How reliant should Brazil be to the inflow of imported capital?
Posted by Erika Tabacniks on 09 Nov 2009 at 01:04 pm | Tagged as: Uncategorized
Brazil changed its financial policy towards capital inflows in mid October by announcing a 2% tax on capital headed to fixed-income and stock investments. Foreign direct investments will remain untaxed.
It is important to understand why Brazil adopted this policy. Lately, foreign investors have shifted money to high-yield emerging markets. Its benchmark index, BOVESPA has seen an increase of nearly 80% this year. The Brazilian currency, the Real, has gained a massive 36% against the U.S. dollar this year. The appreciation of the local currency has had negative effects on the competitiveness of exporters. The new tax is aimed at preventing an “excessive” surge of the local currency.
First, the value of the tax is low. It will not soften the appreciation of the Real. Investors have realized high returns investing in equities or through exposure to currencies and this tax is not enough to convince an investor to look for another option. There are many items that factor into the decision, including Brazil having received an investment-grade rating from Moody’s in 2008. Forecasts of faster economic recovery and growth also bring money into the country, even with the tax.
Second, higher taxes lead to higher interest taxes, so that foreign and Brazilian bonds offer the same return to foreign investors. Higher rates tend to slow down private investment. If the country’s growth rate is lower than its interest rate, government borrowing deteriorates. This would force the government to lower its public spending. High interest rates have a long history in Brazil.
Third, the new tax impedes capital flows. If the goal is to halt the real’s appreciation, another tactic should have been adopted. The government could have reduced public spending that would ultimately allow lower interest rates. Policymakers could also have lowered import tariffs on capital goods. This would increase the country’s imports, resulting in a higher demand for US dollars.
Fourth, despite the issues above, if Brazil still wanted to create a new tax, they should have differentiated between the types of capital. The government’s concern lies with the short-term speculative capital that enters the country. According to the Finance Minister Guido Mantega, this capital could eventually cause a bubble. The tax was applied across the board to short- and long-term capital. Instead, it should have only targeted capital that is in the country for less than 12 months.
Lastly, if the exchange rate is at these levels, then there must be a macroeconomic reason for it. The current surge in the real is to some degree the result of a weaker US dollar internationally. This tendency is beyond the control of Brazilian policymakers.
The financial tax will have a short-term impact on the local currency. Investors have had an immediate reaction to the tax, and the market has slowed down. Brazil’s economic fundamentals still attract investors from abroad. That is where the changes need to occur in order to bolster the currency in the long run.