Economy Ministry is studying band for volume of reserves
Rule adds instability to the market because the Central Bank would also become a buyer of foreign currency in a moment of scarcity — Foto: Scott Eells/Bloomberg
The eventual adoption of a target for foreign exchange reserves could usher in a procyclical exchange rate policy, intensifying exchange rate fluctuations rather than smoothing them out.
The proposal studied by the Economy Ministry, unveiled Tuesday by the newspaper O Globo, is to establish a kind of band for the volume of forex reserves. When the reserves exceed the ceiling, the Central Bank would be obliged to sell reserves. When they are close to the floor, it would have to buy.
The idea goes against the whole philosophy of the exchange rate policy adopted by the Central Bank, which seeks precisely to contain the volatility of the foreign exchange rate and act when the foreign exchange market is dysfunctional.
The volume of foreign reserves usually grows, reaching values close to an eventual ceiling, precisely when more dollars are entering the country. On these occasions, the Central Bank typically buys more currency to counteract an excessive appreciation of the exchange rate disconnected from the long-term fundamentals. If it is forced to sell reserves instead of buying, it will intensify the tendency for the real to appreciate.
The situation would be more dramatic if the Central Bank, under the new rule, was forced to buy dollars when reserves fall below some sort of floor. Reserves usually fall exactly at times of great stress in the market, when the monetary authority usually injects liquidity to avoid an exchange rate overshooting.
The rule designed by the Economy Ministry adds instability to the market because the Central Bank would also become a buyer of foreign currency in a moment of scarcity of hard currency in the market.
The rule also limits the Central Bank’s ability to influence the market without necessarily selling dollars. Brazil’s high volume of reserves helps calm the market, which knows that there is a big player capable of stabilizing it.
If it has to obey a floor, this means that the effective volume of reserves is smaller. It is a situation similar to that experienced when Brazil borrowed from the International Monetary Fund (IMF), but could not use it, because one clause of these programs was precisely a minimum volume of international reserves.
The move to limit the use of foreign reserves by the Central Bank is surprising because, in the law that granted independence to the bank, the Economy Ministry gave up the right to dictate the direction of exchange rate policy. Until then, Law No. 4.595, of 1964, determined that the Central Bank was the executor of exchange policy, which was determined by the National Monetary Council (CMN).
Apparently, the economic team’s concern in limiting the use of foreign reserves is a fiscal issue. The proposal is being developed together with the limit on public debt, within the new rule being studied by the economic team to replace the spending cap rule, which limits growth in public spending to the previous year’s inflation.
In fact, the fiscal cost of foreign reserves is a relevant topic. In the past, the Central Bank offered currency hedges to the entire economy, and the costs ended up being borne by the National Treasury. This usually occurs when the Central Bank seeks to defend an exchange rate completely disconnected from economic fundamentals.
Before taking over as Central Bank president, economist Ilan Goldfajn even suggested the creation of an Exchange Rate Policy Committee, with the Central Bank and the Treasury, precisely to take into account the fiscal costs in the execution of the exchange rate policy. After taking over, however, Mr. Goldfajn never mentioned the idea again.
But at least that proposal had the advantage of giving flexibility in managing the fiscal costs of exchange rate policy, without creating an automatic rule that adds volatility and works as a straitjacket for the Central Bank’s actions.
*By Alex Ribeiro — São Paulo
Source: Valor International