Dealing with capital flows in the postcrisis context: the Brazilian experience
Daniela Magalhães Prates
Institute of Economics -State University of Campinas
(Unicamp), Brazil
Workshop
“Financial
Sector
Development for Sustained Growth”
Organized by the Institute of Economics at the State University of Campinas
(IE/UNICAMP) and HTW Berlin – University of Applied Sciences as part of
the DAAD Partnership on Economic Development
Objective
 Analyzing the Brazilian experience with the
management of capital flows since 2009
 The presentation is organized as follows:
 The stages of the crisis and the New boom of
capital flows
 The post-crisis policy dilemmas
 Brazilian experience
 Final remarks
The stages of the crisis and the New boom of capital flows

 BIS Annual Report 2009: the five stages
of the crisis
The stages of the crisis and the New boom of capital flows

BIS Annual Report 2009: the five stages of the
crisis
1.
2.
3.
4.
5.
Prelude (from July 2007 up to mid-Mar. 2008):
subprime crisis
Events leading up to the Lehman Brothers
bankruptcy (mid-Mar. to mid-Sept 2008)
Global loss of confidence (15 Sept to late Oct
2008): systemic crisis
Investors focus on the global economic downturn
(late Oct. 2008 to mid-March 2009)
First signs of stabilization (from mid-March 2009),
but market conditions continued to be fragile.
The stages of the crisis and the New boom of capital flows

The BIS chronology ends at the fifth stage.
According to the updating proposed here, a new
stage, the seventh one, would have emerged in
the middle of 2009 (and stretched through the end
of the year) with the rebound of the global
economy, associated with the end of the
recession in the major advanced economies and,
mainly, the rapid recovery of emerging countries.

This stage was also pointed by the progressive
improvement of the situation in the global financial
markets during the second half of 2009
The stages of the crisis and the New boom of capital flows

The environment of historically low interest rates
in developed countries and abundant international
liquidity (quantitative easing) had two additional
consequences:
 The
 The
return of capital flows to emerging countries
rebound of commodity prices, associated
with speculation in derivative markets and the
global economic recovery under the leadership of
emerging economies, especially China
The stages of the crisis and the New boom of capital flows

The eighth stage would have emerged at the end of 2009
(and lasted until the end of 2010) with the sovereign crisis
in the euro area. It is also characterized by two
movements:



the withdrawal of fiscal stimulus and the
implementation of tighter fiscal policies in advanced
economies, besides their fragile recovery.
the Fed Quantitative easing 2
These movements encouraged even further the capital
flows to emerging countries and the boom of commodity
prices.
The stages of the crisis and the New boom of capital flows


The ninth and current stage would have
emerged at the beginning of 2011 with the
slowing down in advanced economies.
Besides that, it has been
also
characterized by the Euro crisis, which has
worsened in the past few weeks.
A tenth stage: double dip?
The post-crisis policy dilemmas

As no structural change on the International
Monetary and Financial System was adopted on the
crisis treadmill, once more, “emerging assets”
become objects of desire to the part of global
investors

Moreover, emerging countries (mainly Asia and
Latin America) appear to be less risky due to their
resistance to financial contagion (Unctad, 2011) and
their strong rebound. The perception among
investors of declining risk was reinforced by the rise
in the country risk of GIIPS countries since the
seventh stage of the crisis
The post-crisis policy dilemmas

Return of policy dilemmas stemming from
the combination of high growth rates,
accelerating inflation, excessive exchange
rate appreciation and/or asset price
overshooting.

In the case of commodity exporters
countries (such as Brazil), the exchangerate misalignment has been reinforced by
the commodity price boom.
The post-crisis policy dilemmas
Exchange rate variation by groups of countries, selected periods (%)
The post-crisis policy dilemmas


In order to deal with these dilemmas, policy
makers in emerging countries have resorted
to capital controls and prudential regulation
mechanisms
During the 1990s, when the exchange rate
administered regimes prevailed, some of
these countries adopted the same two kind of
regulatory instruments, which integrated what
Epstein, Grabel and Jomo, (2004) called
“Capital management techniques”.
The post-crisis policy dilemmas

With the adoption of dirty float regimes by many
emerging-market countries after the 1990´s crises,
a new role has emerged for these techniques.

In these regimes, besides reducing these countries’
vulnerability to financial crises, the capital
management techniques increase the degree of
autonomy for economic policy-making and are a
supporting instrument for the exchange rate and
monetary policies in times of boom and burst of
capital flows.
Brazilian experience

The Brazilian experience sheds light on the challenges faced by the
monetary authorities of emerging countries concerning to the
macroeconomic management within the current international monetary
and financial system. In Brazil, three features reinforce the economic
policy dilemmas.

The highest interest rate differential in the Group of 20 nations,
which attracts foreign capital in the form of carry trade
operations

The reserve accumulation policy faces two important
constraints: the high amount of public debt concentrated in the
short term and the high interest rate differential

The high degree of financial openness and the existence of
ample and deep derivative markets, which reduce even more
the capability of the monetary authority to influence the
determination of the exchange rate.
Brazilian experience
Brazilian experience
Three phases
1.
Reserve accumulation and currency appreciation
2.
Reserve accumulation, currency appreciation and very narrow
capital control
3.
Reserve accumulation, currency appreciation
management techniques and exchange rate
techniques

Operations with FX derivatives have a central role in the trajectory of the
BRD/USD exchange rate. In fact, future and forward rates tend to define
the spot rate in the Brazilian FX market. These operations, unrelated
with capital flows, are outside the scope of the capital management
techniques. Thus, besides the “Capital management techniques”, the
Brazilian policy makers have used what here is referred as “Exchange
rate management techniques”, whose focus is the FX derivatives.
and capital
management
Brazilian experience
Exchange rate and FX reserves
Brazilian experience
Date
Oct./2009
Oct./2010
Kind of
measure
Capital
control
Capital
control
Main Measure
The Ministry of Finance reinstated a 2% financial transaction tax (IOF) on equity and fixed income
portfolio inflows.
(i) IOF increased twice (from 2 to 4 percent) for fixed income portfolio investments and equity funds.
(ii) IOF increased to 6 percent for fixed income investments
Oct./2010
Exchange rate (i) IOF on margin requirements on derivatives transactions increased from 0.38 per cent to 6 per cent.
management
(iii) Some loopholes for IOF on margin requirements closed.
Jan./2011
Prudential
regulation
Mar./2011 Capital
control
April/2011 Capital
control
Jul/2011
Jul/2011
BCB requires banks make non-interest bearing deposits equivalent to 60 per cent of short dollar
positions in the spot FX market that exceed US$ 3 billion or their capital base, whichever is smaller
(to be implemented over 90 days)
Increased to 6 percent the IOF on new foreign loans (banking loans and securities issued abroad) with
maturities of up to a year. Companies and banks previously paid only a 5.38 percent IOF on loans up
to 90 days.
(i) 6 percent IOF extended for the renewal of foreign loans with maturities of up to a year
(ii) 6 percent IOF extended for both new and renewed foreign loans with maturities of up to 2 years
BCB changed the non-remunerated deposits on banks’ short positions. From now on a 60 per cent
reserve requirement was mandatory for amounts over USD 1 billion or their capital base (whichever
is smaller)
Exchange rate (i) The government extended its IOF on currency derivatives. The IOF will be charged at a rate of 1%
management
on the notional adjusted value, on the acquisition, sale, or maturity of financial derivative contracts
implemented in which, individually, result in an increase in short currency (dollar) exposure or a
reduction in long currency (dollar) exposure. Net long real positions with a notional value of $10
million or less are exempt from the tax.
(ii) The government also laid down new legislation whereby: the National Monetary Council became
the agency responsible for regulating the derivatives market; this tax can be increased up to 25 per
cent; all FX derivatives must be registered in clearing houses; the FX exposure of all agents must be
consolidated
Prudential
regulation
Brazilian experience

However, the measures adopted by June 2011 had
limited effectiveness in refraining both the capital
inflows and the currency appreciation.
 Huge capital inflows to the Brazilian economy
between January and July 2011 (USD 84.5
billion, only bellow the historical record of USD
86.5 billion registered in the same period of 2007)
 Currency appreciation of 8.0 per cent; the
exchange rate BRL/USD fall from 1.66 on
12/31/2010 to 1.53 on 07/26/2011, a 12-year high
against the dollar.
Brazilian experience
BRL/USD Exchange rate
1.78
1.76
Oct-04: IOF rise (4%) on
fixed income flows
1.74
Jan-06: 60% RR on FX
spot short positions
1.72
1.71
1.70
1.69
1.68
1.68
Mar-29: 6% IOF on new
foreign loans up to a year
1.67
1.66
1.64
1.62
1.60
1.65
Jul-27: IOF on
derivative positions
Oct-06: IOF rise ( 6%) on fixed
incrome flows and margin
requirements on derivatives
transactions
1.58
1.61
1.60
Mar-04: 6% IOF on renewed
foreign loans uo to a year
1.56
1,56
1.54
Mar-06: 6% IOF
on foreign loans
1.52
1,54
Jul-08: Rise on the RR on
FX spot short positions
9/2
9/10
9/18
9/26
10/4
10/12
10/20
10/28
11/5
11/13
11/21
11/29
12/7
12/15
12/23
12/31
1/8
1/16
1/24
2/1
2/9
2/17
2/25
3/5
3/13
3/21
3/29
4/6
4/14
4/22
4/30
5/8
5/16
5/24
6/1
6/9
6/17
6/25
7/3
7/11
7/19
7/27
8/4
8/12
8/20
8/28
9/5
9/13
1.50
Source: Central Bank of Brazil
Brazilian experience

Why the limited effectiveness?
 Early
narrow scope and gradual implementation of
capital
and
exchange
rate
management
techiniques

private agents (banks, foreign investor and
companies) adopted a strategy called regulatory
arbitrage, that is, they found loopholes to
circumvent the regulations, among which the
buildup of long real/short USD positions in the
futures market
 They
had an impact on the composition of inflows
Brazilian experience
IOF on portfolio inflows encouraged the buildup of long real/short dollar
positions in the on-shore derivatives market, which are a form of carry trade
Brazilian experience
 These trades are enabled by resident banks which take the other side of on resident
investors’ positions in the derivatives market and hedge them by undertaking FX
borrowing and increasing the short FX spot positions
Brazilian experience
Brazilian experience
Foreign Capital Inflows - USD Million
20,000
6% IOF on
portfolio flows
2% IOF on
portfolio flows
17,000
RR on bank's
FX position
IOF on
foreign loans
14,000
11,000
8,000
5,000
2,000
-1,000
Financial flows
Source: Central Bank of Brazil.
FDI
Portfolio investments
Other foreign investments
Jul-11
Jun-11
May-11
Apr-11
Mar-11
Feb-11
Jan-11
Dec-10
Nov-10
Oct-10
Sep-10
Aug-10
Jul-10
Jun-10
May-10
Apr-10
Mar-10
Feb-10
Jan-10
Dec-09
Nov-09
Oct-09
Sep-09
Aug-09
Jul-09
Jun-09
May-09
Apr-09
Mar-09
Feb-09
Jan-09
-4,000
Brazilian experience

As a result of the IOF on portfolio inflows, banks undertaked FX borrowing
(hedge its currency risk due to the nonresidents´opposite position in FX
derivative)

As a result of the IOF on foreign loans, banks and companies began to make
longer term loans
Other foreign investments - USD million
9000
RR on bank's
FX position
7000
IOF on short term
foreign loans
5000
3000
1000
-1000
-3000
Trade credit
Source: Central Bank of Brazil.
Bank Loans - CP
Bank loans - LP
Jul-11
Jun-11
May-11
Apr-11
Mar-11
Feb-11
Jan-11
Dec-10
Oct-10
Sep-10
Aug-10
Jul-10
Jun-10
May-10
Apr-10
Mar-10
Feb-10
Jan-10
-5000
Nov-10
6% IOF on
portfolio flows
Brazilian experience

As a result of the IOF on foreign loans, banks and companies began
to issue longer term securities
Brazilian experience

Regulatory arbitrage seems to have also affected FDI flows. Two
channels seem to have been used to circumvent capital controls.

Firstly, intercompany loans can be used by transnational
corporations to anticipate the internalization of resources,
which are applied in the financial market as far as they are
not destined to productive activity.

Secondly, foreign investors have begun to assemble
complex structures using the Law 4131 (which regulates FDI
flow) to make investments in equity or fixed income. It´s
worth to mention that the dividing line between FDI and
portfolio flows is very thin; foreign ownership of 10 per cent
or more of the voting shares of resident companies are
classified as FDI, while holdings below this threshold are
considered as investment portfolio
Brazilian experience
Brazilian experience

As the cooperative controls remain inexistent, in order to reduce the
regulatory arbitrage mechanisms more significantly, and thus the
financial flows (due to its adverse effects both on the exchange rate level
and on external vulnerability), the management of capital flows should
be comprehensive (encompassing all kinds of capital flows) and dynamic
(responding promptly to financial innovations introduced by private
agents).

With respect to the “Exchange rate management techniques”, only on 27
July 2011 the government (after the Real reached a 12-year high against
the dollar) adopted a more comprehensive “Exchange rate management
technique”

Besides the 1 percent IOF on derivative positions (which can be
increased up to 25 per cent), the government also make the
National Monetary Council the agency responsible for regulating
the derivatives market and required that all FX derivatives must be
registered in clearing houses
Brazilian experience


As Trading in the Brazilian real happens mostly at home
and at the future market (BIS Survey, 2010), the new
measure “throw sand in the wheels of foreign exchange
virtual transactions” and reduce the “communicating
vessels” between the onshore and off-shore market.
The last measure seems to have stem the currency’s
rally. But, up to now it is difficult to assess its
effectiveness as the currency depreciation since August
is taking place in a context of renewed financial
instability due to concerns about developments in the
euro area and the strength of global activity
Brazilian experience
Final Remarks

The capital flows and exchange rate management strategy in Dilma´s
government was part of a broader change in the exchange rate policy
1.
Increased coordination between the BCB and the Ministry of
Finance in relation to the objectives of the macroeconomic and the
exchange rate policies. This greater coordination was crowned at
the end of July with the decision to make the CMN into the agency
responsible for regulating the derivatives market. As the dynamics
of this market plays a key role in the trajectory of the exchange rate,
in fact, this decision has made it, along with the BCB one of the
organs responsible for the exchange rate policy.
2.
The increasing deterioration of external competitiveness of Brazilian
industry has certainly become a concern of Dilma´s government. In
order to refrain this deterioration, the exchange rate level appears to
have become one additional exchange rate policy´s goal, along
with the reserve accumulation and the reduction of exchange rate
volatility.
Final Remarks
3.
In order to achieve the new exchange rate policy goals, the
government has to change the set of tools used. The success of
official interventions to keep the exchange rate at the desired level
and/or to mitigate its volatility is inversely proportional to the
degree of financial openness of the economy. In order to stop the
currency appreciation the BCB and the Ministry of Finance, now in
tune, resorted to capital management techniques as well as to
exchange rate management techniques.

The seeds of this new strategy had already been sowed at the
end of Lula´s government (in October, when a set of
measures to curb the appreciation were adopted), but only
after the new president of BCB (Alexandre Tombini) took office
in January, along with the new president, a more
comprehensive strategy for capital flows and FX transactions
was adopted.