By Sebastian Mallaby
Monday, December 14, 2009
RIO DE JANEIRO
The country of the moment is Brazil, that melting pot of almost 200 million people. A thriving democracy, it has a hugely popular president and rapidly falling poverty. It recently won contests to host soccer's World Cup and the 2016 Olympics. It is opening diplomatic missions all over the world. Its economy was one of the last into the financial crisis and one of the first to escape. And yet Brazil's achievements are vulnerable. To keep its marvelous success on track, Brazil may have to do something that horrifies its diplomats: Confront China.
Brazil's vulnerability comes from its currency, the real, which has jumped by a third against the dollar in the past year. A further rise could undermine exporters and make it impossible for domestic producers to compete with cheap imports, puncturing the vitality on which the Brazilian miracle is predicated. And a further rise seems all too possible. The forces driving up the real are not about to reverse themselves.
The first driver is the fragility of the U.S. economy, which causes the Fed to hold down interest rates, inducing capital to seek higher returns elsewhere. Brazil is a favorite destination: Its interest rates are high and financial conditions inspire confidence. Most forecasters expect the U.S. recovery to remain sluggish for the foreseeable future. So the logic of low U.S. interest rates probably won't change, and the upward pressure on the real is likely to continue.
The second force driving up the real is China. If economic logic prevailed, the real would fall against the Chinese yuan: China has a vast current account surplus, while Brazil has a deficit. But last year China re-pegged its currency to the dollar, so the yuan has followed the dollar down, hammering Brazil's ability to compete against Chinese producers. Meanwhile, the illogically weak yuan hurts producers in other countries, encouraging central banks to keep interest rates low and driving yet more capital into Brazil. This pressure from China is likely to grow along with China's economy.
What can Brazil do about its rearing currency? It could cut interest rates to deter money from coming in, but Brazil's economy is hot and lower rates would risk inflation. It could fight capital inflows with taxes -- it has already experimented with this option -- but such restrictions tend to leak like umbrellas made of icing. It could intervene in the foreign-exchange market, selling reals and buying dollars, but then scarce Brazilian savings would get tied up in the depreciating greenback. Or Brazil could protect its industry with tariffs. But protectionism could spark a cycle of retaliation.
The grim truth is that Brazil's domestic tools aren't powerful enough to stop its currency from threatening its success. So what about diplomacy? Asking the United States to raise its interest rates and take pressure off the real is a non-starter. With U.S. unemployment around 10 percent and an additional 7 percent of the U.S. workforce obliged to get by on part-time jobs, there is no way the Fed can raise interest rates to rescue Brazil from its predicament.
That leaves the option of talking to China. Unlike the Fed, China's central bank has good reasons to raise interest rates and abandon its peg to the declining dollar. The peg is distorting the Chinese economy and causing the nation to amass dollar reserves that are destined to lose value. Admittedly, China's political leaders have overruled the technocrats who would like to modify the exchange-rate peg, and they have ignored appeals from the United States and Europe. But the Chinese leadership might be more open to arguments from a successful emerging economy such as Brazil, especially if the Brazilians rounded up support from other middle-income members of the Group of 20.
Unfortunately, Brazil has no stomach for arguments with China. Its diplomats prize solidarity among the emerging "BRIC" nations (Brazil, Russia, India and China), even when that solidarity could threaten the growth on which Brazil's BRIC status is premised. And for the moment, Brazil's currency squeeze is not quite severe enough to scream for attention. The economy is expected to grow by a respectable 3.5 percent or so next year, and Brazil has done so well of late that it seemingly has no time to worry about problems.
On a recent Sunday in Sao Paulo, when Brazilians were reveling in the final day of the soccer season, a gang tunneled into the building of an armored-car company and blew open a safe, making off with nearly $6 million. Security guards heard the explosion but did nothing, assuming the noise came from soccer fans celebrating a goal with particularly tremendous fireworks. Perhaps there is a lesson here. Moments of rejoicing can be moments of trouble.