Brazil's $380 Billion War Chest Is Attracting Envious Glances

(Bloomberg) -- Brazil has huge foreign currency reserves and pays dearly to hold them, so when the chief economic adviser to President-elect Jair Bolsonaro mooted the possibility of selling some, it wasn’t an unreasonable suggestion.

After all, the central bank has $380 billion in reserves, equivalent to 27 months of imports, 19 percent of gross domestic product or 100 times its short term debt. Relatively speaking, that is triple India’s reserves and almost 60 percent more than China’s.

Brazil's $380 Billion War Chest Is Attracting Envious Glances

The war chest is beginning to look incongruous, though, after peace broke out with the financial markets following the election of Bolsonaro to the presidency. Why hold so much hard currency earning so little in interest, when the cost of financing the reserves in reais is so high? The answer, say economists, is that the current market optimism may be little more than a truce and that Brazil’s economy remains fragile, with the fiscal deficit exceeding 7 percent of gross domestic product for the past three years.

"It could prove to be imprudent to lower reserves until the fiscal crisis is essentially resolved," Tony Volpon, chief economist for UBS Brasil and a former central bank board director, said. "Until then, high levels of reserves serve as a needed instrument to manage and dampen the market’s reaction in times of stress."

Brazil's $380 Billion War Chest Is Attracting Envious Glances

Paulo Guedes, Bolsonaro’s designated finance minister, said the proposal to use $100 billion in reserves to reduce public debt was hypothetical, and that it only made sense with a much-weakened currency that was unlikely to happen on his watch. Still, the genie was out of the bottle and the debate is all the rage.

Interest Payments

Unloading the foreign reserves would be a two-step process. The central bank would sell some of them and then immediately reduce its stock of real-denominated repos, which under Brazilian accounting standards form part of the government’s $1 trillion gross debt, explained Carlos Kawall, a former treasury secretary. The attraction of doing that is easy to see. Brazil pays 9.5 percent on its 5-year real-denominated debt, significantly more than it receives on the dollar-denominated debt it holds as part of its reserves. Five-year treasuries currently yield near 3 percent. The math only tilts in the central bank’s favor when the real plunges in value against the dollar.

"There’s an awareness that the reserve levels are too high," Kawall, now chief economist at Banco Safra SA, told Bloomberg News. "It’s the right moment to suggest this discussion over the level of reserves."

In a reply to an emailed request to clarify the rules governing its reserves, Brazil’s central bank said that there are no norms guiding the purchase or sale of reserves and that its actions in the currency market aim to ensure its proper functioning.

The real has gained 1.8 percent against the dollar in the past three months, the best performing emerging market currency after the Turkish lira. The Brazilian currency gained 0.7 percent to 3.7850 per dollar as of 1:10 p.m. in New York. Right now it doesn’t appear to need $380 billion in backup.

Speculative Attack

The obsession with accumulating a big war chest stems from the trauma of past currency crises, particularly the one triggered by the election of leftist Luiz Inacio Lula da Silva in 2002. A massive influx of dollars during the commodity boom through 2011 made the job easier.

Brazil's $380 Billion War Chest Is Attracting Envious Glances

Unwinding that position won’t be easy. If the central bank were to sell the dollars to halt a slide in the real, as Guedes suggested, you may simply be whetting the market’s appetite for more dollars.

"If the market is convinced that the currency is at the wrong level, it’ll take $100 billion, $200 billion easy -- you’ll have a phenomenon similar to a speculative attack," said Marcio Garcia, professor of economics at the Catholic University in Rio de Janeiro. "Using reserves in a moment of stress is complicated."

The urgency to sell reserves has also eased, argues Garcia. The spread between Brazilian and U.S. interest rates on 5-year debt narrowed to 6.5 percent from around 15 percent just over two years ago.

The central bank is technically in charge of managing the reserves and critics suggested the move could be seen as an infringement on its autonomy. Yet Guedes himself is a staunch defender of central bank independence and said the Bolsonaro administration would push legislation to that end.

If history is any indication, foreign currency traders shouldn’t expect a flood of dollars from Brazil’s central bank any time soon. Guedes is not the first to hold out the prospect of down-sizing the monetary insurance policy.

Even before taking office, during his confirmation hearing in the Senate, current central bank chief Ilan Goldfajn suggested discussing the level of reserves when the country were to leave behind levels of uncertainty at the time. That was two and a half years ago.

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