The real forex problem

November 28, 2015 09:00 AM

Almost exactly six years ago, the International Olympic Committee awarded Rio de Janeiro the “privilege” of hosting the 2016 Olympics, and frankly, who could blame them? 

The Brazilian economy was surging on the back of a commodities boom, driving Brazil’s currency—the real—to its highest level in a decade. Indeed, the country cited its strong economy and political stability as major selling points in its Olympic bid. Now, the situation has completely reversed: Brazil’s economy is in shambles, hit by the brutal combination of a slowing Chinese economy, falling commodity prices and political instability. 

Not surprisingly, many of Brazil’s economic issues stem from a slowdown in China, its biggest trading partner. Brazil’s (over)reliance on exporting raw materials to the seemingly insatiable Chinese economic dragon contributed to the country’s rapid growth throughout the early 2000s. As China’s economy has downshifted, Brazil has fallen into a deep recession, with GDP contracting by 6% during the last five quarters alone.

Beyond trade, China’s slowing economy has also had a negative impact on commodity prices. Key Brazilian exports including iron ore, crude oil and agricultural staples, have all fallen by 50%-60% in the last few years, driving down Brazil’s terms of trade and leading to a persistent current account deficit. 

On the political front, President Dilma Rousseff’s approval ratings have fallen into the single digits and a majority of citizens now support her impeachment. Rousseff and her party have also been accused of a massive corruption scandal related to the semi-public energy company Petrobas, where Rousseff previously served as Chair. In early September, Standard & Poor’s downgraded Brazil’s foreign currency debt to junk, citing political turmoil as one of the major catalysts.

Some international observers are hopeful that S&P’s downgrade will serve as a wake-up call to help Brazil get its fiscal house in order. In an effort to restore investors’ confidence, the government recently introduced a 
$17 billion (66.12 billon real) austerity package for 2016, composed of a mix of tax hikes and spending cuts. 

However, the falling currency has driven inflation higher, putting Brazil’s central bank in a bind. It would like to raise interest rates to support the real and counteract growing price pressures, but tightening on both the monetary and fiscal fronts could push the economy into an even deeper recession. If the government’s optimistic forecasts play out, the country could return to a budget surplus next year and avoid further downgrades. Regardless of how the austerity package goes over, Brazil’s economy will remain fragile as long as China continues to struggle and commodity prices remain subdued.

All of these economic concerns have taken a massive toll on Brazilian assets. The market cap of Brazil’s Bovespa stock exchange, which was previously the largest in Latin America, has now fallen below that of Mexico, and the carnage in the Brazilian real has been even more severe (see “Real problem”). The real recently hit an all-time low against the U.S. dollar. In fact, the value of the USD/BRL has nearly halved in the last year alone. Brazil’s central bank governor has vowed to use “all instruments” at his disposal to stabilize the currency, but it remains to be seen whether that will be sufficient. 

The real’s travails could have implications beyond Brazil. As of this writing, the real has become an indicator for emerging market sentiment, meaning that a continued collapse could spill over and cause contagion with other emerging market currencies and stock markets.

The outlook for the real (and many emerging market currencies) will hinge on U.S. monetary policy. If the Fed opts to raise interest rates later this year, capital could flee emerging markets for the safety of the U.S. dollar. If the Fed embarks on a prolonged rate hike cycle, the impact on the real could be even more severe.

About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Weller is a Chartered Market Technician (CMT) and a member of the Market Technicians Association.