- The Brazilian real is trading close to valuation levels seen when the economy was saddled with external debt and faced imminent threat of default in 2000.
- In 2000 central bank reserves amounted to less than half of general government external debt while the current figure is over four times.
- The deeply undervalued currency and stable external debt position suggests that the yield on offer on Brazilian bonds is worth the risk from a potential rise in inflation.
The Brazilian real is trading close to valuation levels seen when the economy was saddled with external debt faced imminent threat of default in 2000. The country’s external debt position is vastly improved since then to the point that the government is now a net creditor in dollar terms when including the country’s large central bank reserve stockpile. The deeply undervalued currency and stable external debt position suggests that the yield on offer on Brazilian bonds is worth the risk from a potential rise in inflation.
Real Effective Exchange Rate Back At Crisis Levels
The Brazilian real selloff rivals that seen at the height of the 2002 debt crisis when markets were pricing in a better than even odds of a bond default. The country was saddled with extreme levels of external debt and required an IMF bailout as bond yields surged amid the prospect of the election of left-wing presidential candidate Luiz Inácio Lula da Silva. Investors who bought the BRL at the height of the crisis went on to see 22% annual total return outperformance against the dollar over the next decade.
Source: Bloomberg, JPMorgan
These outsized returns largely reflect the combination of real effective exchange rate (OTC:REER) undervaluation and high real interest rates, which in turn were supported by strong real GDP growth as the country experienced a terms of trade boom from rising commodity export prices. We are not calling for a similar level of gains as this would likely require much higher real interest rates. However, the cheap REER means that downside risk should be limited.
External Picture Has Vastly Improved Since 2002
There is no question that Brazil is going through an economic and currency crisis at present but we see little threat of this turning into a self-reinforcing debt crisis as was the case in 2002 given the improvements made in the country’s external balance sheet. Back then central bank reserves amounted to less than half of general government external debt but the surge reserve and efforts to reduce their reliance on dollar borrowing has seen reserves rise to roughly 4 times government external debt currently.
Even if we look at the private and public sectors combined, the country’s external balance sheet is in reasonable shape. As of 2019 the country’s net international investment position amounted to 36% of GDP. Roughly half of these net external liabilities are in the form of foreign direct investment which tends to be long-term in nature. Of the country’s portfolio liabilities, which make up roughly another third of total liabilities, the majority are in the form of equities. Of the debt component, over half is in the form of local currency (data can be found here).
While the form and currency denomination of portfolio liabilities does not reduce the risk of portfolio outflows, it does reduce the risk of a vicious cycle of currency weakness leading to rising external debt leading to further currency weakness. Countries which have high levels of dollar debt tend to experience rising interest costs and increases in debt in local currency terms in the event of foreign investor liquidations, which can result in self-fulfilling crises. On the other hand, countries with the bulk of their liabilities in local equities tend to experience temporary currency weakness with much fewer negative feedback loops.
Yield Return Is Worth The Inflation Risk
What Brazil’s relatively stable external balance sheet suggests is that default risk is highly unlikely, which suggests that we should not see the currency’s REER fall to the lows seen in 2002 which are just 15% below current levels. As investors begin to price out the risk of default we expect focus to shift to the return side of the equation and on Brazil’s high level of bond yields relative to inflation.
While the BCB reduced the Selic rate to a new all-time low of 3.00% on May 6, the long end of the yield curve has been rising as rate cuts are seen as temporary. 10-year bond yields are 7.3 percentage points above the U.S meaning that in order for real bond investors to lose money over the next decade currency valuations would have to weaken beyond their 2002 debt crisis lows and/or inflation would have to average 7.3 percentage points higher in Brazil than the U.S. For context, the current year-over-year inflation differential is less than 1pp, while differential implied by breakeven inflation expectations is 2.5pp.
Brazil Vs U.S. Headline CPI
Source: Bloomberg, BLS, IBGE
Ultimately our constructive view rests on the belief that the current economic and emerging political crisis will not morph into an inflation crisis. The big risk comes from the potential for Finance Minister Paulo Guedes’ austere fiscal reform agenda to become permanently sidelined in favour of rising government spending. While this is a growing possibility, we would likely need to see a dramatic deterioration in the country’s finances in order for Brazilian assets to continue underperforming given how cheap they have become.