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International or domestic investors are wondering right now: What’s happening with the Brazilian Real against the Dollar?

Predicting exchange rates is always a hard task for analysts, but some macroeconomic changes during the last 2 years give us very relevant information to understand the downward trend. 

In 2022, the BRL/USD quotation has shown a sharp decline from R$5.57 to R$4.82, a 13.37% decrease.

BRL/USD quotation the past year. Source: Google Finance

Many analysts thought that the World would face a general appreciation of the American currency during the war in Ukraine, as investors add strong currencies in their portfolios for protection, but it’s actually the opposite.

So, what’s behind this drastic change?

In order to understand movements between two different currencies, it’s important to look at how these flotations happen from a macroeconomic perspective. There are several variables that influence currency exchange rates.

Inflation

Inflation consists in the relative purchasing power of one’s economy compared to another. Countries with low inflation rates – as usually perceived in developed economies, have stronger currencies than those with a high inflation rate.

Interest Rates

Interest rates are vastly correlated to inflation and exchange rates. Central banks all over the World use interest rates as part of their monetary policy in order to curb inflation. If a country’s inflation is way up compared to its target inflation, the central bank can raise the interest rate. As a result, many investors from countries with lower interest rates are attracted by the possibility of profiting with zero or low risk abroad. The cash inflow results in an appreciated local currency rate.

Public Debt

Many countries need to finance their annual budgets using deficit financing. A country with a high ratio of debt financing – compared to GDP – could undermine the value of its currency by deterring foreign investment from entering the country. 

Balance of Trade

Balance of trade is the difference between a country’s exports and imports. If a country has positive terms of trade, it means that exports are greater than imports. As a result, there’s a major cash inflow of foreign currency, and its foreign reserves grow – stimulating a stronger local currency. 

Economic Health and Political Stability:

A stable country in terms of politics and economy always attracts more investment from abroad, increasing a local currency’s value. A transparent, well-regulated, and dissociated economy for government interventions also creates a friendly atmosphere for foreign investors.

Considering the factors mentioned above, it gets easier to understand why and how USD has been undervalued compared to Brazilian reais. 

Brazil faces constant interest rate rises since March 2021. Even with recent similar efforts from the Federal Reserve to raise the U.S. interest rates – that could offset the Brazilian interest rates boost, an increase from 2% to 11.75% in 12 months that had a major impact.

Source: Banco Central do Brasil

The terms of trade also have to be considered. Brazil is known worldwide for commodity-exporting. Between Jan/21 and Jan/22, the exports of Brazil have increased by $4.69B (31.4%) from $14.9B to $19.6B. 

The top exports of Brazil were crude petroleum, iron ore, soybeans, refined petroleum, and frozen bovine meat. The exportation is traded mostly to China, the United States, Argentina, Singapore and Chile (find out more here). Considering these price hikes in commodities since the beginning of the COVID crisis, an appreciation of the Brazilian real was already expected.

Dow Jones Commodity Price Index. Source: Dow Jones.

Another major contribution to Brazilian real appreciation is the constant foreign cash inflows, and the undervalued stock market. The sanitary, economic and political crisis witnessed in Brazil since 2020 had an enormous impact on stock prices. An undervalued stock market combined with major risks in East-Europe made Brazil a convenient place for speculation in variable and fixed income.  

Brazilian Stock Index in US Dollars. Source: Trading View

What’s Next?
Exchange rates are reaching the lowest value since the beginning of the COVID crisis. Therefore, analysts are trying to understand if lower rates are here to stay or if this could be a short-term trend.

Many researchers believe that the lower exchange rate levels increase in the long term if FED raises the U.S. interest rates quicker than expected or more intensely. This could create a cash inflow to the U.S.

Excerpt from Brazilian Central Bank Market Readout 03/18/2022. Source: Central Bank

As illustrated above Brazil’s inflation rate expectations have jumped from 5.56% to 6.59% since last month for 2022, and from 3.5% to 3.75% for 2023.  A close look at inflation expectations in both the U.S. and Brazil is necessary. And depending on the strength of domestic inflation during 2022, there could be even higher interest rates and lower exchange rates.