Brazilian Forward Contracts – A Revolutionary Tool in Exchange Rate Management?Posted: April 3, 2015
From August 2013, the Brazilian Central Bank (BCB) began a novel strategy of currency intervention. The BCB directly auctioned forward contracts in the shape of currency swaps to market participants. Every week until December 2013, the bank released US$2 billion worth of swaps that were priced in US dollars and paid out in Brazilian Real. The programme was then extended from January 2014 until the 31st March 2015, albeit at a reduced rate of US$100 million a day from the previous rate of US$200 million a day.
These contracts completely contravened orthodox economic recommendations of non-intervention and the traditional methods used by emerging economies to manage exchange rates. The swaps were explicitly built to provide additional foreign exchange hedging opportunities to stimulate participants and provide additional liquidity in the domestic market. Their careful design meant that the BCB did not need to use their valuable foreign exchange reserves nor demand sterilisation. Furthermore, as the auctions were in US dollars, the swaps were actively attracting valuable foreign exchange into Brazil to help smooth the path of the Real during the peak of the “Taper Tantrum”, reversing the pattern of currency outflows away from Brazil.
This piece shall evaluate the performance of Brazil’s experimental intervention tool and contrast it against the traditional tools available to central banks. Whilst undertaking its analysis, the essay will consider the development path of the Brazilian financial sector and whether such foreign exchange swaps offer other emerging economies a revolutionary way to manage their exchange rates.
The traditional tools
Traditionally, central banks have a singular direct tool to influence foreign exchange rates: cash. Central banks may directly use their own domestic currency to nominally manipulate the market through purchasing other currencies. In turn, the increase in the monetary base will have further influence to interest rates and expectations, thus potentially magnifying the impact sympathetically.
However there is a heightened risk of immediate inflation if the domestic currency used for the operation is not “sterilised”, i.e. an identical value of opposing bonds is not used to neutralise the total money supply. This threat is especially key for emerging economies where the monetary base is relatively small and any impact is likely to be magnified.
Yet, the direct effectiveness of interventions once sterilised is at best, highly debated [e.g. Fatum & Hutchison; 2003]. The proponents of sterilised interventions are left relying on attempting to measure the “signalling” impact of cash interventions – which is difficult to define, track and calculate. And even where interventions are not immediately hampered by inflationary concerns and are thus non-sterilised, there is no guarantee that the cash spent may be effective. Market participants – speculators – are highly likely to actively combat the best intentions of the central bank, ignoring any signalling properties and neutralising any active cash injections.
Alternatively, central banks may attempt to use their reserves of foreign cash to intervene on their own behalf. For example, small nations using their reserves of US dollars or Euros to drive rates one way or the other. However, foreign currency reserves are very expensive to accumulate and may run out long before they achieve their objective.
Central banks may issue bonds to purchase foreign currencies and use debt to intervene. But this is highly dangerous. If priced in the domestic currency, their demand will merely mirror the domestic currency and thus may be weakly demanded during times of crisis. If priced in foreign currencies, the bonds must be carefully priced so future pay-outs do not exceed expectations due to “unforeseen” volatility. Were the domestic currency to suddenly depreciate, these debts may escalate until becoming unpayable and cause financial crises such as the Latin American Debt Crisis in the 1980s or the 1994 Mexican Currency Crisis.
Central banks have also traditionally implemented policy tools to control the flow of foreign exchange and thus the traded value of the domestic currency. However unlike cash, their use will only have an indirect impact on foreign exchange rates – and as such their reliability and range is questionable. Therefore they are best used in a supplementary manner, to help direct intervention or long-term management of rates.
The new tool – DNFCs
The BCB designed the derivatives in the following fashion. The derivatives were called swaps, because they were created as explicit foreign exchange hedging tools. However they operate as US dollar Non-deliverable Forward Contracts that settle in Real. According to Garcia & Volpon [2014; 3-4], they thus would have a better nomenclature of Domestic Non-Deliverable Forwards Contracts. In addition to a given rate of interest, the forward contract promises to pay the difference between the spread of the US dollar and Real at origination – and – the spread at the close of the contract. The unusual factor here is that it settles in a non-convertible currency equal to the promised sum of US dollars. Thus it shifts the convertibility risk from the BCB to the purchasers in the long run, but still allows the purchasers to use the swaps as approximations of US dollars.
The potential impact of the Brazilian swaps on on-shore US dollar rates are two-fold. First, the daily release of the derivatives widens the available interest differential compared to standing Brazilian interbank (US Dollar & Real) interest rates. This makes it more attractive for commercial banks to bring US dollars to Brazil and purchase the swaps, thus supporting the BCB’s goal of defending the Real’s exchange rate against the dollar.
Meanwhile, the tool also motivates institutional investors in favour of the Real. With the ongoing uncertainty over the long term value of the Real-vs-US dollar rate during 2013, many institutional investors were partially dollarizing their Brazilian positions. Dually, this was to protect value and go long on the future value of the dollar. The swaps offered the opportunity for the investors to satisfy such priorities without diminishing BCB foreign reserves. By April 2014, Brazilian and international institutional investors were long US$43.6 billion. [ibid. 12-13]
When assessing the effectiveness of the policy, Chamon et al  found that the BCB’s intervention was most effective during the peak of the Taper Tantrum, August 2013 to December 2013. The estimated positive cumulative effect being +7-+19% against the counterfactual. However the performance of the tool decreased as the programme was reduced and extended beyond January 2014 – when the programme’s impact upon the US dollar/Real exchange rate became indistinct. They conclude that this follows standing economic theory that suggest foreign exchange intervention is most effective during periods of economic turmoil – but weakens over time.
Thus this suggests DNDFs may be a useful tool for emerging economies to manage their exchange rates. However, as will be discussed in the following section, Garcia & Volpon  convincingly highlight that the swaps’ effectiveness is also reliant upon the unique development and construction of Brazil’s financial sector. And therefore other nations with different characteristics may be unable to utilise the derivatives as beneficially.
The Brazilian Context
Although the immediate impetus for this programme arose from a BCB desire to formalise the post-GFC stimulus and reduce the Taper Tantrum related suppression of domestic assets and the Real, much of the effectiveness of the instrument was due to the unique character and development of the Brazilian financial system. [Garcia & Volpon; 2014]
Prior to the 1980s, Brazil had been heavily focused upon undertaking Import Substitution Industrialisation (ISI). This had encouraged a neglect of financial sector development, which remained largely isolated from the international financial market. However the rising pressure of hyperinflation caused by the Latin American Debt Crisis and the end of ISI demanded that the domestic Brazilian financial sector quickly become adept at designing sophisticated derivatives for hedging purposes. This heightened need for hedging tools was further encouraged by the Real being non-convertible and the laws that prevented Brazilian banks to allow foreign deposit services. Thus the currency could not be used outside the country and domestic participants could not legally hedge the inflation-risk through direct exchange into foreign currencies.
Brazilian market participants therefore had a long lead time to grow familiar with such instruments and to become comfortable with contrived US dollar substitutes. Once the swaps were introduced in 2013 by the BCB, the market was sufficient thick and capable to use them as intended. In assessing if the tool may be useful in other emerging markets therefore, this distinction is important. Many other emerging markets – with immature financial systems, thin markets and naive experience of such instruments – are unlikely to be able to utilise the swaps completely. Hence the instrument’s effectiveness to influence the exchange rate in these other economies is highly likely to limited.
Furthermore, the nature of the BCB swaps demands that the holders are using the swaps for hedging and speculative purposes only. Because they settle in Real, the holders will not be able to use the proceeds to settle foreign transactions – i.e. they will not have US dollars to spend on the international markets. Thus their viability as a foreign exchange tool in other economies will be limited by participants’ need and desire to ultimately hold US dollars for expenditure. A simple example would be a small high import nation, whose economic actors are reliant on having foreign exchange to buy essentials internationally. In such a case, the swaps can foreseeably be ineffectual – because demand for them will be insufficient to achieve their goal.
Ultimately, the forward contracts offered by the BCB for 18 months had varied success. Their initial impact up to January 2014 was found to be considerably more recognisable that the latter period with their conclusion in March 2015. [Chamon et al; 2015] Whilst the reduction in their size and the changing global circumstances may have been of import, it seems that the decline of the method’s impact is more likely due to the fatigue that all exchange rate intervention techniques have over time.
In regards to their applicability for other emerging nations as a new tool to defend exchange rates without wasting valuable foreign currency reserves, the derivative’s effect is highly reliant upon the state of the economy upon implementation and the priorities of the domestic actors. Arising from their complexity, their effectiveness when compared to existing alternatives cannot be presumed.
– Chamon, M., Garcia, M., & Souza, L. (2015). FX interventions in Brazil: a synthetic control approach (No. 630).
– Fatum, R., & M Hutchison, M. (2003). Is sterilised foreign exchange intervention effective after all? an event study approach*. The Economic Journal, 113(487), 390-411. a
– Garcia, M., & Volpon, T. (2014). DNDFs: a more efficient way to intervene in FX markets? (No. 621). Department of Economics PUC-Rio (Brazil).
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