Forex Blog: Currency Trading News & Analysis.

November 4th 2009

How will Foreign Investment Tax Affect the Real?

On October 20, the executive office of the government of Brazil enacted an emergency measure, calling for a 2% tax on on all foreign capital inflows. And with one foul swoop, this year’s 35% rise in the Real had come to an end, right?

The tax certainly took investors by surprise, with the Brazilian stock market falling by 3% and the Real falling by 2%, the largest margins for both in several months. The tax is comprehensive and applies to essentially to all foreign capital deployed in Brazilian capital markets, whether fixed income, equities, or currencies. While the tax doesn’t apply to those currently invested in Brazil, the possibility that it would cause potential investors to stay away was enough to cause a sell-off.

The ostensible reason for the tax levy is to prevent a further rise in the Real. By most measures, the currency’s rise has been excessive, more than erasing the losses incurred during the credit crisis. The concern is that a more expensive currency will derail the Brazilian economic recovery before it has a chance to firmly get off the ground. “Brazil’s currency needs to weaken as much as 19 percent for sustainable economic growth, said Nelson Barbosa, the Brazilian Finance Ministry’s top policy adviser.”

According to cynics, however, the tax is a backhanded effort to raise revenue to fund a growing budget deficit. The government continues to spend money (perhaps to offset the negative impact on exports brought on by the Real’s rise) as part of its stimulus plan, but is increasingly tapping the bond markets to do so. The tax is expected to bring in an impressive $2.3 Billion over the next year, which could go part of the way towards fixing the government’s fiscal problems.

The real question, of course, is how the Real will fare going forward. The initial reaction, as I said, was ‘The Party’s over…‘ But investors with a longer-term horizon aren’t fretting. “In the medium term, the measure will have a limited impact. The fundamentals point to a stronger real, with commodities rising and the dollar weakening globally,” asserted one economist. While investors aren’t happy about paying an arbitrary 2% fee to the government, such pales in comparison to the 10%+ returns that investors still aim to reap from investing in Brazil over the long-term.

Ignoring the possible bubbles forming in Brazilian capital markets (admittedly, a dubious suggestion), Brazil still looks like a good bet, especially on a comparative basis. Interest rate futures point to a benchmark interest rate of 10.3% at this time next year, compared to ~1% in the US. Even after accounting for inflation and the 2% tax levy, the yield spread between Brazil and the US remains impressive. For that reason, the Real has already stalled in its expected fall against the US Dollar, standing only 1.7% below where it was on the day the tax was declared.


It’s unclear how determined the Brazilian government is towards pushing down the Real. The comments by its finance minister suggest that the consensus is that it is not slightly – but extremely overvalued. Thus, it’s likely that the government will enact other aggressive measures to prevent it at least from rising further. It continues to buy Dollars on the spot market, and is trying to make it easier for Brazilians to take money out of Brazil. It is not yet ready to tamper with its floating currency, but by its own admission, the “government was studying additional measures to regulate the heavy inflow of foreign investments and its impact on the country’s currency.”

There are also implications for other (emerging market) currencies. As I wrote earlier this week (“Central Banks Prop Up Dollar“) a number of Central Banks have already intervened or are currently mulling intervention in forex markets, to push down their currencies. You can be sure that other governments will be studying the situation in Brazil closely, with the possibility of implementing such policies themselves.

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Posted by Adam Kritzer | in Emerging Currencies, Exotic Currencies, News | No Comments »

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