By: Dr. Mike Campbell
Brazil is the largest country in South America and has a GDP of about $1.5 trillion. The value of the Brazilian currency, the Real, has risen by 11.3% against the Euro over the course of the last twelve months, making her exports more expensive (and less competitive) in world markets. Inflation in Brazil is running at 5.9% and this is a problem for one of the world’s fastest-growing developing economies.
The usual economic tool used to tackle inflation is to increase the cost of borrowing by putting interest rates up. The idea is that this will put a brake on the economy and cause prices to stabilise or fall as demand dies down.
However, in Forex terms, having a higher interest rate can make a currency more valuable as investors put their money on deposit in the country’s banks to get a better return. Obviously, for this to happen, they need to make the deposit in the local currency which increases demand for it, causing it to appreciate. If a currency is pretty stable, such a move makes sense; certainly if the margin is high enough.
In the case of Brazil, the currency has strengthened against other major currencies which means that the investors also gain the up-side of the currency movement in addition to the interest that their deposit attracts.
The Brazilian authorities have just agreed to another increase in bank interest rate which now stands at 11.25% - more than ten times the rate available to European depositors using EU banks. There is a danger that the move will attract more inwards investment in Brazilian financial institutes which will push the Real still higher and make the country’s exports less competitive in the global marketplace.