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Convertibility: Brazilian Experience

The proponents of free capital movement claim that one advantage is the supervision of economic policies by the financial market in the direction of "prudent" policies. The Brazilian case shows precisely the opposite: inflows have not been concerned about fiscal and exchange rate "irresponsibility" and have eagerly responded to arbitrage opportunities, until the "market mood" suddenly changes, resulting in a mix of herd behaviour and a speculative attack on the national currency.

Convertibility: BrazilianExperience

The proponents of free capital movement claim that oneadvantage is the supervision of economic policies by the financialmarket in the direction of “prudent” policies. The Brazilian caseshows precisely the opposite: inflows have not been concerned about fiscal and exchange rate “irresponsibility” and have eagerlyresponded to arbitrage opportunities, until the “market mood”suddenly changes, resulting in a mix of herd behaviour and aspeculative attack on the national currency.


Macroeconomics in the Last 20 Years

ome would see Brazil as a country where macroeconomic policies swing between extremes. It is easy to identify periods since the second world war when the country wanted to integrate itself more fully with the international market, and other periods when there were calls for self-sufficiency and a need to strengthen state control over important sectors of the economy.

In the last 20 years, or so, the Brazilian economy can be clearly divided into three different phases. The first (1983-1994) was characterised by successive efforts to curb inflation, renegotiate external debt and reduce the current account deficit. In this period the country did not experience a large movement of capital, which would have limited the autonomy of economic policies, given that high inflation, capital controls and the default of 1987 had isolated the Brazilian economy from the international financial market.

The Real Plan, launched in July 1994, demarcates the beginning of the second phase (1994-1998), which drastically changed the previous perception. The limits imposed by the mobility of capital made clear the need for pro-market reforms to improve the “microeconomic fundamentals” that eventually would give sustainability to the reorientation of the economy and macroeconomic adjustment. Advocacy of liberalisation came for the most part from the academic mainstream, financial-market practitioners and a number of politicians. Some broad features of the Real Plan were (i) it was established by a law; (ii) introduced some sort of fiscal adjustment; (iii) reduced price indexation; (iv) increased market deregulation and trade liberalisation; and

(v) established a new currency (Real) with stable acquisitive power based upon an exchange rate anchor. Emphasis was placed on privatisation of public enterprises, incentives to private foreign investment, maintenance of freedom to movement of capital. The process of convertibility was enhanced, a trend that continues to currently take place.

The combination of financial liberalisation and a real interest rate differential between Brazil and the international capital market would have made possible a relatively fixed and overvalued exchange rate in order to allow a competitive shock and reduce the inertial component of Brazilian inflation. The differential in interest rates also functioned to ensure a positive net inflow of external capital, to finance the balance of payments. The main criticism of this approach was its implicit external fragility: in the absence of a stable international environment there was a significant risk of speculative attack. Thus, the viability of the Real Plan depended basically on variables not controlled by policy-makers, such as the expectations of the financial market and the speed of regulatory procedures in Brazil’s Congress. Moreover, international financial instability increased external vulnerability (due to the liberalisation of the capital account) through the so-called contagion effects, sudden drying up of capital inflows and speculative attacks on the exchange rate. In January 1999, these speculative attacks resulted in the collapse of the exchange rate regime. It is fair to say that the non-sustainability of the macroeconomic model derived from what Obstfeld (1998) denominated as the “inconsistent trinity”.1

The third phase, which began in 1999 and continues today, was based on the adoption of an inflation target, a floating exchange rate regime and a generation of substantial primary surpluses. The aim of the fiscal policy was to reverse the unsustainable rising trend of the public debt/GDP ratio in 1994-98, despite the increasing tax burden. It is relevant to note that, as in the initial stages of the Real Plan, two important macroeconomic functions were delegated to restrictive monetary policy: (i) to reduce inflation until it reached a “long-run steady state”; and (ii) to manage international capital flows in periods of financial stress. Another peculiar aspect that should be mentioned is that the operationalisation of the inflation target in Brazil requires a higher real interest rate than the one necessary to satisfy the international parity condition. As a consequence, international arbitrage tends to overvalue the domestic currency, reducing the profitability of investments meant for production for the external market.

Although the Brazilian government was adopting most of the policies suggested by the international financial market, in 2002 the country suffered a sudden drying up of capital inflows and a large increase in outflows, due to a crisis of confidence related to domestic electoral uncertainty. This is not a surprising outcome but the standard consequence of currency convertibility: the partial loss of autonomy in the conduct of economic policies.

Indeed, in the past Brazil has faced managerial difficulties, chiefly due to external shocks that are transmitted to the real economy by abrupt fluctuations in the exchange rate, which, in turn, reflect the instability of international capital flows. The result has been a disappointing macroeconomic volatility. The trajectory of the economic indicators leads to the conclusion that the process of economic liberalisation has produced a volatile and quasi-stagnating impact on output (and hence on employment) and an adverse shock to investment. From 1995 to 2005, the average increase in GDP per capita was 1.15 per cent and the investment ratio as a proportion of GDP (removing the variation in stocks) averaged 14.71 per cent.

Trends in Capital AccountLegislation

Despite the financial crises in Mexico (1995), east Asia (1997) and Russia (1998),

Economic and Political Weekly May 13, 2006 the general trend in Brazil since the late Real Interest Rate and the Real Effective Exchange Rate 1980s has been in the direction of greater

investment companies and funds were

allowed to operate in the country, and

2 3 4 5 6 7 8 9 10 11 7 7 8 8 8 9 9 9 9 1 1Real interest rate - (EMBI + BR)Real effective exchange rate index

some portfolio investments were allowed.

Another important point was the opening

up of the securities market to foreign

institutional investors in 1991. The

“floating exchange rate market”, intro

duced in 1988, allowed further liberali

sation of residents’ outflows, and the main change was the possibility of conversion from domestic to foreign currency

through non-resident accounts. In practice, residents in Brazil could deposit funds in a non-resident account held in a

Jun 04Jul 04Aug 04Sep 04Oct 04Nov 04Dec 04Jan 05Feb 05Mar 05Apr 05May 05Jun 05Jul 05Aug 05Sep 05Sep 05Oct 05Nov 05Dec 05Jan 06Feb 06

Real interest rate - (EMBI+ BR)

Real effective exchange rate index

Source: J P Morgan (EBMI+); Central Bank of Brazil (Selic; Inflation Expectations and Real Effective

Exchange Rate).

domestic bank, which could convert domestic to foreign currency. Such accounts represented the introduction of de facto convertibility.

Other measures which enhanced convertibility and stimulated foreign capital flows during the 1990s were a general tax reduction on remittances abroad, the authorisation to issue external debt instruments denominated in foreign currency and the permission to foreign investors to operate in the options and futures markets. Furthermore, the issuance abroad of convertible debentures was authorised and so too the depository receipts representing Brazilian securities.

Notwithstanding the liberal trend, from 1993 to 1996 new capital controls were adopted which were motivated by concerns regarding the cost of sterilising capital inflows.2 The restrictive actions involved quantitative controls and pricebased measures through the use of the financial transactions tax. Looking at the way these controls were implemented leads to the conclusion that when there was a substantial increase in capital inflows, policy- makers placed limitations on inflows and stimulated outflows. The measures easing outflows made it clear that the overall objective was to reduce net inflows without affecting the liberal project of increasing integration with the international financial market.

Since the first half of the 2000s, nonresidents have been allowed to invest in the same instruments in the financial and capital markets as residents. The current registration process of external flows by the central bank of Brazil has become a documentary requirement instead of an active authorisation process. Regardless of the large liberalisation, the present convertibility of the Real is based on an apparatus of rules of different kinds made in different circumstances, instead of a previously announced, organised and gradually implemented legal process. The consequence is an excessively bureaucratic and complicated system that obstructs the attainment of the “advantages” of financial liberalisation.

The truth about capital account opening in Brazil is that the economic rationale behind it was to make possible the “major macroeconomic objective” of price stabilisation based on an exchange rate anchor.3 Thus, the procedural order did not follow the sequence and timing prescribed in the literature. The result was a vast openness without the necessary improvements and maturity in the related institutions or macroeconomic indicators.

Hopes and Fears

Two undesired collateral effects of the Real Plan, both relating to capital account convertibility, were: (i) deterioration of the external sector; and (ii) precarious public finances. With regard to the external sector, the overvalued exchange rate-based stabilisation programme led to large current account deficits. Notwithstanding the non-sustainability of the consequent increase in external debt and the level of the overvalued exchange rate, the financial market supported the programme (mainly by portfolio inflows) from July 1994 to the end of 1998. In addition, the controlled exchange rate associated with the interest rate differential stimulated the expansion of external debt by the private sector. In January 1999, capital outflows forced a drastic policy shift in order to avoid a complete depletion of government foreign reserves.

The exchange rate depreciation, related to the adoption of a floating exchange system and to the crisis of confidence in 2002, stimulated a reorientation of production in direction of tradeable goods, resulting in expanding trade balance surpluses. The floating regime also provides further incentives for borrowers to better assess exchange risks. The uncertainty that this regime introduces makes it highly risky to issue foreign currency debt, in particular for agents who do not have dollar revenues (the non-tradeable sector). These incentives and newer export stimuli resulted in an improvement of the external indicators, as the external debt/ GDP ratio dropped from 3.6 in January 1999 to 0.8 in March 2006. Thus, Brazil experienced what the literature had already pointed out in the early 1990s: the appropriate exchange rate regime for a financially open economy is the one capable of absorbing part of the external shocks through flexible relative prices.

The Real Plan required an initial fiscal adjustment that should have been further expanded, but this adjustment has been postponed. Actually, despite some advances in this area, in the last 10 years fiscal policy has been marked by a continuous increase in the tax burden. Since 1994 the tax burden expanded from about 26 per cent of GDP to around 40 per cent of GDP today. Government expenditure increased faster than GDP, with the opposite occurring in government capital investment outlays, currently at negligible levels. What is the relationship between these “residues of Real Plan” and capital account convertibility?

Economic and Political Weekly May 13, 2006

The defenders of free capital movement frequently mention that one of its advantages would be the constant supervision of economic policies by the financial market in the direction of “prudent and/or responsible” policies. The Brazilian case shows precisely the opposite: inflows have not been concerned about fiscal and exchange rate “irresponsibility” and have eagerly responded to arbitrage opportunities until the “market mood” suddenly changes, resulting in a mix of herd behaviour and a speculative attack on the national currency. In reality, the inflows supported a deterioration of the external account and helped delay the indispensable fiscal adjustment. The Brazilian experience corroborates the interpretation that the international financial market seems to impose a sudden and pungent discipline through a financial crisis, and not a constant and soft adjustment of the required policies.

Another aspect indicated in the literature as one of the benefits of financial opening is the “efficiency effect” attributable to the intensification in competition and the adoption of more sophisticated financial techniques. Some new technologies were introduced in the Brazilian financial sector and the firms were efficient in the sense of selecting the best profit opportunity that the market offered. Nonetheless, the indicators of financial density in Brazil remain lower than international levels, revealing a paradox of competitiveness/efficiency on the one side and low macroeconomic functionality on the other. Moreover, the credit facilities that exist for consumers and firms, besides being limited, have high spreads. The averages of two indicators illustrate these arguments. From January 1999 to February 2006, the total credit/GDP ratio was 27.31 per cent and the annual spread in credit operations 41.96 per cent (which refers to the difference between the cost of borrowing funds and the interest rate earned).

The high interest rate differential necessary to maintain capital inflows resulted in a high opportunity cost of credit for productive investment, since public bonds carried less risk, greater return and were more liquid than private sector debt instruments. This perverse relation transferred income from consumers and entrepreneurs to the public sector and rentiers, redirected part of the credit that could have been channelled to the private sector and put greater pressure on the real interest rate, harming further the prospects of future growth.

Defenders of financial opening also affirm that foreign investors have a high aversion to corruption, which could enhance the quality of public administration. This statement is without solid proof in Brazil. In 2005, for example, the country witnessed one of the biggest revelations of corruption in high places. However, since the allegations did not reach the citadels of orthodox economic policy and because the main explanatory variable of capital movement (the interest rate) was very high in relation to international levels, these allegations did not result in sudden capital outflows. On the contrary, the real effective exchange rate registered a strong appreciation of 15.8 per cent, the country risk (EMBI+ Brazil) fell 28.8 per cent and the São Paulo stock market index registered an increase of 27.7 per cent led by overseas investments. Therefore, the macroeconomic benefits of capital account convertibility are questionable. It is possible that Brazil has already suffered greatly from the costs of hasty financial liberalisation.

A Recent Problem

In an environment of capital account convertibility, central banks of countries with weak currencies have difficulties in simultaneously maintaining credit and money stability. The reason is the existence of a hierarchy between currencies, defining distinct conditions in the organisation and operation of the financial and exchange markets. Moreover, the volatility of monetary conditions along with the presence of fragile institutions, inadequately developed markets and an instability in risk aversion (illusions and peculiarities) have an effect on the variation in investment. This being the circumstance, it is crucial to manage liquidity in strong currencies, as well as accumulate international reserves and current account surpluses, with the purpose of preventing external shocks that may disturb the autonomy (even in relative terms) of the main domestic monetary variables (interest and exchange rates).

It is not only in periods of risk aversion that financial opening has an adverse effect on economic variables. Actually, in periods of voluminous international liquidity, the national currency tends to appreciate, especially where interest rate differentials are significant. This is one of the most recent and unfavourable problems faced by the Brazilian economy. The graph shows the inverse relationship between the real interest rate less the sovereign risk premium (EMBI+ Brazil) and the real effective exchange rate. The period coincides with the last monetary restriction that was necessary to reach the established inflation target. It is important to say that although the appreciation took place, the Central Bank of Brazil in the same period bought $ 32 billion in international reserves, doubling its level and showing that “the dirty float” is not sufficient to avoid currency appreciation when international capital flows can freely move in and out of the country.

The virtuous trajectory of the trade balance after adoption of the floating exchange regime, expanded the supply of foreign currency, raised confidence in some indicators of external vulnerability and reduced the country’s risk premium. All these factors influence the demand for assets denominated in domestic currency, which acts in the direction of appreciation. Nonetheless, the monetary policy is a determinant of the exchange rate direction, since it defines the conditions of international arbitrage.

The actual level of the exchange rate is lower than the average in the period of controlled exchange rate (1994-98), which history shows was an unsustainable value. This overvaluation has consequences regarding the capability and incentives for new investments, especially in sectors more sensitive to variations in profitability. In fact, since September 2004, the 12-month accumulated growth rate of manufactured exports registered a significant fall (from around 24 per cent in the last quarter of 2004 to roughly 6 per cent in March 2006). At the same time, the export profitability index declined, reaching its lowest level of the last 12 years in March 2006.

Furthermore, the overvaluation of the Brazilian economy reduces the number of sectors capable of profitable export returns. In this vein, this tends to concentrate the growth of exports in sectors that had the “compensation effect” of an increase in international prices, or in sectors that had a considerable comparative advantage. Recent indicators of export performance show an increasing concentration in agricultural commodities.

Concluding Remarks

The Brazilian experience with capital account convertibility and the enforced conventional measures to protect the

Economic and Political Weekly May 13, 2006 financial system seem to be more dangerous to the country’s social-economic progress than what the supporters of such a strategy may suppose. A standard conclusion of the mainstream literature in this matter indicates that the faster countries privatise and liberalise, the better. Our analysis suggests that, contrary to such a view, the speed of capital account convertibility is negatively associated with sustained growth, stability and a more equitable income distribution. On the contrary, it confirms that strong institutions are very important for avoiding extreme measures.

The Brazilian experience definitely shows that the excessive volatility of the real effective exchange rate and the high real interest rates reveal a non-synergetic environment. In conclusion, more careful management policies are indispensable to circumvent severe financial crises associated with imprudent capital account convertibility.




1 The concept of inconsistent trinity can be seen as the practical impossibility to have, concomitantly, capital account convertibility, administration of the exchange rate and autonomy to use the interest rate to achieve other economic objectives. In other words, the financial opening forces the national economic authorities to take a decision to choose control of one of two instruments: exchange rate or interest rate. See Obstfeld, M (1998), ‘The Global Capital Market: Benefactor or Menace?’, Journal of Economic Perspectives, American Economic Association Vol 12, Number 4.

2 The combination of enormous liquidity in international markets, the openness in Brazil’s capital account and the interest differential led to a rush of capital inflows that put pressure on the exchange rate and the money market. These circumstances lead to endogenous restrictions; in other words, the limitations had a pro-cyclical character.

3 In fact, it is fair to say that capital inflows, in the absence of fiscal adjustment, had been the real anchor of the Real Plan. That is the purpose of maintaining a high yield difference during the period of the exchange rate anchor.

Economic and Political Weekly May 13, 2006

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