Salma Abdelaal

ECON02103a

:Exchange Rate Regimes

The Brazilian Case

The exchange rate is a key variable in the modern economy. It is

the price of one currency in terms of another currency. Its

importance stems from the fact that it has three roles to play; it can

be an indicator, instrument or even a target. The exchange rate

regime a country chooses to implement affects, and the exchange

rate itself acts as an indicator of, the price level and inflation, and

the real exchange rate and consequently balance of payments and

level of economic activity and growth (Latter; 1996). As a result, the

exchange rate is used as an instrument to control and direct the

previously mentioned policy objectives. Brazil provides an

interesting case study of how a country determines it exchange rate

regime to serve the varying needs of the economy at different

points in time. The reason why I found Brazil to be the right choice

for my paper is that it exchange rate policies have covered a very

wide range of the exchange rate regime spectrum moving from

fixed to crawling peg to floating exchange rates to a system of

devaluations then to the use of adjustable exchange bands and

finally to a flexible regime with inflation targeting as the center of

focus in formulating the monetary policy. Another fact that makes

the Brazilian case more appealing is that it had multiple currency

 changeovers and that it portrayed the effects of the Asian and

Russian crises of the late 1990s and the global financial crisis of

2008 (Frenkel & Rapetti; 2010). This paper is written with the aim of

shedding light on the various exchange rate regimes recently

adopted by Brazil and data on the corresponding exchange rates. In

addition, it covers the extent of the usage of monetary tools in

affecting the exchange rate. Finally, a conclusion is reached

.regarding the choice of the appropriate regime

In the wake of the Second World War, Brazil was one of the many

countries that followed the Bretton Woods system whereby it had to

fix the exchange rate of its currency, the Brazilian Cruzeiro, against

the dollar. However, the high inflation rates during that period

helped create an unfavourable balance of payments, and

devaluations of the domestic currency seemed to provide a solution.

Yet, inflation continued to rise leading to an appreciation in the real

exchange rate and, again, problems with the balance of payments.

In an attempt to tackle these problems and achieve export growth,

Brazil resorted to the crawling peg in 1968. Under this system,

monetary authorities pegged the national currency to the dollar but

made small and steady changes to the exchange rate. Indeed, the

period from 1968 to 1973 was characterized by very high growth

especially in exports. Nevertheless, the inflation problem persisted

.((Frenkel & Rapetti; 2010

During the 1970s the main focus of Brazilian policymakers was to

encourage growth and boost the import substitution process which

led to an increase in foreign debt coupled with a rise in the current

account deficit as a result of the global inflationary pressures, due

mainly to the oil shocks. Meanwhile, the exchange rate regime and

monetary policy were retained rather unchanged. Yet, this was

about to change. The increase in international interest rates in 1979

and the debt crisis of 1982 caused Brazil to revise its monetary and

fiscal policies and devaluate the currency. The sharp devaluations

along with the "monetization of fiscal deficits" caused inflation to

soar. As a result, in 1986, Brazil introduced the heterodox

stabilization programmes whereby the government would

significantly devaluate its currency against the dollar, restore

balance in the labour and financial markets and limit the application

of indexation and change over to a new currency, the Cruzado. The

plans were relatively effective as they helped decrease inflation and

accelerate growth. However, the target of restoring external

balance required the use of devaluations and fiscal policies in a way

that counteracts the results of the plans so inflation continued to

rise and a new currency, the Novo Cruzado, was introduced to equal

1000 Cruzado (Frenkel & Rapetti 2010; The Chinese University of

.(Hong Kong 2000; Suarez 2003

The 1990s was a very unstable period for Brazil as well as for

other Latin American countries. The low interest rates that prevailed

in the international markets and the introduction of the Brady Plan

 by the US government in 1990 to restructure developing countries'

debts have played a huge role in increasing the flow of foreign

capital into Brazil. But that also did not help with the inflation

situation. Nevertheless, the scene was about to change in 1994 as

the Real Plan was put into action. The plan was introduced to bring

price stability through the consolidation of the fiscal policy and the

introduction of the Unit of Real Value. This new unit of account,

which was pegged to the dollar, was adopted first to cease the use

of indexation and second to be replace the Cruzado as the national

currency. Then, Brazil implemented a new exchange rate regime;

that is the asymmetric band under which it had to sell foreign

exchange reserves when the exchange rate of the Real to the dollar

equals one but as the rate rises there was no pressure to intervene.

Yet, stabilization came at a price; the real exchange rate

appreciated resulting in a rise in the trade balance deficit and

foreign debt. In 1999, following the Russian and Asian crises of

1997-1998 and in an attempt to evade speculations, the Real was

left to float while the monetary policy was still centered around

controlling inflation. However, the Real did not actually float freely

as the central bank had occasionally intervened in influencing its

exchange rate through the adjustment of the interest rate and

foreign reserve reflecting a rather managed floating exchange rate

regime. This intervention can be justified as an attempt to prevent

the exchange rate from severely depreciating to keep inflation

 under control and also to keep it from highly appreciating to

.(maintain a favourable trade balance (Frenkel & Rapetti; 2010

In the late 1990s and early 2000s, the real exchange rate

depreciated as a result of a series of crises and political instability.

Yet, as from 2002 the real exchange rate started a trend of

appreciation triggered by a biased monetary policy. The period

between 2004 and 2008 witnessed a huge increase in foreign

capital flows into developing countries including Brazil.

Consequently, foreign exchange reserves have significantly

increased preventing sharp appreciations of the exchange rate

.((Frenkel & Rapetti; 2010

In 2008 Brazil, and the rest of the world, had to face a new

challenge; that was the global financial crisis. At the outbreak of the

crisis Brazil was severely affected. There was a sharp drop in

manufactured exports, coupled with a credit crunch and a

devaluation of the Real by over 30% this had a devastating impact

on the industrial sector. Many companies went bankrupt and

survivors had to lower the level of production, stock and investment.

On the contrary, the service, public and retail trade, real estate and

telecommunications sectors were actually performing well in spite of

the crisis thanks to the rise in government and private spending and

the efforts exerted by the central and other public banks to increase

liquidity and reduce interest. Then, during the second quarter of

2009 the overall economy went through an upturn in which the

 cautious monetary policy, revaluation of the Real and rise in

exports, mainly triggered by demand from China, played an

important role. Thus, it can be argued that the exchange rate policy

has not been employed to pull the country out of the crisis (De

.(Barros; 2010

The data collected on the exchange rate of the Brazilian Real

against the dollar from 2000 to 2010 support the previous analysis.

The exchange rate followed a trend of depreciation from 2000 to

2002 which can be attributed to the Brazilian currency and energy

crisis, capital flight in response to the presidential elections and the

crisis in argentine (Frenkel & Rapetti; 2010). Then, from 2002 the

trend was a steady rise in the exchange rate that was interrupted by

the financial crisis in 2008 leading the rate to fall sharply by 50.5%

from July to December 2008. As the economy began to recover the

.exchange rate resumed its upward trend

Data retrieved from X-rates.com

In conclusion, no generalizations can be made regarding the best

exchange rate regime; a country should choose the regime that is

most appropriate to its conditions and objectives. The most

prominent problem Brazil has been facing is inflation. Thus, the

 exchange rate has been used as a tool to control inflation rather

than a target and based on that Brazil would choose the exchange

rate regime. From the adoption of a fixed exchange rate regime to a

crawling peg to adjustable bands and finally to a floating and

inflation targeting regime, reducing inflation has assumed priority

over maintaining exchange rate stability. However, inflation

targeting has its own downside. In a paper by libanio, he evaluated

inflation targeting based on its effect on growth. This was his

conclusion: "The results suggest that monetary policy has been

procyclical and asymmetric in Brazil, so that it can be described by

the expression “too ‘tight’ during contractions, not so ‘loose’ during

expansions”. In this case, it can be argued that monetary policy

under inflation targeting has been detrimental to aggregate

demand and growth" (2010). Another study conducted by Dehejia

and Rowe on macroeconomic stabilization had a conclusion that

targeting price level under a floating exchange rate system was

more effective in bringing stability to the overall economy than a

fixed exchange rate system and a floating system that targets

inflation. This conclusion was reached based on comparing the

deviations of aggregate output, the real interest rate and the real

exchange rate from their natural values, price targeting provided

the least deviations (2000). Thus, perhaps the price targeting

.regime would better serve Brazil's objectives

 :References

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rate regime of Asian countries. Hong Kong: The Chinese

University of Hong Kong. Retrieved November 18th 2010, from

http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?

cid=18

De Barros, J. (2010). The impact of the international financial crisis

on Brazil. Madrid: Fundacion Real Instituto Elcano.

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economy/ari38-2010

Dehejia, V. & Rowe, N. (2000). Macroeconomic Stabilisation: Fixed

Exchange Rates vs Inflation Targeting vs Price Level Targeting.

Ottawa: Carlton University. Retrieved 21st November 2010,

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 Frenkel, R. & Rapetti, M. (2010). A concise history of exchange rate

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http://www.cepr.net/documents/publications/exchange-rates-

latin-america-2010-04.pdf

Latter, T. (1996). The choice of exchange rate regime. London: The

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http://www.bankofengland.co.uk/education/ccbs/handbooks/pdf/ccbs

hb02.pdf

Libanio, G.(2010). A note on inflation targeting and economic growth

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Suarez, L. (2003). Monetary policy and exchange rates: guiding

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http://www.piie.com/publications/chapters_preview/350/6iie3470.pdf

X-RATES (2010). Historic lookup. X-RATES. Retrieved November 19th

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