Brazil's real buffeted by speculation over US rates

Before Brazil's largest company announced it had lost billions of dollars to corruption, few onlookers predicted that one consequence would be a welcome strengthening of the national currency.

But when Petrobras, the state-controlled oil company, recently announced losses totalling R$51bn in 2014 - part of it due to a vast corruption scandal afflicting the company the real appreciated 3 per cent against the US dollar, easing pressure on many beleaguered domestic companies.

With its twin budget and current account deficits as well as high levels of US dollar-denominated corporate debt Brazil is considered one of the emerging markets most vulnerable to any tightening of monetary policy in the US.

Battered by declining economic growth and the problems at Petrobras Brazil's currency was trading at R$2.24 to the dollar a year ago before weakening in the ensuing months to R$3.31 in March.

When Petrobras released its long-delayed results the markets breathed a sigh of relief. The company had averted a technical default on its bonds that could have threatened Brazil's sovereign rating and sent debt servicing costs soaring.

Now the focus has returned to more mundane matters, in particular, how Brazil's new finance minister Joaquim Levy plans to balance a budget that has slipped into the red and set the country's sinking economy back on a growth path.

"The positives of the financial house being put in order with minister Levy will go a long way to reduce the overall country risk premium," said Will Landers, portfolio manager of BlackRock Latin American Investment Trust. "But the reality is you are going to be talking about over a year of very weak growth and for next year hopefully there will be some recovery but it is still very unclear."

A weekly survey by the Brazilian central bank of economists showed they expect economic growth this year to shrink 1.18 per cent, inflation to end the year at 8.26 per cent and the benchmark interest rate at 13.5 per cent.

They also predicted the real would end the year at R$3.20 before weakening next year to end 2016 at R$3.30.

The real has also been buffeted by fluctuations in the dollar amid speculation over "lift off" - when the Federal Reserve will begin raising rates - and by economic news from China, one of the principal buyers of Brazilian commodities.

The real was the best performer among emerging market economies between late March and late April, thanks partly to the improved Petrobras outlook, a rebound in the oil price and the fact that US rate hike expectations have been pushed further out towards the end of the year.

On the domestic front, Mr Levy has had some success in uniting a fragmented congress behind his aim of implementing a 1.2 per cent primary fiscal surplus this year - the budget balance before interest payments. This is considered important to prevent a rise in Brazil's gross public debt, which increased last year after it recorded its first primary budget deficit in more than a decade, threatening the country's investment grade rating.

But most currency strategists expect the respite for the currency to be temporary. "I'm confident that the political scenario will be a bit more benign than in March and that Brazil-specific factors will be more positive," says Dirk Willer, head of emerging market strategy at Citigroup.

"But the real will be the victim of the next move up in US rates."

The real has already slipped this month, moving back above R$3 to the dollar amid indications of less central bank support.

Ultimately, however, emerging market currencies like Brazil have to take a view as to the least worst option - a weak US economy or a strong one.

"At the moment, where the market is still obsessed with the coming Fed tightening cycle, we are still in an environment where a weak US economy is good for these currencies," says Mr Willer.

Most economists believe that for Brazilian exporters to recover some of the efficiency and competitiveness lost due to rising inflation, the government will allow the real to depreciate yet further.

"In our view, the real remains the only single mechanism that may rapidly help the macro environment adjust, given a loss of competitiveness over the last decade," said Santander, the banking group, in a research note.

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