Brazilian real faces many headwinds

The Brazilian real has lost over 10% against the US dollar since late June, approaching the lows seen in early 2021. This surprised many commentators as the real's decline occurred despite monetary tightening by the Central Bank of Brazil (BCB). Last March, the BCB was one of the first central banks to raise interest rates after the pandemic (see Chart 1) and initially this favoured the real. Since the end of June, despite the Selic rate increasing by 2 percentage points and the BCB signalling further increases, the real has weakened again.

Chart 1. Brazil policy rates

Source: Refinitv and EFGAM calculations

This probably reflects the fact that the monetary policy tightening has been barely sufficient to prevent real interest rates - nominal rates adjusted for inflation- from becoming even more negative. Indeed, the inflation rate has exceeded 10% year-on-year and looks set to rise further due to high commodity prices, primarily energy and food. These, along with the past drop in the real, have pushed producer price inflation to over 40% year-on-year and this will affect consumer prices in the coming months. The prospect of negative real interest rates for several more months makes the real unattractive from a portfolio investment perspective.

The weakness of the real is nothing new. Looking back over the last 20 years, it is evident that the trend of real exchange rate is influenced by the current account balance: an external account deficit coincides with declines in the real exchange rate (see Chart 2). In recent months, the external balance has deteriorated, reversing the trend seen since mid-2020. The fact that this occurred at the same time as the recovery of international trade betrays the lack of competitiveness of Brazilian exports and maintains pressure for further depreciation of the real.

Chart 2. External accounts and Brazilian real

Source: Refinitiv and EFGAM calculations

According to estimates based on Purchasing Power Parity (PPP), the Brazilian real is overvalued by about 15% against the US dollar (see Chart 3). This reflects the higher inflation of tradable goods prices recorded in Brazil compared to its main trading partners, including the US and the eurozone.

Chart 3. Brazilian real exchange rate and PPP

Source: Refinitiv and EFGAM calculations

A further headwind for the Brazilian real is the increasing political uncertainty as the October 2022 general elections approach (see Chart 4). The polls put former President Luiz Inacio Lula da Silva comfortably ahead of incumbent President, Jair Bolsonaro. The election campaign promises to be tense: Bolsonaro has already expressed doubts about the legitimacy of the current electoral system after Parliament rejected his reform proposal and many see his statements as an attempt to delegitimise the vote in case of defeat. Pressure on Bolsonaro is expected to increase following publication of the investigation into alleged criminal malfeasance in the Covaxin case. While the risk of Bolsonaro being impeached is very low, it would unsurprising if international investors remained on the sidelines despite the high risk premium offered by Brazilian assets, including the real.

Chart 4. Brazil policy uncertainty index

Source: policyuncertainty.com, Refinitiv and EFGAM calculations

Conclusion

To conclude, the recent weakness of the Brazilian real exchange rate reflects both the falling real interest rates, on account of ramping inflation, and increased political uncertainty as next year general elections come into focus. Furthermore, structural factors, including the persistent current account deficit and the high inflation of tradeable goods, weigh on the Brazilian real exchange rate whose downtrend seems likely to continue.