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A Hapless Brazil Incurs Massive Losses On FX Swaps Amid Currency Carnage

As we’ve documented extensively of late, a host of idiosyncratic political factors have served to exacerbate what was already a very, very bad situation for emerging markets. 

This dynamic is most readily apparent in Brazil and Turkey, and although Ankara probably has a leg up in the race for “most at risk from domestic turmoil”, Brazil isn’t far behind as President Dilma Rousseff battles abysmal approval ratings and a recalcitrant Congress in an effort to shore up the country’s finances by convincing lawmakers to sign off on much needed austerity measures. 

Meanwhile, a confluence of exogenous shocks that include slumping commodity prices, depressed Chinese demand, the PBoC yuan devaluation, and the threat of an imminent Fed hike have conspired with country-specific political turmoil to send the BRL plunging and that, in turn, has put Copom in what former Treasury secretary Carlos Kawall calls “crisis mode.” 

Of course crises are often costly to combat, especially when you’re an emerging market in the current environment and when it comes to Brazil, the use of alternative measures (like effectively selling dollars in the futures market) to avoid FX reserve liquidation is now weighing heavily on the fiscal outlook. As Goldman noted earlier this week on the heels of the latest monthly budget data, “the overall fiscal deficit is tracking at a disquieting 9.2% of GDP, driven in part by the surging net interest bill, which was exacerbated by the large losses on the central bank stock of Dollar-swaps.” Here’s what Capital Economics had to say after an emergency swaps auction was called by Copom in a desperate attempt to shore up the BRL last week:

First, the size of the planned auctions is reasonably large. Up to $2bn in swaps will be auctioned in total, with auctions so far planned for today and tomorrow (with additional dates presumably added in the future). To put this into context, when the central bank first launched the programme in 2013 the weekly limit on the auctions was $2bn, but by the end it was auctioning less than $200mn a week.


Second, we’re not convinced restarting the FX swap programme will do much to stabilise the currency. Indeed, if anything, the initial reaction has been for the real to fall further (it is currently down by 1.8% against the dollar today). Interventions in the currency market rarely have much effect and there are particular issues with using FX swaps as a policy tool. Specifically, if the central bank gets caught on the wrong side of the trade (i.e. the real weakens further), the government will incur a fiscal cost. Losses on FX swap contracts have already inflated the government’s budget deficit by more than 1% of GDP this year, adding to concerns about the fiscal outlook.


Finally, the central bank (and government) is clearly becoming spooked by the fall in the real. Generally speaking, while many analysts have worried about the impact of a weaker currency, we have taken the view that it is part of the solution rather than the problem. If currency falls become disorderly, however, that complicates the issue for policymakers. It’s early days, but if the real continues to come under pressure it’s possible that the interest rate tightening cycle could be re-started at next month’s COPOM meeting.

Just how costly has protecting the BRL via swaps been, you ask? For the answer we go to BNamericas:

Brazil's central bank has already seen losses of almost 2% of GDP as a result of foreign exchange swaps, local paper Valor Econômico reported, citing fiscal data released this week.


The program also accounts for about 30% of the increase in gross general government debt incurred in the last year.


According to another local paper, Estadão, when looking at the amount spent on both swaps and line auctions, which are contracts to sell dollars with the promise of repurchasing them later with interest, the central bank has already offered 80bn reais to the market in less than one month.


In the 12 months leading up to August, the cost of swaps totaled 112bn reais (US$28.0bn), or four times the estimated primary deficit in the 2016 budget. It also exceeded by almost 14 times the primary surplus planned for 2015 (8.7bn reais).


This spending represents almost a quarter of the public sector's interest payment 484bn reais, or 8.45% of GDP in the 12 months leading up to August. The expense also puts pressure on the nominal deficit, which totaled 528bn reais, or 9.21% of GDP, a historical high. When excluding the effect of swaps, the nominal deficit would be 7.26% of GDP, still one of the highest in the emerging world.

Unfortunately for Brazil, "it is not a problem of liquidity, but of fundamentals," (to quote Barclays), meaning that the pressure on the BRL is likely to continue up to and until the picture improves in terms of commodity prices and until the Rousseff government can prove to the market that plans to get a handle on the deficit are credible. Notably, the currency rallied hard on Friday after Rousseff cut eight ministries, and committed to reduce minister salaries by 10%:

Still, this may ultimately be seen as nothing more than a cosmetic change by the market. But don't take our word for it, just ask Gustav Gorski, chief economist at Quantitas Gestao de Recursos who, according to Bloomberg, says "the ministerial reform announced today by President Dilma Rousseff is the only way to keep PMDB party in allied base [and] the impact was estimated at 1b reais by planning ministry, which isn’t enough."

In other words, the pressure on the BRL isn't likely to abate for long and as outlined above, the irony of using swaps to defend the currency is that it contributes to the very same budget deficit that's pressuring the FX market in the first place and so because that's clearly unsustainable, you can expect that in relateively short order, the trajectory shown here...

... will start to look a lot more like the trajectory shown here...

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And because we would hate to disappoint anyone...