Intervention Policy in Brazil, What is the Rationale

8/10/2019 Intervention Policy in Brazil, What is the Rationale

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Macro VisionFriday, August 23, 2013

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Intervention Policy in Brazil: What is the Rational?

The Brazilian Central Bank has announced a program to sell USD 500 million every day (except

on Fridays) in the form of USD swaps until at least December 31. Each Friday, the central bank

will offer up to USD 1 billion of spot-dollar funding (these have been the two most-used

instruments in central bank FX-market interventions.)

This program adds up to an additional amount of roughly USD 35 billion to be provided to the

market in terms of USD direct selling (through swaps) and USD 18 billion of spot-dollar funding.

Assuming that the central bank rolls over the existing USD swap positions (around USD 41 billion),

the total of USD positions being offered to the market is USD 94 billion, or 25% of total reserves

(USD 376 billion).

The Brazilian real has depreciated markedly recently, from 2.0 in April to around 2.45 in mid-August. Concerns are rising about the consequences of this depreciation on inflation and interest

rates, and therefore growth. The government has been intervening in the FX market, but in a more

ad-hoc manner.

The apparent objective of the current program is to supply dollars on a regular basis in order to

increase predictability and transparency in the FX market. Is this a good policy? What is the

rationale for it?

The literature provides some precedents for this type of policy.

Since the Nixon shock and the consequent end of the Bretton Woods system of fixed exchange

rates in 1973, major currency swings have led to eventual currency crises (such as the LatinAmerican crises, the ERM crisis and also the Asian crises). Analysts first tried to explain why

currency crises occur. First-generation models of currency crises focused on the argument that

overly expansive domestic economic policies are not sustainable under fixed-exchange-rate

regimes. Market players bet on the unsustainability of these policies and deplete the countries

foreign-exchange reserves, thereby provoking devaluation.

Later, models emphasized that reserves do not have to be depleted, nor do fundamentals have to

be inconsistent so that countries devalue. In fact, currency crises can be self-fulfilling prophecies

as noted by Obstfeld (1996). The idea behind this second generation of models is that there can

be multiple equilibria for the same set of economic fundamentals.

Finally, by the turn of the century, the work of Morris and Shin (1998) addressed the currency

problem in a world with asymmetric information, explaining why currency crises occur despite no

change in fundamentals. Market participants have some private, although imperfect, information

about the fundamentals of the economy and base their decisions on it. A crisis can occur even if

fundamentals are good, because of information imperfections. Furthermore, in this new setting, a

crisis can take place even if fundamentals remain the same. If a new set of information is

distributed imperfectly through the economy, there may be a crisis.

It is important to remember in analyzing the new measure by the Brazilian Central Bank, that in

these models, transparency may alter the results. As shown by Heinemann and Illing (2002), if

information imperfections are reduced, the likelihood of a crisis in a scenario of good fundamentals

is diminished. Daniels et al. (2011) show that incorporating a threat of policy response leads to a


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lower probability of currency depreciation.

The recent measure may be an attempt to increase transparency in order to curb the currency

depreciation in Brazil. The idea is to increase the transparency of public policy to diminish the

imperfection of private actors information, thereby reducing the likelihood of an outcome detached

from fundamentals. The announcement of a clear amount of intervention is a move in this

direction, as is announcing that the amount of intervention will be calibrated to increase

effectiveness if necessary.

Igor Barenboim

References

Daniels, T, Jager, H. and Klaassen, F. (2011) Currency Crises with a Threat of Interest RateDefence Journal of International Economics,85, 14-24

Heinemann, F. and Illing, G. (2002), Speculative Attacks: Unique Equilibrium and TransparencyJournal of International Economics 58,429-450

Krugman, P.R. (1979), A Model of Balance-of-Payments Crises Journal of Money, Credit and

Banking 11, 311-325

Morris, S. and Shin, H. S. (1998), Unique Equilibrium in a Model of Self-Fulfilling CurrencyAttacks American Economic Review 88, 587-597

Obstfeld, M. (1996), Models of Currency Crises with Self Fulfilling Features European EconomicReview 40, 1037-1047

Macro Research ItaIlan GoldfajnChief Economist

Tel: +5511 3708-2696E-mail:[email protected]

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Intervention Policy in Brazil, What is the Rationale