The Controversy over the Appreciation of the Real

BRAZIL ECONOMICS - Report 22 Jan 2021 by Affonso Pastore, Cristina Pinotti and Paula Magalhães

The financial market has a tendency to forecast that the Real will get stronger in 2021. We don’t deny that international causes might lead to this result. The elevation of international commodity prices is producing gains in the terms of trade, causing the real exchange rate to appreciate, and the increase of liquidity in the United States is already much greater than what happened in the reaction to the crisis of 2008-09. However, there is good evidence that although the movements of the Real in the recent past have been sensitive to these two forces, the behavior has been predominantly influenced by domestic factors. The pandemic hit the country in an extremely fragile fiscal situation, provoking an increase in the risk premiums, in turn affecting the interest rate and currency markets. We show in this work that the huge international liquidity triggered by the strong monetary reaction in the USA has been present since May 2020, causing (among other consequences) the dollar to weaken. That depreciation has been the main force determining the behavior of the median exchange rates of a sample of 20 emerging country currencies, but its effect on Brazil is so small that it disappears against the backdrop of the movements caused by domestic factors. Likewise, since the start of the Chinese recovery, after only one quarter of contracting GDP, the international prices of commodities have been rising, producing gains in Brazil’s terms of trade. With regard to domestic factors, there is a hypothesis among financial market participants that even in light of the pressures from the miserable conduction of the health crisis and its effects on the economy, the government from here on will be more fiscally responsible, leading to a decline of the risk premiums and appreciation of the Real. However, based on its handling of the health crisis in 2020 and failure to pursue reforms to enable fiscal consolidation, we believe this interpretation is questionable. For this reason, even though we recognize that external forces exist, which have been in action since May 2020 and might lead to some appreciation of the Real in 2021, in light of the preceding observations we cannot state this is probable. We thus maintain our view that the Real will tend to remain weak in 2021.

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