Late on Wednesday Brazil — land of impressive football and interest rates — announced a further development in its controversial capital controls.
From the Wall Street Journal:
BRASILIA—Brazil’s government will apply a tax on Brazilian stocks traded as American depositary receipts, another effort to stem the rapid flow of capital into Brazilian securities that has sent the country’s currency soaring against the U.S. dollar.
That move comes just a month after the South American country decided to impose a 2 per cent tax on foreign-exchange inflows, in an effort to rein in the appreciation of its local currency, the real. The new tax — which will apply to ADRs issued as of Thursday — is presumably a fresh effort to restrict the flow of investment into the country and stop it from favouring the (overseas) Brazilian ADR market over the capital-controlled domestic market.
For those unfamiliar with ADRs, they’re basically a kind of certificate issued by an American bank that represent ownership in the shares of non-US companies that nevertheless trade in the US financial markets (there’s a useful list of Brazilian ADRs available here). The goal is to help American investors buy shares in foreign companies without some of the hassles and potential risks normally associated with cross-border and cross-currency transactions.
When Brazil first announced its foreign exchange inflow tax, the move prompted speculation that there would be a spike in interest in ADRs as a way around the control measure (long live arbitrage, eh?). Here’s a November 4 example from Seeking Alpha’s Marc Chandler, using Brazil’s Petrobas:
1. Each U.S. ADR is worth two local shares. The local shares are trading around BRL41.4. Using an exchange rate of BRL1.7285 = $1, that means that each local share is worth about $23.95. If a foreign investor wanted to buy it, they would pay $23.95 plus 2% or $24.43 [$24.43*2=$48.86]
2. The ADR should trade for twice that or $48.86. But the ADR is trading around $47.91. Excluding the 2% tax, fair value would be $47.90.
Thus the need, presumably, for the extra tax on new ADRs. When Brazilian companies sell ADRs to foreign investors, they have to deposit the shares with Brazil’s custodial agency — Cetip — and that’s when the new tax will come into play. Cetip will charge the issuing company 1.5 per cent when the shares are deposited. Brazilian companies will pass on the extra cost to the (overseas) buyers of the shares — et voila — another capital control!
But the move — like the original inflow tax — has already generated criticism from analysts.
Here, for instance, is Standard Chartered’s Douglas Smith:
This is another instance of ineffective policy following ineffective policy. To alleviate pressure on the BRL to strengthen, the government could cut import tariffs on capital goods, which would also have the positive effect of helping boost much needed investment. It could support infrastructure and boost productivity gains which would lower the real interest rate which attracts capital inflows. If the reason for the tax is to raise revenue, the real issue is bloated public spending that should be pared back now that the economy is growing. Unfortunately, spending is now becoming pro-cyclical and thus more revenue is needed. With presidential elections in October 2010 and government candidate Dilma Rousseff behind in the polls, any fiscal retrenchment is unlikely.
The new tax will have a negative effect on the BRL and the Bovespa in the short run for sure. In the end though, will it make much difference? Brazil still has among the highest interest rates in the world (and will be hiking in Q1 by our estimates), Brazil’s economy is one of the first EM economies to grow strongly after the global shock, and the global environment is one of broad, USD weakness. Thus, pressure on the BRL to gain will resume after this noise but not without an appropriate premium for the risk of additional controls.
You can see that “negative effect” in the below chart:
Whether that turns out to be a temporary or more longer-term effect, of course remains to be seen.
Brazil equity tax boosts ADR interest – LatinFinance (subscription required)
The return of capital controls, Indonesia edition – FT Alphaville
An own goal in Brazil’s capital controls? – FT Alphaville
Fatal attraction – FT editorial comment