The Central Bank's Buying Spree
Jan 18, 2006
Gray Newman (New York) and Heloisa Marone (New York)
Brazil’s central bank has gone on a buying spree at a pace rarely seen in Latin America. In the last three months of 2005, the central bank bought up nearly $12 billion dollars from the spot market to add to reserves. And in the first days of the new year, the central bank has continued to buy up dollars. With that kind of reserve run-up, it is not hard to understand why the authorities decided last month to pay off all $15.5 billion that remained due to the IMF.
The buying spree, however, has not been limited to the spot market. Last month, the central bank ramped up its operations in the forward markets, buying dollars forward in a size that dwarfed its purchases in the spot market. While December’s spot market acquisitions of $4 billion raised eyebrows, the central bank purchases were even larger in the forward markets, where it issued $9.6 billion worth of “reverse currency swaps.” As a derivatives transaction settled ultimately in local currency, the central bank will not actually gain possession of dollars, but still the magnitude of the central bank’s actions was without precedent. Both the aggressive spot intervention and the increasingly heavy reliance on derivative positions raise a number of questions about the central bank’s ultimate goal. While we believe the central bank when it argues that it is not targeting the exchange rate, the magnitude of its moves of late almost guarantees that market participants will begin to reexamine the currency and ask whether the central bank has a currency target. Even more alarming, we are concerned that the central bank’s moves of late run the risk of producing a stronger rather than weaker real. By so aggressively accumulating reserves—reserves net of the IMF nearly doubled last year—at such a significant cost, investors are bound to begin asking how much longer the reserve buildup can go on. Nowhere in the world is the cost associated with sterilized reserve accumulation greater than in Brazil, given the wide spread between global interest rates (which reserves earn) and local interest rates (which the central bank must pay to soak the additional liquidity created by its interventions). It would be ironic, to say the least, if the actions of the central bank end up actually causing the currency to strengthen further. Yet that is precisely what we suspect could happen in the coming months. Zero dollar-linked liabilities The central bank justifies its moves as a means of offsetting Brazil’s dollar obligations. The latest data available on Brazil’s debt stock showed $11.2 billion of dollar-linked domestic paper outstanding, along with about $3.2 billion of dollar-linked swaps as of the end of November. However, with the reverse swaps conducted since then — in December and the first two weeks of January we estimate reverse swaps totaled nearly $14 billion — Brazil will likely have eliminated all dollar-linked domestic obligations by mid-January. Although there is still a significant amount of dollar-linked paper outstanding between now and January 2009 when the last notes are due, the vulnerability has already been eliminated given the recent reverse swaps. And unless the central bank stops the reverse swaps suddenly by the end of the month of January, Brazil’s public sector will be in a net long dollar position (netting out all dollar-linked domestic debt instruments and all dollar-linked swaps). This is a far cry from the turbulence of late 2002 and early 2003 when the combination of dollar-linked debt and FX swaps exceeded one-third of Brazil’s domestic debt stock. No more net external debt We are not critical of the central bank’s decision to issue reverse swaps aimed at essentially canceling out all of the FX-swaps which the central bank had originally issued beginning in 2002. Nor are we unduly concerned that the reverse swaps now, or by mid-January, are likely to neutralize all remaining dollar-linked domestic debt instruments. What we are concerned about, however, is that with no more FX-swaps that need to be reversed, and now no more dollar-linked debt that needs to be offset, market participants are likely to expect the central bank to stop and the currency to appreciate. No problem so far: the central bank can argue that its actions have never had the intention of stopping the currency from appreciating and that its only goal had been to take advantage of the abundance of inflows to reduce Brazil’s external vulnerability. But imagine what happens next. Within the next few weeks, if Brazil keeps engaging in reverse swaps the central bank runs the risk of being misunderstood. Continued spot and forward intervention could easily be seen as an attempt to limit the currency from gaining ground and yet in a world where the US tightening cycle appears largely over, where liquidity remains abundant, and where the US dollar continues to raise concerns, it is not hard to see investors willing to bet for real strength. Of course, the central bank can argue that Brazil’s external vulnerability is not limited to the dollar-linked paper or FX-swaps, but includes all dollar obligations of the sovereign. And it could thus justify further reserve accumulation as well as reverse swaps. Gross public external debt was near $70 billion as of November compared with roughly $51 billion in reserves (we excluded obligations to the IMF given the fact that they were set to be re-paid). However, with the dramatic increase in reserves in December and what we have seen in January, we estimate that Brazil’s net public external debt (external debt plus other liabilities less reserves) is now below $20 billion. With reserve accumulation of the pace we have seen in the last months of 2005, Brazil could boast zero net public external debt by April of this year. If we then recalculate to take into account the reverse swaps, Brazil’s public sector could find itself long dollars by as early as February. Given the wide spread between domestic and international interest rates, the notion of Brazil going long dollars hardly seems attractive. And the move is likely to increase speculation that the end of reserve accumulation and reverse swaps is near. That in turn, short of a sudden renewal of global risk aversion, seems to set the stage for currency gains. The longer the authorities continue to accumulate or engage in reverse swaps, the greater the pressure builds that the real will eventually strengthen as the authorities are forced to end the intervention policy. Bottom line Is there a way out? The central bank has a chance this week with the Copom decision on Wednesday January 18 to send a powerful signal by cutting the Selic interest rate by 100 basis points from 18% to 17%. We expect a less aggressive move of 75 basis points. Still, the sooner Brazil moves to reduce the spread between its domestic rates and those abroad, the more likely it is that it can avoid creating the conditions for a speculative inflow betting on the currency’s rebound. The authorities could also take the opportunity to seek out other ways to reduce or eliminate its limited external debt vulnerabilities short of massive reserve accumulation and increased reliance on derivative products.
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2005 Trade Momentum Moderated but Still Strong
Jan 18, 2006
Deyi Tan (Singapore) and Denise Yam CFA (Singapore)
Exports rose 13.7% for the full year: Exports rose 22.6%YoY in December as re-exports and domestic exports registered strong expansion of 17.0% and 27.5% respectively. Though 2005’s total export growth of 13.7%YoY was a shade paler than the 20.9%YoY in 2004, the double-digit momentum is considered strong given the pressures bearing down on global demand in 2005. Meanwhile, high import intensity in exports as well as rising domestic sentiments contributed to the import growth (+21.4%YoY and +14.0% for 2005). Trade balance stands at SG$4.4bn in December. NODX rose 7.4%YoY in 2005; China is the single largest driver: Non-oil domestic exports rose 31.6%YoY in December (vs 14.3%YoY in November), bringing the full year growth to 7.4%YoY (vs 17.0%YoY in 2004). This rides on the back of the rising trajectory of the electronic exports (+16.2%YoY) which has picked up gradually since 3Q and also the non-electronic exports (+49.3%YoY). However, the strong performance is also partly due to base effects. Specifically, the recovery in the electronic sector continues to firm out with ICs registering 22.0%YoY (vs +10.5%YoY in November) and PC parts, 39.5%YoY (vs +20.0%). These offset the weakness still seen in PCs (-21.5%) and diskdrives (-17.1%). Meanwhile, upward volatility in the pharmaceutical exports (+386.9%YoY) in the non-electronic segment added 13%-pt to NODX growth. The breakdown by export markets show that China continues to be the single greatest contributor to NODX growth for 2005 (27.2%YoY & +2.4ppt) while export demand from the United States shrunk by 1.7%YoY (-0.3ppt). Export diversification on investment into niche areas to lend structural strength: Cyclically, we see NODX momentum continuing on an upward trajectory at least until 1H06. Structurally, the recent announcements to increase R&D into niche areas in the medium term should diversify risks from reliance on the electronic sector, which has been continuously forced up the value chain by low-cost competition elsewhere in the region. A case in point: previous diversification in the form of the pharmaceutical sector has seen the non-electronic share in NODX increasing by 11% and contributing 73% of NODX growth in the past 5 years.
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Chain Reaction
Jan 18, 2006
Serhan Cevik (from New York)
Turkey needs a new energy strategy to reduce its dependency on fossil-fuel imports. Turkey’s oil and natural gas consumption per unit of output has increased by 33.5% in the past 15 years. And, with the price of crude oil surging more than 200% in real terms in the last four years, the country’s fossil-fuel imports now account for nearly 6.2% of GDP, making it one of the most oil-dependent economies in the world. Needless to say, the increasing dependence on imported oil and natural gas as the main sources of energy exposes the Turkish economy to price fluctuations and geo-political supply risks in the global energy market. Although oil prices may have been partly inflated by financial speculation and, as Morgan Stanley’s projections suggest, decline to an average of US$61.3 per barrel in 2006 and US$47.9 next year, Turkey’s structural dependency nonetheless requires a rethinking of energy policies beyond short-term price fluctuations. Oil dependency is a drag on the economy and limits foreign-policy options. Increasing energy quotes in the last couple of years have already had adverse effects on the Turkish economy: lowering output growth, limiting the pace of disinflation and leading to a significant widening in the current account deficit. If unchecked, Turkey’s energy intensity and import dependency will only get worse, as the demand for crude oil and natural gas doubles in the next five years. We think that the dispute between Russia and Ukraine disrupting natural gas supplies across Europe has clearly exposed the weakness of Turkey’s energy policies and the consequences of over-dependency on energy imports that reach beyond economic considerations. The fact that Turkey imports 65% of its natural gas from Russia and 95% of its oil from six neighbouring countries presents a strategic challenge, in our view, and highlights the urgency of developing a new strategy on the security and diversification of energy supply in the long term. The authorities must introduce conservation and efficiency-boosting measures. Reducing the degree of dependency on imported oil and natural gas is a challenging task. In the short term, the focus must be on improving the diversity of supply and storage capacity and on introducing conservation and efficiency-boosting strategies. The mobilisation of energy-saving policies, such as incentivising mass transportation and fuel-efficient cars, could reduce the demand for imported oil and natural gas. Indeed, according to official estimates, a 2% conservation ratio would save over $10 billion in the next ten years. For the long term, however, Turkey needs an energy policy that would reduce fossil-fuel dependency and the cost of electricity, which is already the highest among OECD countries. With soaring oil prices, alternative energy sources and technologies have become more competitive. Though Turkey is blessed with abundant water supplies, hydraulic generators produce only 25.3% of electricity and fossil fuels — oil, natural gas and coal — account for almost 74.6% of total electricity production. In addition to building new hydraulic electricity generators, Turkey should incorporate renewable sources of energy, such as wind and solar power, into an environment-friendly energy strategy. However, such alternatives usually provide intermittent, rather than baseload supply for the national grid, and therefore would be inadequate to satisfy increasing electricity demand. In our view, with soaring oil and natural gas prices, pursuing alternative energy technologies, such as biofuel and coal liquefaction, has also become economically feasible. Especially, developing biofuel capacity may help to address some of the inefficiencies in Turkey’s agriculture sector. Nuclear energy would lessen oil dependence and ensure environmental sustainability. Given that renewables provide a limited supply of energy, nuclear power is a worthwhile alternative that could improve self-sufficiency in energy generation as well as reduce greenhouse gas emissions. Many European countries rely heavily on atomic energy: in France about 75% of all electricity is nuclear-generated, in Belgium 55%, and Sweden 50%. Thanks to technological advances, the new generation of nuclear power plants are cheaper to build, safer to operate and produce less waste than earlier models. Moreover, once a nuclear reactor is operational, the electricity generated is cheaper than many other methods and creates no carbon-dioxide emissions. This is why we believe that a network of nuclear power plants would help Turkey in diversifying energy sources, reducing its vulnerability to supply shocks and ensuring environmental sustainability.
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