What a waste of time and effort!

Yesterday, the Brazilian government announced measures to hold down the soaring Brazilian real (BRL). The politicians are trying to stem the tide of rising speculators betting on the real.

The biggest change they introduced was imposing a 2% IOF tax on capital inflows, for both fixed income investments and equities. (IOF is Portuguese for a tax on financial operations.)

This new measure is in effect as of today.

A quick note: Brazil’s government did NOT impose this tax on foreign direct investments (FDI). The rationale behind this move is that they want to reduce the flow of “hot” money used for investment and equities. But at the same time, they don’t want to hurt the country’s industrial progress, which is aided by foreign investments.

Frankly, I think this move to restrict capital flows is a pointless exercise at best. It’s simply a waste of time to think that they can control the strengthening Brazilian real.

Why a Desperate Brazil Is Imposing Capital Controls

This decision to introduce capital controls is a complete reversal from Brazil’s traditional monetary policies.

I can’t help but think that the monetary authorities are getting desperate about controlling the currency and they have limited options to try.

Or maybe this is just a precursor to the rate hikes that the Central Bank has had to contemplate much earlier than previously announced.

Here are the reasons I believe the Ministry of Finance imposed this 2% tax:

Next year we have elections scheduled in Brazil. This means the two competing parties would like to spend large amounts of capital. The ruling party does not want to withdraw any fiscal stimulus and wants to woo the voters with easy monetary policies with the hope of getting re-elected.

This has made the Ministry of Finance try this unconventional method of control.

Further, Brazilian stocks have been on fire lately. This impressive run-up in Brazil’s stock market means the IPO pipeline is now heavy for next year. In fact, there are several mega IPO’s planned for the first half of 2010.

And in this environment, taxing of just the fixed income flows would have proven rather ineffective. So they’re focusing on both fixed income and equities.

Trying to Stop the Real: A Fool’s Errand

Mark my words: This 2% tax won’t have any effect in slowing down the Brazilian real.

The reason for the Brazilian real’s rise is twofold. First, the strong Brazilian economy is going gangbusters. Brazil’s economy is in the perfect position to profit off of the rising growth in both China and India as they demand more imports.

The second equally important factor is the steep decline in the U.S. dollar. The dollar has really been hit hard. I don’t believe the dollar beating is complete yet. So I expect this trend to continue for some time to come.

As long as these twin causes continue to flame the fires of the Brazilian real, such feeble attempts by the Ministry of Finance will have no major impact on the real’s strength.

Now, keep in mind the Brazilian monetary authorities didn’t have to be creative here.

No, instead, they could have attempted to control the strength of the Brazilian real by using rather conventional means. They could have tried one of several strategies like enhancing their export competitiveness by introducing measures to continue the demand for Brazilian exports.

They also could have enhanced internal competitiveness in each export sector to enhance the product quality and make their exports more attractive to the world.

Unfortunately, it seems Brazil would rather resort to draconian measure and implement such capital tax reforms.

Long-term, I only see one downside to this 2% tax for the Brazilian real. That global investors could lose some of their confidence in Brazil’s economy. Due to such unilateral moves, it’s possible that investors could reduce their investments in Brazil because of the reduced transparency. This could have negative consequences for Brazil in the mid to longer- term.

In the short-term, I believe that the Brazilian real will continue to rise further as long as China continues to grow and as long as the U.S. dollar continues to decline.

Stay long Brazil! Call the Brazilian Finance Ministers’ bluff!

And if the dolts in the Forex market decide to drop the real for now, take advantage of the opportunity to load up on the Brazilian real for the long-term.

Yours in FX Profits,
Ashish Advani

P.S. Tomorrow, my currency colleague (and Brazilian native) Evaldo Albuquerque will be back with more on why Brazil is leading the world’s recovery this year. Till then, if you’re looking for a way to buy the real for the long run, you may want to check out EverBank’s latest principal-protected CD. It gives you exposure to the Brazilian real and three other foreign currencies. Best of all, it’s 100% risk-free. Click here for details.