Real's rise cannot be stopped by inflows tax

SINCE 2007, we have been repeatedly told that the US dollar needs to weaken in order to rectify the global imbalances that were, at least partially, to blame for the economic downturn. But not everybody has welcomed the greenback&rsquo;s recent decline. European officials have already been making noises about how the strength of the euro will harm the Eurozone&rsquo;s competitiveness and stymie its recovery. <br /><br />But it is across the Atlantic in Brazil that the most radical action has been taken, where policymakers have decided to take drastic measures to prevent their currency from appreciating even further against the dollar. <br /><br />Brazil has been aggressively intervening in its FX market for some time, without much success &ndash; the Brazilian real has already risen 33 per cent against the greenback so far this year &ndash; so last week its government decided to introduce a tax of 2 per cent on all capital inflows, including the purchase of equities but excluding foreign direct investment (FDI).<br /><br /><strong>REAL STRENGTH</strong><br />This has had some slight impact on the value of the real, which almost immediately fell 2 per cent against the greenback following the announcement (it later regained some of these losses). However, many observers are doubtful that the capital inflows tax will be effective enough to counter the real&rsquo;s strength. <br /><br />So despite Brazilian policymakers&rsquo; best efforts to stem the appreciation in the currency, foreign exchange traders should not be surprised to see the Brazilian currency strengthen further against the dollar. <br /><br />A combination of high interest rates and healthy prospects for economic growth are expected to underpin the real. Although interest rates have fallen over the past year, Brazil still has one of the highest short-term interest rates of the emerging economies &ndash; the cost of borrowing currently stands at 8.75 per cent &ndash; which makes it an ideal target currency for carry traders looking to divest themselves of US dollars. There is also an expectation that Brazil&rsquo;s central bank will raise rates in the first half of the year, which should make the real even stronger.<br /><br />But the strong domestic growth story will be the driving factor, says You-Na Park, emerging markets analyst at Commerzbank, who sees the greenback rising to 1.66 reals by the end of 2010. <br /><br />She says: &ldquo;Brazil is not that export-oriented compared to the Asian countries so the slowdown in economic activity has been more moderate and the growth in the last quarters came from domestic demand and especially from the consumer sector.&rdquo; <br /><br />The unemployment rate is falling in Brazil, which should keep confidence high and supportive of demand. <br /><br />Park adds that the recent ratings upgrade of Brazil by Moody&rsquo;s will also boost the real: &ldquo;Now that all three major ratings agencies view Brazil as investment grade, investors will be more attracted. A lot more funds are now able to invest in Brazilian bonds and the equity market.&rdquo;<br /><br />With Brazil supporting its growth from within rather than relying on exports, and with interest rates poised to stay high for some time to come, currency traders should be looking to go long on the real from its current value against the dollar and any dips in the market should be viewed as an opportunity to buy at better rates.