beyondbrics

By Tony Volpon of Nomura

Why has growth in Brazil been so disappointing these past two years, falling from 7.5 per cent in 2010 to below 1 per cent in 2012? There are two competing responses. The first, favored by the government, puts the blame mainly on external factors, such as the European crisis and the growth slowdown in China. The second emphasizes supply-side constraints, whether in poor infrastructure or tight labor markets.

Though these two explanations are not mutually exclusive, they are hard to fully square up with the data.

While external factors may have been relevant at the start of the slowdown in Q3 2011, a fact flagged by the Central Bank of Brazil in its surprise August rate cut of that year, it does not really explain on-going anemic growth. The much better performance of other Latin American economies these past two years weakens this politically-convenient explanation.

The supply-side hypothesis looks at how investment demand has fallen because of a lack of competitiveness. But while we have seen a substantial fall in BRL, which should have increased competitiveness, there is no indication that investment levels are recovering. Might there be other factors in play?

We believe the answer is yes. Specifically, we would like to offer a novel explanation for Brazil’s growth slowdown that looks at how the imposition of investor-unfriendly capital controls caused a self-inflicted “sudden stop” that, through a variety of channels, decreased investment and credit growth.

In a series of papers beginning in the 1990s, the Argentinean economist Guillermo Calvo put forward the thesis that the main driver of business cycles in emerging market economies is the sudden, exogenous shift in the supply of capital. Abrupt reversals of capital flows, dubbed “sudden stops”, would generate the need to rapidly revert current account deficits by reducing domestic absorption, usually through a quick contraction in investments.

After the most acute phase of the 2008-09 crisis, many emerging market countries witnessed very rapid inflows of capital. The fears that these inflows would cause excessive currency appreciation, credit growth and asset bubbles revived the debate over the use of capital control measures, leading to the now famous change of view by the International Monetary Fund agreeing with the use of capital controls in certain cases.

Brazil received substantial capital inflows after the crisis and has been an ardent user of capital controls. The first measure taken was as early as October 2009, with the imposition of a 2 per cent IOF entry tax on portfolio inflows. A series of other measures were taken, progressively closing off channels by which financial markets brought money into Brazil (see Table 1). The government made it clear that it would keep punishing investors with more measures until flows ceased and BRL fell.

Source: Nomura, Bloomberg, Brazilian finance ministry

How have capital control measures affected the economy? If “sudden surges” can lead to excess credit creation and asset bubbles, can the imposition of severe capital controls (in effect a self-inflicted “sudden stop”) lead to falling credit creation and falling asset prices, negatively impacting investment and growth?

We believe this is the case in Brazil. The progressive imposition of capital controls worked as a powerful pro-cyclical mechanism in an economy already slowing down for external and internal reasons. By progressively shutting off the supply of foreign capital, the government inadvertently tightened monetary policy, even as it lowered the Selic policy rate.

Investments were further hit by falling equity prices and falling investment confidence in Brazil, as international portfolio investors suffered losses. This, we believe, also contaminated local investment sentiment. Thus we see in Brazil a new kind of phenomena. Different from a classical “sudden stop” that has as its root cause international factors, and
its main transmission mechanism the need to rapidly revert current account deficits, in Brazil we have seen a domestically-caused “sudden stop” that has credit and asset markets as their main transmission mechanisms.

How do foreign inflows affect monetary conditions? The obvious channel is through the cost of credit: cutting off portfolio inflows will reduce the supply, making its price more expensive for any level of demand. There is also a bank-lending channel effect: inflows that are intermediated by the banking system may lead to lower lending spreads, and therefore higher loan books, even if inflows are sterilized. Thus cutting off foreign flows may decrease overall bank liquidity, as well as forcing lenders, at the margin, to switch from cheaper foreign currency financing to more expensive domestic credit. We should note that these various effects (loan pricing, size and composition) would occur even if the policy rate fell.

We should also note that the central bank itself has recognized the importance of capital inflows in increasing the supply of domestic credit, and justified many of the capital control measures implemented during the 2009-2011 period as being macro-prudential in nature, geared towards decreasing aggregate demand.

Another transmission channel through which a “sudden stop” impacts economic activity is via lower asset prices, which have negative effects on the cost of capital and so directly affect the level of investments. Concentrating on equity portfolio flows, two possible impacts are possible. First, capital controls raise the cost of buying equities which would lead investors to allocate more capital to other countries. But more importantly, as shown in recent work by Kristin Forbes, international investors have seen capital controls in Brazil as “indicating an anti-investor bias of the country”, “an increase in policy uncertainty in the future”, “a government that does not know what to do”, or “a lack of stability in economic policy”. Such negative perceptions may in fact be more important than the impact of the IOF tax itself.

The obvious policy implication of our analysis is that once growth stalled in Brazil the government should have quickly removed all capital controls. If curtailing inflows made sense when policymakers were trying to cool off growth in 2010 and early 2011, why not remove these controls once the economy weakened significantly?

Why has this not happened? One way to understand this is to think about what one believes to be the key “price” in the economy.

In our analysis, the way that capital controls were executed in Brazil (progressively and without warning) generated an unexpected contraction of credit, leading to tighter monetary conditions even as the policy rate fell; as well as causing falling asset prices and worsening expectations. This view emphasizes the credit and expectation channels from policy to investments, and sees asset prices as the “key” determinant in the economy for investments.

Another view, which we believe is widely held within the government (but not the central bank), sees as the key question the level of the exchange rate. Capital inflows, insofar as they lead to “excess” appreciation, damage industrial competiveness. Industry is the key to sustainable growth and keeping the exchange rate competitive is the main driver for industrial health and economic growth.

These two distinct “world views” lead to very different policy prescriptions in relation to capital controls. Is there a way to distinguish between them?

We think so, and the answer has already been given by the continued weak growth of the Brazilian economy. If the level of the exchange rate were the key “price” and transmission channel, then we should have already seen positive impact on investments and growth after the large depreciation of BRL that occurred in March of 2012. That growth has faltered after one year of the devaluation is, we believe, proof that the credit and expectation channels have been much more important than the level of the exchange rate for investments, and ultimately the self-inflicted “sudden stop” contributed to the severe growth slowdown that continues to afflict the Brazilian economy today.

We believe the evidenced presented here should lead to a re-think of the new popularity of capital controls as policy instruments. The Brazilian experiment is a warning that capital controls may be too blunt and pro-cyclical a tool, that may lead to unforeseen and unwanted consequences.

Tony Volpon is head of EM research, Americas, at Nomura Securities in New York. A version of this post was originally published as a research note.

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