JPMorgan strategist Hajime Kitano is skipping the 2013 predictions.Instead, Kitano is moving the conversation forward to 2014, which he says could be the year that the Brazilian real finally crashes, enveloping the country in a financial crisis.
The reason, Kitano says, is that the real is one of the most overvalued currencies on the planet, second only to the Australian dollar.
Of course, Brazilian authorities are aware of this concern and have been quite outspoken about the overvalued real, attacking developed market central banks like the Federal Reserve and Bank of Japan for instituting easy money policies that have the pernicious side effect of driving up the value of the Brazilian currency against the U.S. dollar.
The country’s finance minister, Guido Mantega, went so far as to dub this phenomenon “currency wars” back in 2010. In that case, Brazil is definitely one of the losers.
This leads us to Kitano’s latest ruminations on the subject:
It is that time of year when we are often asked ‘What will next year’s surprise be?’ When asked this over the past few years, our reply has been a dramatic fall in the Brazilian real. This is because we considered the Brazilian real overvalued, and expected a return to average values.
Figure 1 shows the real effective Brazilian real. It has tended to fall after peaking in July 2011, but remains above its average since 1970 +2σ.
In other words, the Brazilian real has peaked, but still remains extraordinarily high by historical standards:
Today’s Brazilian real reminds Kitano of both the U.S. dollar leading up the savings and loan crisis in the late 1980s and the Japanese yen in the mid 1990s. Both peaked at levels higher than two standard deviations above the historical average before leading to a financial crisis.
Strangely enough, a financial crisis thus occurred in both Japan and the U.S. two years and seven months after their real effective exchange rates reached a record- high level. Of course, we expect criticism that this is an arbitrary and much too simplistic comparison. Indeed, the backdrops to these financial crises were different, and the timing can be considered a coincidence.
Nevertheless, we think it is undeniable that extreme exchange rates distort the real economy. As mentioned earlier, the Brazilian real reached its highest ever real effective rate in July 2011. Two years and seven months later will be February 2014.
As such, it may well be possible to again suggest a Brazilian financial crisis as a potential surprise in 2014 when asked the same question at the end of 2013.
The need for Brazil to devalue its currency is real, but if it happens too quickly, it will cause problems.
To that end, Barclays strategists Guilherme Loureiro and Marcelo Salmon note this morning that the Brazilian central bank has been intervening in currency markets to prevent the real from devaluing against the dollar.
The Brazilian Central Bank has been intervening in the FX market over the past few trading sessions, selling USD in the derivatives market and proving funding liquidity in the spot market through buy-back auctions. By cutting the IOF tax on external borrowings today, the government is showing concerns about the levels of hard currency liquidity in the FX markets, which either due to seasonal factors or negative sentiment towards the country have been pressuring the BRL to weaker levels at a fast pace.
In our view, policymakers will continue to intervene in the market in order to prevent fast bouts of BRL depreciation, but given the weak growth background, we beleive there is little, if any, intent to pull the USDBRL down below 2.10.
This quandary has Brazil’s monetary authorities stuck between a rock and a hard place for now.
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