Brazil has received huge capital inflows, pushing its foreign reserves from about $80bn at the end of 2006 to about $380bn today (see chart below). The central bank says it has “sterilised” those potentially expansionary and inflationary inflows by selling government bonds – standard practice at central banks around the world.
But the effectiveness of such sterilisation is increasingly being called into question. Now one of the Brazilian central bank’s own economists says it hasn’t worked in Brazil and that the country’s recent credit boom – in which credit has doubled from 25 per cent of GDP in 2005 to 50 per cent today – has been boosted by foreign currency inflows.
Juan Pablo Painceira, the central bank economist argues in a recent paper that Brazilian sterilisation — whereby Brazilian exporters or foreign investors bring dollars and other foreign currencies to Brazil and sell them to commercial banks, which sell them on to the central bank, which in effect prints new reals to hoover up the foreign FX and has to take the new reals out of circulation by selling short-term government bonds to the commercial banks — is, indeed, expansionary.
From Wheatley again:
Painceira argues that having these short-term bonds on their books – which he describes as “nearly-cash yielding interest” – encourages banks to expand their lending to businesses and, especially, consumers.
Very few central banks have to deal with inflows of the order of Brazil’s. If it were a matter of a few billion dollars, or even a few tens of billions, the effects might not be significant. But $300bn over five years amounts to a significant structural problem.
The idea that the consequences of sterilisation aren’t always straightforward is well worth making and has obvious resonance in Europe right now. We note, of course, that this isn’t an exact parallel (one sterilisation involves neutralising the impact of capital flows, the other an expansion of the central bank’s balance sheet) but the simple point is that taking steps to alter effects on the money supply can have unintended consequences.
The argument here in Europe is that ECB sterilisation is mostly about show and doesn’t really alter bank behaviour as it just transforms the holdings of reserves in their accounts at the ECB into a slightly different form.
JPMorgan’s Greg Fuzesi gave three very good reasons why:
First, it does not shrink the ECB’s balance sheet back to its original size, as would be the case if the ECB sold other assets to finance its SMP purchases.
Second, it ties the funds down only for a very short one-week period, with these reserves even eligible as collateral at ECB refinancing operations.
Third, as a result, the banking system’s balance sheet remains more liquid and less risky as holdings of peripheral bonds have been permanently replaced with a short-dated claim on the ECB.
(We have popped an oldish note on the ECB’s sterilisastion process in the usual place already.)