Brazil Central Bank Raises Interest Rates Another 0.75%

Brazil's central bank raised its benchmark interest rate three-quarters of a percentage point yesterday. Three of the eight directors expressed the view thatthe raise was excessive, which seems to indicate that the monetary tightening process may be nearing its close in this cycle. Policy makers voted 5-3 to raised the so-called Selic rate a fourth time since April to 13.75 percent from 13 percent in an attempt to keep a tight grip on inflation, and to confirm the Banks growing reputation as the "Bundesbank of Latin America". The decision raised Brazil's real interest rate - which is the nominal rate adjusted for the 6.17% CPI inflation -  to 7.58, the highest among emerging and developed economies alike. The dissenters on the board voted for a half-point increase.






Real Decline

Despite the interest rate rise the real fell below the 1.80-per-dollar level today for the first time since January an indication more of deteriorating global sentiment - today's drop was triggered by speculation Lehman Brothers is about to collapse. The real dropped 1.8 percent to 1.8202 per dollar at 11:03 a.m. New York time, from 1.7878 yesterday. Earlier it touched 1.8374, the weakest since Jan. 22. Lehman's 38 percent fall today pushed the Standard & Poor's 500 Index to its lowest since November 2005. As wer can see in the chart below, the real had been rising steadily in 2008 until the start of August. Then the wind clearly changed, and the dollar had been rising and the real falling.

If we look at the three month chart things are even clearer, and we can see that sentiment had been deteriorating since mid July, and then really to a hard jolt downwards in late August. Most of this evidently has no direct relation with the strength of the Brazilian economy, or with any deterioration in the inflation outlook (quite the contrary, see below) but rather with global factors, like, of course, commodity prices, since the movement conforms reasonably well wilh the downward shift in the price of oil.




Brazil's stock market, the Bovespa index (about half of which consists of raw material companies), is also vulnerable to concerns about global growth, and the has dropped around  23 percent so far this year, hurt by both inflation concerns and a decline in commodity prices.

But we need to ask ourselves some basic questions about the current USD rally and the extent to which a continuing US slowdown would will lower growth in key global movers like Brazil and India. It is also worth asking the question whether there is any real danger of capital flight from either of these two economies to the dollar perceived as a safe heaven currency. This whole argument seems to be very overstretched at this point. Indeed it seems to be a real paradox that the USD continues to be considered a safe heaven despite US credit markets being the epicenter of the current global economic turmoil, and especially at a time when returns on USD assets continue to be negative, while any continuing upward movement in the dollar can only help the trade deficit deteriorate again, Thus it is my view that the current USD rally unsustainable as seen against a select group of emerging economy currencies (and in particular the rupee and the real, is not justified, and basically not sustainable with increasing all those imbalances people had been working so hard to try and correct.


And Is Inflation Already On The Wane?


At the same time Brazil's consumer prices rose at their slowest pace in 11 months in August after food and beverage costs fell for the first time in more than two years. The August price increase as measured by the benchmark IPCA index was just 0.28 percent, compared with 0.53 percent in July, as a result annual inflation slowed to 6.17 percent from a three-year high of 6.37 percent.

Food and beverage costs dropped 0.18 percent last month, the first decline since June 2006, after rising 1.05 percent in July. On the other hand, non-food inflation actually accelerated, indicating the central bank is quite right to try to squeeze out second round effects at this point. Service prices rose by 0.73 percent in August, up from 0.51 in July. Prices for non-food goods not subject to government regulation also rose 0.5 percent in August, up from 0.3 percent in July.

The Impact Of Energy Prices

Energy prices also seem to be easing, and rapidly.


Oil prices fell to their lowest level in five months today as investors worried that the ongoing economic slowdown would continue to chip away at the demand for energy. Light, sweet crude for October delivery fell $1.88 to $100.70 a barrel on the Nymex, after dropping as low as $100.10 a barrel at one point. The contract settled yesterday at $102.58 — the lowest close since April 1. The last time crude traded below the $100 mark was April 2 Oil prices have now fallen more than $40 from the record high of $147.27 a barrel on July 11, two months ago, as a struggling global economy has cut into demand for energy. The US is leading the way in the decline in demand for oil, and the US Energy Information Administration reported last week that imports of crude in August were 200,000 barrels a day below the same four-week period last year. This pattern is repeated to some degree or another in economy after economy across the globe.

Now this decline in oil will evidently have a floor, but where exactly does that floor lie? My own view is that the decline will continue, but that it may hit bottom around $80, since at some point inflation will ease back as a major problem in a number of significant economies, and growth will rebound in some key movers (deciding which those are going to be is the tricky issue at this point), and then of course the oil price will start to head up again.

My feeling is also that we could then see quite a quick turnaround in inflation in some emerging economies like India (from the current 13% to say 7%) or Brazil (back down to the 4.5% range?) and this will then mean the negative "lose-lose" dynamic we have been seeing across a number of emerging economies of rising inflation, rising trade deficits, rising interest rates, falling currencies and falling growth can transform itself once more into the "win-win" dynamic of falling inflation, falling trade deficits, slightly lower (but still very yield differential attractive) interest rates, rising currencies and rising growth.

The interesting question is when will we hit the inflection point? Well, if we look at the NYMEX chart below, we will see that oil prices really started to take off in October 2007, and that at current rates of decline in oil prices the two curves should cross (ie 2008 prices should be below 2007 ones) sometime between October and November. Now this will be quite an important event in the emerging market economies, since given the weight which has been attached to energy and food rises in the total inflation picture, once these (for so called base effect reasons) start to clock negative readings, headline inflation should start to sink back.




GDP Growth Remains Strong

The key question then is, of course, how much will Brazil's economic growth be negatively affected by falling commodity prices, and how much will it benefit from the easing back in inflation? In the short run this is a hard one to call (although I think in the longer run commodity prices are likely to remain relatively high, and this will be more to Brazil's advantage than anything, especially if the central bank can manage to squeeze second round inflation effects out of the system.

Brazil's economic growth actually accelerated in the second quarter, so at this point there is no great sign of any formidible slowdown.  Gross domestic product in fact was up 6.1 percent from a year earlier, beating all the main forecasts. Growth was fueled by a mixture of investments and exports, and was up from a revised 5.9 percent rate in the first quarter. The economy was also up 1.6% quarter on quarter, from the first quarter of 2008.

Capital investment in Q2 was up an annual 6.2 percent, the fastest pace since the second quarter of 1995. Household spending grew 6.7 percent after a 6.6 percent expansion in the first quarter. The volume of exports rose 5.1 percent, reversing a 21 percent decline in the first quarter.

Finance Minister Guido Mantega argued today that he expected Brazil's economic growth this year to be above the current government's 5 percent forecast. Mantega, who has to some extent been a critic of central bank rate increases, said economic growth wasn't stoking inflation because supply was keeping up with demand.

The Iara Field

Basically it is hard to see why some people are so pessimistic for the outlook on the Brazilian economy. The favourable demographic moment Brazil is facing in terms of the share of the population in the working age groups means there is plenty of available capacity, and the continuing development of Brazil's oil industry means that there should be a constant and adequate inward flow of capital.  As if to ram this point home, Petroleo Brasileiro, Brazil's state-controlled oil company (otherwise know as Petrobras), said yesterday that its Iara offshore field contains 3 billion to 4 billion barrels of oil, making it the second giant find in a year and offering enough oil on its own to keep Brazil supplied for up to five years.

The assessment  is the first estimate of recoverable oil since the discovery of the field was announced on Aug. 11. Petrobras  said in January its Jupiter field in the same region contained gas quantities similar to its Tupi area, the largest oil find in the Americas since 1976. Iara is in the Santos Basin to the north of Tupi, a 5 billion- to 8 billion-barrel field announced in November. If confirmed, Iara and Tupi, which sit in non-adjacent parts of the same exploration block, could almost double Brazil's 12.6 billion barrels of proven oil reserves. 

The Iara estimate is based on a well drilled in 2,230 meters (7,315 feet) of water. The final well depth is 6,080 meters. Petrobras has not said whether Iara is an extension of Tupi. Unleased and unexplored areas sit between the two fields. The block, named BM-S-11, is in two, non-contiguous parts. The Iara portion is less than a quarter the size of the Tupi portion, according to a map supplied by Petrobras.

The Outlook Is Solid

So my feeling is that within six months or so of the oil "cross-over" we should see the Brazilian economy really start to pick up speed again, and in particular we should see a strong rebound in industrial output. Brazil, remember, is still growing at a 6.4% annual rate, and while this may well drop back in Q3 and Q4, this velocity will quite possibly be attained again as the key emerging economies start to "break sweat" and head upwards towards their earlier strong upward paths. Brazil will be there amonst the leaders, as will India. But when the role call is taken, just who will be present and who will be absent is going to make interesting reading.