Sunday, October 3, 2010

The world "appreciates" the Brazilian currency (the "Real") but Brazilians are NOT appreciative! Are they ingrates? Maybe not...

     In the midst of a national election, the Brazilian government is worried that its currency has appreciated too much in the Foreign Exchange Market. WSJ: "Brazil's Surging Currency Figures in Election"

""Election time in Brazil once meant wondering whether the nation's historically skittish currency would crash. This time around, policy makers are wrestling with a different problem: Money so strong they fear it may hinder the country's export-driven economic.."

     When a countries currency appreciates relative to other currencies, its goods and services become more expensive for foreigners to purchase.  Note: nothing about the good or service has changed, only the value of the currencies used to purchase those goods or services has changed.
     In class, we learned that the prime mover of currency values are relative interest rates.  Interest rates in Brazil have been significantly higher than interest rates in many other stable, developed countries.  Brazil's "financial assets" are desirable, hence so is its currency to purchase those financial assets.  This has been one of the primary reasons for rapid appreciation of the Brazilian Real (the name of the Brazilian currency).
"For example, Brazil's 10.75% overnight interest rate is among the highest in the world. That encourages speculators to borrow in the U.S. and Japan where money is cheap, deposit it in Brazil, and pocket the difference. This so-called carry trade pumps up the real by attracting a flood of dollars."
The first graph below shows the Market for the Brazilian Real ("BRL") at equilibrium.  I will use the US Dollar as the other currency, but it could be any other currency.  Notice in the Market for BRL we price it in dollars ("USD/R$*).  You should literally read this as "the dollar price per BRL" or more simply "How many dollars does it take to BUY ONE BRL".  To keep it simple, let's assume the exchange rate is $1.00USD can buy R$1.00 and vice versa.  In other words the currencies trade at parity. 

As already established,  Brazilian financial assets have become more desirable because of the higher interest that can be earned on financial capital.  There is now going to be movement in the Foreign Exchange Market (FOREX) between the USD and the BRL.  Holders of dollars will want to take advantage of higher interest rates in Brazil. They will take their USD to the FOREX and exchange them for BRL's.  This will INCREASE the supply of USD in the FOREX and INCREASE the demand for the Brazilian Real. See graph below.

The new equilibrium price is now at "USD/R$1" We established that at equilibrium we could buy R$1.00 with $1.00. Just looking at the graph we can see that it now takes something more than $1.00 to buy R$1.00, say, $1.69 (the actual exchange rate as of 10/03/10). 
    When holders of dollars exchange for BRL's they have to pay $1.69 instead of the previous $1.00.  Consistent with the Law of Demand, as the price of BRL increases the quantity demanded of BRL decreases which means (1) holders of dollars will purchase fewer BRL's and in turn purchase fewer Brazilian goods or services and/or (2) the goods or services they continue to buy in Brazil will effectively be more expensive and the quantity demanded of those goods and services will decrease.  Either way, exports of finished goods or services from Brazil will be negatively impacted. 
     Can you think of any good news Brazil can wring out of an Appreciating currency?  There are some positives...Extra credit for responding and giving me one...or ten... :)
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