Itaú BBA - The Art of Floating and Intervening, by Ilan Goldfajn

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The Art of Floating and Intervening, by Ilan Goldfajn

September 9, 2013

They say the exchange rate was invented to keep us humble.

They say the exchange rate was invented to keep us humble. If past trends are hard to explain, imagine forecasting the future. Less than 18 months ago the real fell below 1.70 per dollar and, after an intense depreciation, reached 2.45 last month. The central bank of Brazil announced a new intervention mechanism that has eased concerns but kept the (perpetual) debate alive. Where is the real headed? What is the best move in this situation?

I divide the current debate on exchange rate and intervention into two views (not necessarily mutually exclusive). The first view advocates that the exchange rate should go where it needs to go. The idea is to reinforce the importance of fully preserving the exchange rate fluctuation – which is part of the Brazilian macroeconomic tripod, along with inflation target and fiscal responsibility – in order to find a new equilibrium exchange rate, regain competitiveness and stimulate more rapid growth. This process becomes even more relevant when the current exchange rate depreciation shock seems to have a significant global component. It is, in fact, the dollar that is appreciating, now that the outlook indicates a recovery in the U.S. given capital flows reverse to back to the country. As a matter of fact, several other emerging currencies have also experienced a sharp depreciation, signaling the U.S.’s new leading role with the rebound of the dollar.

In this global context, the fluctuation of the real would be the most direct route to achieve a new equilibrium, thereby accelerating the necessary economic adjustment to this new reality. If the future requires a more depreciated exchange rate, it is better not to slow the process and, instead, begin to focus on the consequences of this new equilibrium.

The problem is that the floating exchange rate regime is far from perfect. It is only the "least of the evils" among the available exchange-rate regimes, which include fixed and administered, among others. It suffers from some of the ailments common to other exchange rate regimes, as well as some idiosyncratic evils (of course, it has more advantages).

The common "evil" is that none of the exchange rate regimes have the ability to perform miracles. All of them require consistent macroeconomic policies – including fiscal policy. Fluctuation only leads to a new stable equilibrium if the monetary (interest rates) and fiscal policies provide an anchor for prices. Otherwise, depreciation will lead to inflation, which will in turn lead to further depreciation (to maintain the value in real terms), risking entering a depreciation-inflation spiral. In the absence of an anchor, currency fluctuation (without intervention) will quickly reveal the existing deficiencies.

The specific problem of this regime is that the currency can float excessively, beyond its fundamentals. In reality, there may be what its called overshooting – a term immortalized by the work of Professor Rudiger Dornbusch, which refers to movements that take the exchange rate beyond its medium/long-term equilibrium, to afterwards return to these levels. Dornbusch studied how interest-rate changes may lead to overshooting – an exercise that fits well in the current context. These movements are now widely known both in theory and in practice.

Interventions have been common practice in preserving fluctuation while staying alert to excessive movements. However, the understanding is that the intervention should limit itself to the goal of avoiding excessive volatility, arising, for example, from lack of liquidity (in which case there is no market due to uncertainty) and unstable processes (such as bubbles).

However, the difficulty lies in practice. There is no safe way to separate excess fluctuation from that justified by fundamentals. In the current case of Brazil, how much of the domestic uncertainty may be leveraging the global shock? In many cases, some assessment of where the exchange should be headed is required, which is a task easier stated than calculated.

In the case of Brazil, there are at least two ways to approach the equilibrium of the real. The first is to start with the premise that Brazil is expensive when measured in dollars (or any other strong currency), and calculate the exchange rate that would make prices in Brazil equal to international prices. This approach embodies an aspect of the Purchasing Power Parity theory (PPP), which states that prices eventually converge over time. In this case, the Brazilian exchange rate would still have to depreciate a good deal. However, empirical evidence shows that this type of price deviation can only be corrected in the long term – decades, not months, or even years. The second approach is to calculate the exchange rate that would adjust the current account deficit to levels consistent with the new global reality. An adjustment of the current account deficit, from the current 3.5% of GDP to around 1.5% in a few years, requires an exchange rate of around 2.30 per dollar.

The second view on intervention advocates the benefits of smoothing the current shock over time. In recent years, Brazil has drawn on intervention to accumulate reserves totaling USD 370 billion, which are costly to maintain (as they involve the payment of the difference between the country's high interest rates and the low interest rates received on reserves deposited abroad) but are seen as insurance to cushion shocks. At the present, the shock occurred and the insurance must be used. Intervention is the way to finance the current account deficit over time (as well as investor portfolio adjustments) until the new exchange rate stimulates exports and reduces imports. The risk associated with this view is classic: that intervention, rather than smoothing, will replace the need for other economic adjustments (fiscal, monetary and structural).

Brazil must seek to avoid artificial levels of its exchange rate, which may prevent the needed adjustment in the economy. However, Brazil needs also to avoid self fulfilling processes (bubbles and overshootings), as well as the optimizing the speed of the adjustment by using the available reserves. Achieving the proper balance is both science and art.

Ilan Goldfajn is chief economist and partner at Itaú Unibanco.

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