BRL: Weak Fundamentals To Drive Further Depreciation

Short-Term Outlook

We expect the Brazilian real to continue trading within the BRL2.200/US$ and BRL2.400/US$ range in the coming months. Our view for relatively moderate, steady depreciation is underpinned by our expectation that the Banco Central do Brasil (BCB) will continue utilising its FX swap programme to prevent any sharp sell-off in the unit ( see 'BRL: Major Downside Limited For Now', November 27 2013). Nevertheless, the real will remain vulnerable to bouts of risk aversion and we therefore cannot rule out another sharp sell-off in the next few months. In this regard, we believe that the unit's recent low of BRL2.455/US$ level will provide a key level of support in the coming months ( see 'Technicals Highlight Risks Of Significant BRL Weakness', December 5 2013).

Core View

Weakness To Persist Throughout 2014
Brazil - Exchange Rate, BRL/US$ (Daily)
BMI BRAZIL CURRENCY FORECAST
Spot Short-Term 2014 2015
BRL/US$, ave 2.373 2.400 2.350 2.400
BRL/EUR, ave 3.226 - 2.940 2.880
BCB Selic Rate, % eop 10.50 - 9.75 9.25
Source: BMI, Bloomberg January 16 2014

Short-Term Outlook

We expect the Brazilian real to continue trading within the BRL2.200/US$ and BRL2.400/US$ range in the coming months. Our view for relatively moderate, steady depreciation is underpinned by our expectation that the Banco Central do Brasil (BCB) will continue utilising its FX swap programme to prevent any sharp sell-off in the unit ( see 'BRL: Major Downside Limited For Now', November 27 2013). Nevertheless, the real will remain vulnerable to bouts of risk aversion and we therefore cannot rule out another sharp sell-off in the next few months. In this regard, we believe that the unit's recent low of BRL2.455/US$ level will provide a key level of support in the coming months ( see 'Technicals Highlight Risks Of Significant BRL Weakness', December 5 2013).

Weakness To Persist Throughout 2014
Brazil - Exchange Rate, BRL/US$ (Daily)

Core View

We maintain our long-held view that further downside is ahead for the Brazilian real, as relatively slow growth, weak balance of payments dynamics, and continued fiscal deterioration keep downside pressure on the unit. Given more significant depreciation than we expected in late 2013 - the unit ended the year at BRL2.361/US$ as compared to our BRL2.300/US$ forecast - and significant capital outflows in recent months, we now expect the unit to average BRL2.350/US$ in 2014, weaker than our previous BRL2.300/US$ forecast. In addition, we have adjusted our end-2014 exchange rate forecast to BRL2.450/US$, from BRL2.380/US$ previously ( see 'BRL: Fundamentals Point To Further Downside', October 4 2013). Moreover, we expect weakness to persist in 2015, given no significant improvement in the country's balance of payments dynamics, forecasting the unit to average BRL2.400/US$ and end the year at BRL2.500/US$.

Fundamentals Support BRL Weakness...

Lower metals prices and weaker demand on the back of slowing growth in China will continue to impact Brazil's balance of payments outlook in the next few years, underpinning our view for a multi-year period of currency weakness. Indeed, due in large part to these dynamics, we estimate that Brazil posted its first trade deficit in over a decade in 2013, and expect the trade account to remain in the red in the next several years as export growth remains relatively moderate and imports pick up ( see 'Current Account Deterioration To Continue', January 13). This in turn will see the current account shortfall widen to 4.2% of GDP in 2014, from an estimated 3.7% in 2013, and significantly wider than 2.4% of GDP in 2012.

Furthermore, a lacklustre growth outlook, as the economy struggles to recover following a substantial slowdown in economic activity in 2011 and 2012, a still-erratic policy trajectory, and elevated credit risk due to significant fiscal deterioration in recent years are likely to mute capital inflows ( see 'Another Year Of Unspectacular Growth In 2014', December 11 2013). We maintain that the country is in for a period of relatively slow growth over the medium term, forecasting average real GDP growth of 3.0% between 2014 and 2017, as compared to 3.4% during the previous four years. This is due in part to significant business environment challenges, including government intervention in industry, numerous changes to infrastructure concessions, a substantial tax burden, as well as local content and hiring requirements. With investors questioning the risk/reward calculus of investing in Brazil, we see little to suggest that a surge in capital inflows is on the horizon, further supporting our view for currency weakness in the coming years.

In addition, after nearly a decade of appreciation in real terms, we believe that the path of least resistance to address the economy's lack of competitiveness is exchange rate depreciation. The alternative would be structural tax and labour market reform, both of which would require significant political capital and are therefore unlikely to start before the general election in October 2014 ( see 'Commodity Currencies Likely Peaked As Rebalancing Takes Hold', October 1 2013).

Depreciatory Trend Here To Stay
Brazil - Exchange Rate, BRL/US$ (Weekly)

But BCB Backstop To Remain In Place

Despite significant downside pressures on the unit, our view for relatively moderate currency weakness in the coming quarters is underpinned in large part by the BCB's reluctance to tolerate sharp FX depreciation amid elevated inflation. Since the currency hit a multi-year low of BRL2.455/US$ in August 2013, the bank has utilised an FX swap programme to minimise currency volatility, and we expect this type of intervention will remain the bank's primary tool to defend the currency in 2014. With inflation remaining elevated at 5.9% year-on-year (y-o-y) as of December 2013, fiscal policy still expansionary, and the central bank having hiked the Selic target rate by 325bps to 10.50% since April 2013, we believe that the BCB will remain focused on preventing any sharp depreciation in the unit. Indeed, the pass-through effects of significant weakness would hurt consumers' purchasing power and likely force the bank to tighten monetary policy further, weighing on a still-weak economic recovery.

Downside Risks Persist

Although the timing is difficult to predict, we believe that at some point, the BCB's FX swap programme will begin to offer diminishing returns. This could follow a significant deterioration in the fiscal accounts or an uptick in political risk, which could cause investors to challenge the backstop the BCB has placed behind the real ( see 'Technicals Highlight Risks Of Significant BRL Weakness', December 5 2013). In this scenario, we expect that the BCB would dip into its robust stockpile of international reserves, equivalent to 17 months of import cover as of November 2013, to defend the unit. However, such a scenario could still see a sharp sell-off in the unit, posing downside risks to our 2014 average and end-year exchange rate forecasts.

Rising Outflows A Major Risk
Brazil - Exchange Rate, BRL/US$ & Net FX Flows, US$mn

Downside risks to the unit are exacerbated by growing capital outflows in recent months ( see chart). Indeed, should the BCB begin to lose control of the real's trajectory in light of a significant acceleration in capital outflows, the unit would likely weaken more quickly and to a greater extent that we currently forecast.

BRAZIL - EXCHANGE RATE
2010 2011 2012 2013 2014f 2015f 2016f 2017f 2018f
Exchange rate BRL/US$, ave 1 1.76 1.67 1.95 2.16 2.35 2.40 2.32 2.25 2.17
BRL/US$, ave % y-o-y 1 -12.0 -4.8 16.7 10.6 8.8 2.1 -3.3 -3.0 -3.6
BRL/US$, ave, PPP 2 1.74 1.83 1.89 1.89 1.95 2.02 2.08 2.13 2.18
Exchange rate BRL/EUR, ave 1 2.33 2.33 2.48 2.85 2.98 2.95 2.78 2.70 2.60
BRL/GBP, ave 1 2.73 2.70 3.12 3.35 3.74 3.86 3.80 3.71 3.62
BRL/CHF, ave 1 1.69 1.89 2.08 2.10 2.19 2.26 2.21 2.16 2.09
BRL/AUD, ave 1 1.62 1.73 2.02 2.09 1.99 1.92 1.77 1.69 1.63
JPY/BRL, ave 1 154.49 133.56 156.04 211.75 239.70 244.80 236.64 229.50 221.34
BRL/CNY, eop 1 0.25 0.29 0.33 0.38 0.40 0.40 0.37 0.35 0.34
Notes: f BMI forecasts. Sources: 1 BMI calculation; 2 BMI calculation/IMF.

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Geography: Brazil, Brazil
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