Brazil’s new FX low is not the financial record to watch

The news flashed across social media and was picked up by national TV news and the newspapers. It caused much hand-wringing and anxiety – not least as these stories were often accompanied by photographs of supporters of the impeachment of Dilma Rousseff holding signs in 2016 saying: “I want my R$1.99 to the dollar back” – the implication being that the political upheaval caused by these protests had backfired.

In Brazil, the exchange rate matters. The Brazilian middle classes quickly grew accustomed to the heady valuations of 2012 to 2015 (peaking at R$1.53) that enabled them to travel to the US to visit Mickey Mouse’s kingdom and snap up boxes of iPhones in the Miami South Beach Apple store.

Now Twitter and Facebook are awash with expressions of economic anxiety – and the cancellation of foreign travel.

Latin Americans are keenly aware of their currency valuations – a historical hangover from many countries’ bouts of high inflation and currency collapses (sadly Argentina is again living through this). Falling to lows such as this touches a nerve in the national psyche.

Bankers trying to contextualize this new FX record have been drowned out by the angst. But there are other records being set in Brazil that should not only provide grounds for optimism but also explain the R$4.20 threshold.

Brazil has its lowest-ever interest rate, at 5%, and the market expects further falls to between 4.25% and 4.5% by the end of the year. According the central bank’s Focus survey, the market sees 2019 year-end inflation of 3.6% – unprecedented in the country’s modern history.

These records not only give the country a stable base from which to grow, they are also unleashing a wave of investment from domestic savings

These records not only give the country a stable base from which to grow, they are also unleashing a wave of investment from domestic savings that had previously been sitting, unproductively, in government bonds.

A few years ago investors were getting double-digit returns from these products. No more. Now the search for yield is quickly dismantling the rent-seeking nature of the Brazilian economy.

And this is where these records relate to the under-performing real. Many studies show that as the country’s rate has converged with the low levels of developed markets, it has increased the real’s vulnerability to sharp sell-offs.

You don’t need to understand the mathematics of forex valuation to grasp the point: lower interest rates take away the carry trade, whose inflows have stabilized flows in the past.

And it’s not just Brazil. Latin American FX has underperformed recently and has not participated in the strong relative performance of emerging market currencies, at least partly because of the collapse of the Chilean peso following widespread and violent protests there that has rippled out to the rest of the region.

Upside

Saying goodbye to the carry trade is a positive thing for the economy. The government no longer needs to pay exorbitant rates to attract inflows and then, captured by these high rates, have to pay again to subsidize long-term investment at below market rates through state development bank BNDES.

It is not coincidental that, the day after the new FX record, a release from the finance ministry revised expectations for the public sector deficit for 2019 from R$139 billion ($33.1 billion) to R$80 billion, with further reductions to the 2020 forecast.

The stepping back of BNDES is also having a revolutionary impact on the country’s financial markets. Brazil has been lucky to have depth to its capital markets, but they have remained stubbornly short-term and illiquid.

Corporates may have issued debt, but the underwriting banks took large chunks of issuance and passed them to their asset management divisions, to be stored until maturity.

Now – finally – a secondary market is evolving and that is important for issuers, underwriters and investors alike.

According to the country’s banking association Anbima, the volume of secondary trading has already reached more than double that of 2018 – R$85 billion, compared with R$43 billion in 2018 and just R$31 billion in 2017.

The reason for this is clear: record low interest rates. Investors have not only been forced to move away from sovereign debt (and the largest segment of secondary trading is related to infrastructure debt), but the tightness of spreads in the primary issuance market has also led investors to explore relative value in previously issued transactions.

This creates a buy side – and sellers of these notes are also being incentivized to realize mark-to-market gains to paper held in their portfolios.

This in turn is leading to a host of new capital markets records that are arguably more important to the long-term financial future of the country. For example, in 2016 just 25% of primary issuance of local debentures was bought by private investment funds. In 2019 this has leapt to 55%, while the portion held by the coordinating banks has fallen from 35% to just 10%.

Growing demand (and those lower interest rates again) has also lengthened tenors. In 2018, 31.5% of all deals were less than three years, compared with just 20.5% this year. Meanwhile 46.3% of deals have maturities of between four and six years.

These internal debt capital records – lower, longer, more circulated – are creating an opportunity for renewed Brazilian growth and resilience. That’s the real story.