The Fiscal Risk and The Behavior Of The Exchange Rate

BRAZIL ECONOMICS - Report 17 May 2022 by Affonso Pastore, Cristina Pinotti and Paula Magalhães

In this Report, we evaluate the behavior of the Real after the pandemic. To explain the discrepancy between its behavior and that of the currencies of most other countries, we apply a model that, with proper consideration of the various structural breaks, quantitatively evaluates the effects of three variables: the risk associated with Brazil’s fiscal policy; the behavior of the dollar; and the gap between the interest rates in Brazil and the United States.

The evidence shows predominance of variations in the risk premiums, but there is also clear evidence that the Real is also affected by the interest rate differential and movements of the dollar. We stress that the EMBI (and CDS quotations) previously reflected the fiscal risk effectively, but in recent years they have lost power due to the reduction to practically zero of the dollarized proportion of the public debt. We also call attention to the fact that despite the recent improvement of the fiscal results (due to the effect of inflation, which increases revenues more than expenses), the fiscal fundamentals are still fragile.

We attribute the appreciation of the Real at the end of 2021 and start of 2022 to the increase in the interest rate gap between Brazil and the USA, and point out that the market may be underestimating the possible effects of a decline of this differential (monetary tightening in the USA coinciding with the end of the tightening cycle in Brazil) along with the growth of global risk perception, and consequent risk aversion, and the fragility of Brazil’s fiscal fundamentals.

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