The Banco do Brasil, Brazil’s central bank, announced that it is beginning to study market demand for rolling over the swaps it introduced this year to stem the depreciation in the real. As I noted back in August, the bank was playing with fire by appealing to the swaps market. The problem with using swaps as a currency supporting measure is their ultimate maturity – central bank use of swaps are designed only to buy time.

That they have done so is not at all surprising. These central bank measures often create “positive” trends in any number of markets that receive intervention, all over the world. Not many of these interventions create a lasting impression, again, as they are only hoping to instill enough calm to inhibit “disorder.” Once the initial euphoria wears off, the warts are back in the spotlight. That was the essence of the World Bank warning a few weeks back.

In current case of the BRIC’s, much of this apparent “success” has been related to dollar funding markets processing the “taper off” probability after September 4. Dollar tightening has given way to a noticeable pause, allowing the currencies several months of breathing room.

In the case of the Brazilian real, the credibility issue of the swaps program is heightened in importance beyond other currencies. The major reason is that these swaps are not really dollar swaps at all, at least in any meaningful sense.

The way the Brazilian derivatives market works is different than what is implied in mainstream commentary. Without getting too far into those weeds, the Brazilian monetary authorities realized, from past experience with currency depreciation-type emergencies, that they did not necessarily need to offer dollars. Instead, the Brazilian treasury sells, continuously, domestic public debt indexed to US dollar rates.

The Banco’s “swaps”, then, act only on implied future dollar rates, increasing the cupom cambial (the onshore dollar rate implied by currency futures and spreads with dollar rates). In other words, since the central bank “swap” reduces the futures price of dollars in relative comparison to the spot price, there is a greater incentive for banks (both Brazilian and foreign) to borrow US dollars on foreign markets and import them to take advantage of the cupom cambial spread. The swap isn’t really a swap in the conventional sense since the central bank is only swapping dollar indexed securities – deliverable in reals. In short, it is the old central bank axiom of getting the “market” to do your dirty work for you.

The downside of such a program again relates to credibility. Since this is, at best, one step removed from actual dollar flows (dependent on banks to take on dollar funding risk), a renewed tightness in dollar funding makes it exceptionally susceptible to being reversed before rates and spreads “normalize.” Further, with financial institutions being encouraged to take on US dollar risk, the Banco needs to maintain the markets’ sense of a dollar backstop by keeping the option open to actually mobilize its reserves position. The slightest hint of doubt about dollar reserves can send banks scurrying to cover their short dollar positions – akin to calling the central bank bluff.

That credibility is already in doubt, somewhat, at the start since the Banco has first appealed to the indirect “swaps” option. That, rightfully, signals wariness about direct action in dollar reserves. Should doubts fester about mobilization of reserves, as they did in 2008, banks begin to ignore the cupom cambial spread opportunity, eventually interjecting or heightening dollar volatility. The result is a ratchet effect, where spreads grow wider without any “beneficial” dollar inflows.

It will be interesting to see, then, how the currency markets interpret the latest announcement about potentially scaling back the swap support program. I’ve thought that Brazil was in desperate trouble from the start since its domestic economy is not supportive, making it a prime candidate for “outflows” in any dollar tightening scenario. Throw in a banking system that went short the dollar/long the real with the idea the Banco do Brasil was going to support its currency, and that has the makings of a sharp reversal should tightening reappear (or the Brazilian economy continues to worsen).

The current period of calm is likely just a reprieve, except now the central bank has actively courted increased dollar leverage in its own system.

 

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