The Hidden Dilemma: Brazilian Interest rate vs. Exchange Rate
Pretext
First quarter of 2024: Brazil experiences a positive shock. Normally, every new year in Brazil starts on a weak economic note. Summer vacation. And when is Carnival? Many say Brazil only wakes up after Carnival.
This time seems to be different. January 2024 registered growth of +0.6%. The central bank had expected a plus of around +0.4%, the commercial banks and analysts sat back and relaxed, as their heavyweight omniscient analysis simulations had accurately predicted a maximum plus of +0.2% (...). However, December 2023 had already sent out positive signals at +0.82%. Ignored?
The figures were frantically adjusted - the forecasts, just a few weeks old, were collected without a word. All reports changed direction. A robustly strong first trimester was expected in Brazil. It was now said that the payment of the defaults declared under the Bolsonaro government was having a positive effect on the national economy. We had reported on this effect in our GreyRhino newsletter March 2024. Our assumption was based on the statements of numerous CEOs in Brazil, who made it clear that they expect the payments to be made immediately and that a significant portion of the money will flow into investments and material purchases. Entrepreneurs in Brazil predicted a further increase in demand in almost all sectors for 2024.
All this also led to a review of the growth forecast for Brazil in 2024. In the first days of January, the banks' analysis sectors published their forecast: unanimously between +1.1 and 1.3%. Maximum. The indicators are controlled - apparently the high priests of the free market believe in a planned economy - or have no holistic contact with the business world.
And a correction began. Virtually all banks are now forecasting +1.5% to +2.3%; the central bank is currently forecasting +1.9%. The positive development in the manufacturing industry is particularly striking. The increase of +2.2% is currently already above the expected overall growth.
A lot of light - but also quite a few shadows. To understand the scenario, let's turn back the movie.
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Extract from the latest report by the Brazilian central bank, March 2024
The Central Bank of Brazil recently made a significant move by reducing its key interest rate, known as the SELIC rate, by 50 basis points (bps) to 10.75% during its March 2024 meeting. This decision was in line with market expectations. Here are some key observations I extracted from the executive report.
External Environment Volatility: The global economic landscape remains uncertain, with ongoing debates surrounding monetary policy easing in major economies and the pace of inflation decline worldwide.
Domestic Economic Indicators: Economic activity indicators in Brazil align with the Central Bank's anticipated slowdown scenario.
Inflation Trends: While headline consumer inflation shows a disinflation trend, underlying inflation measures have exceeded the target in recent releases.
Copom's Projections: The Copom (Brazilian Monetary Policy Committee) projects 3.5% and 3.2% inflation for 2024/25.
Rate Cut Rationale: The interest rate reduction aims to aid convergence toward the inflation target and stabilize economic activity.
Fiscal Anchoring: The Committee emphasizes the need for fiscal targets to anchor inflation expectations.
Further Reductions: If the current scenario persists, the Central Bank plans further rate reductions, demonstrating prudence and moderation in monetary policy amid global uncertainties.
Outlook and Expectations
Market Forecast: While the Central Bank expects the Selic rate to be around 4.5% above inflation, the median market forecast suggests it may end 2024 at 9%.
Inflation Expectations: Inflation expectations for 2024 and 2025 stand at around 3.8% and 3.5%, respectively.
Focus on Fiscal Measures: The Central Bank's cautious approach underscores the importance of fiscal targets to maintain stability.
In summary, Brazil's interest rate landscape is dynamic, influenced by both global and domestic factors. As we navigate economic uncertainties, policymakers will continue to balance inflation control and economic growth.
However, it is clear that the continued sustained robust growth in economic activity raises doubts about the further path of interest rate cuts.
And now things got exciting!
What interested investors, investors and above all entrepreneurs most about the outcome of the central bank's March decision was not the widely announced reduction in the SELIC rate by 0.5 percentage points from 11.25% to 10.75%, but what will happen in the further meetings up to June: whether the central bank will be able to reduce the pace of interest rate cuts to 0.25 points or whether it will maintain the 0.5 points.
This question goes far beyond the pure stakes, but defines the capacity for investment via the development of the exchange rate of the Brazilian real to the USD.
One thing is crystal clear:
it is not the interest rate that determines this trend - it is a reversal of the appreciation of the real since 2023 into a devaluation and thus the drying up of potential investments.
Since the central bank began its current rate-cutting cycle in August 2023, Copom has reinforced expectations of monetary policy momentum by referring to maintaining the Selic cut rate of 0.5 points "in the coming meetings" at each decision.
The plural of this section of the statement was interpreted by market participants as follows: A 0.5 point cut has been decided for at least two meetings.
Recently, analysts and some central bank directors have considered the possibility of deleting the signal "in the coming meetings" from the Copom statement, as inflation - especially in service prices - has surprised to the upside and economic indicators have also been better than expected. Not to mention that the rate-cutting cycle in Brazil is already in full swing and that the central bank has reiterated several times that the final Selic rate will remain in the restrictive range.
The wording was not retained. And it is probably doing well. Because the devaluation pressure on the real is increasing. The pressure is being built up in the USA. If we give in to political pressure, as was the case in the previous government, all the work of the last 1.5 years or so may be a waste of time.
Brazil enters 2024 with a massively better scenario in terms of demand. While the central bank assumed in its forward guidance that an interest rate cut of -0.5% would come every six weeks, as if on autopilot, the current report shows that the plural of the projection has been cashed in. Significantly higher demand and sustainably better economic activity require a greater degree of freedom to reach into the toolbox. Added to this is the uncertainty in the USA and the pace of interest rate developments there. At this point, there is already increased pressure on the exchange rate in all its facets. A look back at the last few years may serve as an impending warning signal.
A look in the rear-view mirror - otherwise you understand very little
Let's take a deeper look at the economic journey of Brazil from 2019 to 2022, focusing on the trajectory of interest rates, currency devaluation, and the persistent rise in inflation.
Brazil's Interest Rate Trajectory (2019-2022)
Background
In 2019, Brazil faced a delicate balancing act: controlling inflation while stimulating economic growth. The country's central bank, Banco Central do Brasil, used the SELIC rate as a key tool to achieve this equilibrium.
At this point, it must be clear to the reader that all banks were in fact trumpeting an exchange rate of the Brazilian real to the USD at a level below 3.0. The commercial banks, with the strong support of the national central bank, created a positive scenario that was never apparent in the economy. It is also interesting in this context that the so-called Mr. Financial Market never tired of singing the praises of the government's economic policy at the time.
However, a surgical look at the details reveals a clear turnaround on the first working day of the third quarter of 2019: the devaluation of the real began. And it did not stop until around Q2 2022, leading to the strongest and longest period of massive devaluation of the Brazilian real, which had been a robust currency until then. We will come back to this period later and why it is so important for understanding 2024.
Interest Rate Movements
2019: The Selic rate started the year at 6.50%. Despite global uncertainties, Brazil's economy showed signs of recovery, prompting the central bank to gradually reduce rates. This was the official interpretation, although the majority of companies had already frozen their investment plans or undergone a massive revision.
2020: The pandemic hit, causing economic turmoil. In response, the Selic rate plummeted to an all-time low of 2.00% to support growth. That was also the official interpretation. Low interest rates do not necessarily mean growth. The effect was different: a massive devaluation of the Brazilian real set in and the central bank looked on without reacting. The devaluation imported a long-lasting trend of inflation. Why didn't the central bank react?
2022: Inflation persisted, prompting interest rate hikes. By December 2022, the Selic rate reached 13.75%, reflecting Brazil's struggle to balance inflation control with economic recovery. Investment was at an extremely low level and productivity had collapsed. The national industry had slipped even further in technological terms. The Brazilian real was massively devalued in an irresponsible manner, causing lasting damage to competitive industry.
Currency Devaluation
The Brazilian real (BRL) experienced significant devaluation during this period. A weaker real made imports costlier, contributing to inflation. Factors like political instability, fiscal deficits, and global economic uncertainties influenced the real's depreciation. Far too late, the national central bank, which historically reacts extremely quickly and energetically, showed an understanding of the situation. It can be assumed that for the first time in Brazil's recent economic history, since the introduction of the real, the central bank was massively abused politically. And apparently enjoyed being abused.
Rising Inflation
2019: Inflation was relatively moderate at 3.73%.
2020: Despite the pandemic, inflation remained under control at 3.21%.
2021: Inflation accelerated to 8.30%, driven by rising food and fuel prices.
2022: Inflation surged further to 9.28%, posing challenges to an unprepared central bank for monetary policy.
2023: In February, inflation eased slightly to 4.50%, but underlying pressures persisted.
Copom's Dilemma
The Copom (Monetary Policy Committee) faced a delicate task: taming inflation without stifling economic recovery. It projected inflation at 3.5% for 2024-25 and cut rates to aid convergence to the target. Fiscal targets were crucial to anchor inflation expectations.
Conclusion
Brazil's monetary policy dance involved navigating inflation, growth, and currency dynamics. The Selic rate's trajectory reflected this intricate balancing act. As Brazil moves forward, policymakers must continue their prudent approach to maintain stability amidst global uncertainties.
The two “Brazils”
If you allow yourself a well-intentioned superficial glance, you can quickly see that there are two Braziles in the economic world of the nation on the Sugar Loaf Mountain:
The world of national companies that play in the world league. Regardless of whether it is a question of productivity indicators, innovation, the use of state-of-the-art production technology or process engineering. There are companies of all sizes - from start-ups to large global corporations. And they are always companies that need to invest constantly.
Then there is the world of "written-off companies". Written off in the truest sense of the word. These are mostly companies that manufacture their products with old, fully depreciated machines and systems.
The massive devaluation of the Brazilian real that began in Q3 2019 had one big winner: the group of "depreciated companies". And one big loser: the national companies in the global league.
With such a massively weakened real, these national champs were suddenly no longer able to invest in the way that was necessary for their positioning. The period of massive devaluation also saw a significant acceleration in the death of start-ups. These young, mostly tech-oriented companies are particularly dependent on constant investments. And these are mostly invoiced globally in US dollars. Game over for many.
The winners of this policy suddenly no longer had any productivity pressure. They no longer really needed to fear national champs, nor the now prohibitively expensive imports.
Market power and a protective wall through an unproductive industry through massive and sustained negative devaluation - that was the aim of the government at the time - hand in hand with the central bank.
This group of companies could now produce on depreciated, outdated machinery and equipment, no longer needed to fear any real competition and could raise prices at will. Not only was inflation imported through negligent devaluation, but an internal structure was created that produced inflation and created massive profits for unproductive companies.
It should be remembered that the government responsible for this between 2019-2022 verbally pursued a completely different narrative and boldly communicated it to the outside world. But they should be judged by their actions ... . This is exactly how nations such as e.x. Venezuela or Argentina ended up in the situation they find themselves in today.
There is something in the central bank's report ...
There is a striking passage in the central bank's report where they say that Brazilian industry is beginning to operate at the limits of its capacity. The unused production capacity is at a low level not seen for a long time. And this is now leading to a serious review of the pace of interest rate cuts.
There is a reason for this: the massive and completely unnecessary devaluation of the real in the period from Q3 2019 to around mid-2022. And thus the significantly enlarged deep hole in the national investment ratio. Could this be made up? Only if the investment ratio effectively doubles from now on. Is that realistic? No. Lost time cannot be made up. It is the same effect as unrealized compound interest. Time cannot be recovered.
The economic damage caused from Q3 2019 until around mid-2022 will continue to have an impact for at least one generation.
Q&A
In view of our current projects and discussions with former clients, as well as potential future clients, we would like to try to answer a few acute questions. We are currently also looking at the following questions in some projects where we are involved in the first revision of our clients' 2024 budgets.
What prospects can we currently derive for 2024?
The reduction in inflation will continue slightly, but will quickly come to a halt. Pressure on the real will increase significantly from the USD. Annual inflation will probably be somewhere between 4.5% and 5%, but closer to 5%. This can already be observed in the P&L of numerous clients in the materials and supplies items. There is also a lot of pressure on the horizon from the B2B and B2C service side.
What growth prospects can we see?
In the GreyRhino newsletter March 2024, we still wrote of +2.5% to a maximum of +2.8%. Due to the need not to cut interest rates for a second time, the potential should fall to around +2.2 to 2.3%. In general, however, we can assume that Brazil will also be a positive surprise again in 2024.
So how will the SELIC key interest rate develop?
A continuation of interest rate cuts at a rate of -0.5% every six weeks is already in the critical phase. The real is starting to depreciate, which will increase inflationary pressure.
A targeted key interest rate of 9% by the end of 2024 appears highly dangerous.
Lessons should be learned from the recent past. Buying low interest rates with a depreciated currency is simply stupid. A temporary holding line at 12% for around three months would probably have been healthy, but that was missed. The key interest rate should not fall below 10% under any circumstances, or even better remain at 10.5% until the end of 2024. Devaluation pressure on the real is much more damaging than a slightly higher interest rate. Everyone should have learned this by now. Especially in view of the fact that the real interest rate should be around 5.5%, a key interest rate SELIC of 10.5% is urgently needed. Otherwise we are entering dangerous waters.
