Over the past several months, the Brazilian real (“BRL”) has depreciated substantially. This depreciation has occurred alongside extreme volatility. The US Dollar – BRL exchange rate (“USDBRL”) currently sits about 16% above where it was at the beginning of the year, but about 6.5% below its peak in March. Given the recent appreciation since mid-March, it seems like a good time to ask: “Where to now?”

This will be the first of two posts detailing the possible path of the BRL in the context of a simple exchange rate model.

Source: Bloomberg

A Small (Really Small) Model

While painful for some, equations are helpful to frame discussions in a way that make assumptions and mechanisms explicit, and so I am going to use one. I promise it won’t be intimidating.

formula 1

S is the USDBRL exchange rate[1].  If S goes up, the BRL depreciates relative to the dollar because 1 USD now buys more BRL. The subscripts denote time, so t is today, and t+1 is next period (call it next year to fix ideas). The “i”s are interest rates, and the one with the asterisk is the Brazilian rate. That final term is the Greek letter rho, and it is a catch-all term that economists call the risk premium.

Let’s quickly get a feel for how this equation works. Imagine the risk premium is 0. Then we have:

formula 2

For a fixed expectation of the future exchange rate, an increase in the US interest rate, or i, makes St increase. Accordingly, if the US interest rate goes up, the dollar gets stronger. This makes sense; if you could get a higher return in the US than in Brazil, everyone would take their money out of Brazil and put it into the US. That activity strengthens the exchange rate until such a point that, in people’s minds, the currency move from today until next year will wipe out any gain they could get from the interest rate differential. This can be seen more clearly by rewriting the equation like this:

formula 3

If the term on the right hand side is positive, then the term on the left hand side must be positive (and the same number!). That means that the exchange rate today is such that, in the market’s expectation, it will decrease by the same amount as the interest differential. This is the idea of “Uncovered Interest Parity” and it suggests that investing in the foreign exchange market is pointless because you will get the same return regardless of the currency[2]. It is the foreign exchange market version of the famous Efficient Market Hypothesis most closely associated with stocks.

As a theory, Uncovered Interest Parity has been extremely successful at, well, not being successful. We do not see returns equalized on deposits in different currencies, and hence the introduction of a risk premium. This risk premium should be thought of as accounting for the risk of BRL in all its forms, be it currency volatility, default risk or capital controls. Once more (and for the last time I promise!):

formula 4

We see that if rho goes up because default risk in Brazil goes up, for instance, that leads to a higher St as well, i.e. an appreciating USD and depreciating BRL.

Ok, we made it. We now know how a change in the risk premium affects the currency today. Let’s look at some data and apply this little model to how that data relates to changes in the exchange rate going forward.

The Risk Premium and the Fiscal Situation

Brazilian President Rousseff’s appointment of University of Chicago trained economist (read: Orthodox, read: Balanced Budget!) Joaquim Levy was meant to show markets that she is serious about tackling the country’s fiscal issues, which have deteriorated during the last couple years.

Source: Bloomberg

Finance Minister Levy has embarked on an austerity program with a target primary budget surplus of 1.2% by the end of 2015. His goal, at least partly, will be to appease the rating agencies that have downgraded/lowered outlooks on the country in recent years: Currently BBB [or equivalent] with Fitch and Moody’s with a negative outlook, and BBB- with S&P with a stable outlook.

For our purposes, the fiscal situation/rating agencies opinions directly affect that risk premium term in our exchange rate equation. An improvement in the debt situation of Brazil should lead to a reduction in the risk premium and an appreciation of BRL. Recent releases regarding the success (failures) of the budget tightening have in fact led to BRL appreciation (depreciation). See for instance: Recent Success, Recent Failure.

Ok, so they are tightening the budget. That will reduce the risk premium and lead to an appreciating BRL. That must be what we think right? Well, not exactly. A good measure for default risk is the Debt/GDP ratio. Let’s see how well austerity has worked recently in reducing Debt/GDP in other countries:

Source: De Grauwe and Ji 2013

Here, we have a graph produced in 2013 examining the success of austerity in the EU. The austerity measure is one created by the Financial Times. We see that those countries that tightened the most were the ones that had the largest increases in Debt/GDP.

How could this happen? Well, we all know that government expenditure is a component of GDP. If governments cut back on spending and there is no subsequent increase in private expenditure, GDP growth will slow. This can lead to a vicious cycle in which declining GDP growth hits tax revenue, leading to missed budget targets and further government spending cuts, which in turn leads to even further GDP slowing, and so on.

What is happening in Brazil? From the Wall Street Journal on March 26, 2015:

“Brazil’s jobless rate rose to 5.9% in February, the highest in almost two years, according to the country’s statistics agency. Meanwhile, the central bank estimated gross domestic product shrank 0.1% in 2014 and forecast a contraction of 0.5% for this year…”

The country’s economy is slowing (for a variety of reasons), and Brazil risks falling into the same austerity trap that afflicted the European Periphery for several years. If this happens, it is quite possible that Debt/GDP will rise, increasing default risk and leading to BRL depreciation. More practically (and something that our simple equation does not capture) is the institutional rigidities inherent in asset management that will force asset allocations away from Brazil if they are downgraded below investment grade by the ratings agencies, resulting in an even larger depreciation than would occur minus these rigidities.

The next post will detail some additional reasons why BRL may face an even tougher road ahead using another piece of our model (EtSt+1), but I promised I would stop with the equations!

[1] Actually, it is the log exchange rate. This equation is a log approximation to an equilibrium condition that pops out of a harder model, but the variables move in the same direction as the harder one. Here, we will keep it simple!

[2] Pointless in terms of excess returns. There could still be diversification benefits.