22 November 2008

The recent evolution of the exchange rate in Brazil: a Minsky moment

by Paulo Gala
The current crisis has quite clearly shown the so-called dual nature of the exchange rate: on the one hand, the relative price between tradables and non-tradables, and, on the other hand, the price of a financial asset. It also becomes increasingly clear that the determination of the exchange rate has essentially a financial dynamics, especially in a context of open capital accounts. From the perspective of prices of tradables and non-tradables, the country was getting into a problematic situation, as the real exchange rate appreciation was making it increasingly difficult to insert domestic production in the world economy. Brazilian prices, once converted to dollars, reached surprisingly high levels, thus eliminating the competitiveness of our industries, even the most efficient ones. This can be observed in the reversal of the manufacturing trade balance, with an explosion of imports and a stagnation of exports. Our trade surplus was more and more dependent on high commodity prices, in a bubble that now seems to have burst. The recent path of the current account showed clearly that the Brazilian currency was becoming misaligned towards overvaluation. The explosive increase in the dollar price of Brazilian non-tradables certainly did not result from an increase in productivity and wages, as we would like it to be. Numerous papers showed that the Brazilian currency was relatively overvalued, whether in terms of measures of PPP (Purchasing power parity) deviations, or in measures such as BEER (Behavioural Equilibrium Exchange Rates). How then to explain the appreciation path that put the exchange rate increasingly “out of place”? Now comes the financial nature of the exchange rate. As the country received the investment grade and investors showed a strong appetite for investments in emerging countries, there was a flood of capital to Brazil. Last year only the capital account accumulated a surplus in excess of US$90 billion. Investments in the stock market, securities, and derivatives caused an increasing appreciation of the Brazilian currency, which seemed more and more undervalued in the eyes of financial market. The period of relative stillness in the world markets during the last few years stimulated the "Minskyan" spirits of the financial agents that were increasingly betting on uncertain positions in emerging markets. In Brazil, the exchange rate continued to appreciate as long as these operations were highly profitable. Domestic companies betting on derivatives related to the appreciation of the Brazilian real, as well as capital flows to the stock market and securities, caused one of the highest exchange rate appreciations in the emerging world in the last years. And now the “Minsky moment” comes, in which deleveraging and deflation of assets predominate. The appreciation movement built during 2 years is undone in 2 weeks. In a troubled way, to say the least, the exchange rate returns to a more reasonable position in terms of prices of tradables and non-tradables. For those who have been studying Keynes and Minsky, there is nothing new in this type of financial dynamics. It is worth mentioning, however, the negative consequences of the type of arrangement we are living in today. As the relative price between tradables and non-tradables, the exchange rate strongly affects the country's technological dynamics, as long as it impacts decisions regarding investment, production, and innovation. The level of the real exchange rate plays a fundamental role in macroeconomic dynamics from a long-term perspective. By influencing the determination of sector specialization, particularly regarding incentives to industry, the impact of the exchange rate level on the dynamics of productivity is high. Exchange rate overvaluations are particularly harmful to processes of economic development, since they substantially reduce the profitability of production and investment in manufacturing tradable sectors. By reallocating resources to non-manufacturing sectors, especially to the production of commodities (with decreasing returns to scale), and to non-tradable sectors, exchange rate overvaluations eventually affect the economy's whole technological dynamics. To conclude, it is worth mentioning the impacts of exchange rate volatility in the economy's performance. In an open capital account setting, the exchange rate is financially determined and depends on the traditional Minskyan “boom” and “bust” dynamics. The relative price between tradables and non-tradables is now determined in the financial market, with very complex dynamics. That is to say, the profitability of manufacturing production, which it is essential to long-term economic development, begins to depend on the whims of financial markets.
Paulo Gala received Master and PhD degrees in Economics from the Sao Paulo School of Economics, Getulio Vargas Foundation. He is the author of several papers, articles and book chapters on the following subjects: Macroeconomics, Development Economics and Economic Methodology. Currently, he is a professor at the Sao Paulo School of Economics, Getulio Vargas Foundation. pgala3@gmail.com

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