Whoops, so much for that Olympics-inspired Brazilian ETF effect.
Brazil, land of football and painful female grooming, has just imposed a tax on foreign investments in the country.
From the FT:
Brazil has imposed a 2 per cent tax effective from Tuesday on money entering the country to invest in equities and fixed income instruments. Direct investment in the productive economy will not be affected.
The move, announced shortly before local markets closed on Monday evening, is designed to slow the appreciation of Brazil’s currency, the real, which has gained 36 per cent against the US dollar this year.
Unsurprisingly, the move has sparked a flurry of market activity overnight and on Tuesday morning — not least because the government had repeatedly denied it would impose such capital controls over the past few months (the capriciousness of emerging markets, eh?).
As Clusterstock notes, the iShares MSCI Brazil (EWZ) ETF promptly tanked 4 per cent in after hours trading. The Brazilian real, which has been one of the best-performing major currencies so far this year, dropped to 1.7177 against the US dollar on Monday evening. It’s now trading at 1.716.
The Brazilian authorities have been explicit that this is about weakening the real, but there has also been some suggestion that it’s about popping latent asset bubbles, as well. Here, for instance, are some Monday comments from Brazilian finance minister Guido Mantega:
Mantega said the measures may not lead the real to weaken, but are designed to slow its appreciation and prevent the creation of bubbles in Brazilian markets. “These are to prevent excesses,” he said.
Which is just as well really, because there seems to be a growing consensus among analysts that the tax will do little to stop the real’s appreciation:
While the tax may help keep the real at about 1.7 per U.S. dollar in the next few months, it won’t be able to deter the currency’s appreciation in the long term as investors create new strategies to buy Brazilian assets from abroad to bypass the levy, said Antonio Madeira, an economist at MCM Consultores Associados Ltd.
“These kinds of taxes provide some room for maneuver, but it’s not very much,” Nicolas Eyzaguirre, the International Monetary Fund’s Director for the Western Hemisphere, said by e- mail. “With today’s financial engineering, it’s not very difficult to disguise pure financial flows as trade flows or even foreign direct investment. In fact, the experience in a number of countries is that, over time, the system becomes rather porous.”
So why do it, then?
Here’s some theorising from RBS’s currency strategist Flavia Cattan-Naslausky. Of note in particular, is the idea that this capital control decision, made by Brazil’s Ministry of Finance, may be the prelude to an official interest rate hike by Brazil’s central bank. Australia, which became the first G20 nation to raise hikes since the peak of the financial crisis, earlier this month, has seen its currency appreciate markedly in recent weeks.
Here’s what Cattan-Naslausky says:
Contrary to expectations, Brazil announced the immediate introduction of a 2% entry tax on foreign inflows into fixed income investments as well as the more surprising inclusion of equity investments for the IOF in an attempt to slow the appreciation of the BRL. Though the government’s assessment last week that “the central bank’s ability to fight currency appreciation is limited” was a warning sign for more aggressive measures, the decision to introduce capital controls is more aggressive than we initially expected. I attribute the Ministry of Finance’s decision to three key factors:1- the realization that taxing fixed income alone would only redirect investments to equity markets. With a heavy pipeline of IPOs and secondary market offerings through Q1 10, taxing fixed income alone would have little effect;2 – there is plenty of limitation on the fiscal side of the equation. Faced with a strong outlook for foreign flows and the government’s reluctance to cut back permanent fiscal stimulus and overall expenditures ahead of an election year, the necessary sterilization of FX intervention would be too much of a burden given the pace of fiscal deterioration;3- the government may be preparing for an early start to the hiking cycle. With a positive growth outlook and relatively high real rates, BRL would continue to attract a large share of foreign investment with the risk of currency undershooting.
Related links:
Capital flows, real exchange rates, and capital controls: Some Latin American Experiences – NBER working paper
Stakes soar in Olympics host contest, and ETFs know it – FT Alphaville