being in a “normal situation”, as attested by the steep rise of its CDS quotations and the steadily weakening exchange rate, reflecting the risks derived from the political incapacity and lack of resolve to undertake the necessary fiscal adjustment. In the macroeconomic policy arena, Brazil has fallen into a situation of fiscal dominance and is very near the “populist” paradigm described and analyzed in 1990 by Dornbusch and Edwards. Hence, the government should by all means try to avoid creating the notion that it is starting to jeopardize the country’s external solvency. Interventions in the forex market – if any – should be very limited.

The solution for the current problems that bedevil the Brazilian economy needs to come from the fiscal policy field, not from the use of instruments that signal erosion of external solvency.

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