• Categories
  • Archives

To the Rescue

To the

By raising the rate it charges for lending, the Brazilian
central bank hopes to make the real more valuable. Unfortunately, this only amounts to
closing the barn door after the horses have escaped.
By Mike Sproul

Brazil’s recent devaluation of its currency exposes a common weakness shared by all
modern central banks: While they carefully monitor interest rates and the money supply,
they pay little attention to their own assets. Thus the Brazilian central bank, which
holds a great deal of its assets in the form of Brazilian government bonds, was badly hurt
when those bonds dropped in value. As a result, the bank had fewer resources backing its
money, and so the value of the real fell. To make matters worse, the bank chose to support
its currency by buying reals on the open market for more than they were worth. This means
the bank threw away even more of its assets—inadvertently causing the real to fall
still further.

An example will help to illustrate the bank’s problem: Suppose the Brazilian central
bank has just commenced business. On the day it opens, people deposit 100 U.S. dollars in
the bank. The bank gives out paper receipts for the dollars deposited. The bank then
promises that each receipt will be redeemable at the bank for one U.S. dollar. Assuming
that the bank is trusted, people will begin to use its receipts as a local paper money,
equivalent in most respects to genuine U.S. dollars. This, in essence, is how paper money
first comes into being. As long as the paper money is redeemable for dollars, people will
value the money just as they value dollars. When the bank closes for the weekend and the
paper money becomes temporarily irredeemable, people will still value it as long as they
know the bank still has its assets. Even when the paper money becomes irredeemable for
months or years at a time, people will still value it according to the value of the assets
held in the bank.

Once the central bank has established a paper money, it typically begins to acquire
government bonds as its chief asset. The Brazilian central bank, for example, uses
newly-printed paper reals to buy Brazilian government bonds. In principle there is nothing
wrong with this. If the bank prints 100 new reals, and uses them to buy bonds worth $100,
then the bank still has one dollar’s worth of backing for every real issued, and the value
of the real will be stable. But here is the problem: Brazil’s treasury has become so
stretched that not even an IMF bailout can save it, so Brazilian government bonds drop in
value. But those bonds are the backing for the real. When the bonds drop in value, the
real must drop too. The central bank has committed the age-old financial error of putting
too many eggs in one basket: It owns too many Brazilian government bonds, so when those
bonds lose value, the real is pulled down with them.

The Brazilian central bank has tried to stop the fall of the real with two
tools—both of them counterproductive. First, it tried to support the real in
international markets by using its dollar reserves to buy reals at an artificially high
rate. Let’s say the fair market value of the real is just $.90. If the bank starts buying
those reals at artificially high prices—say if it pays $1 for each real that it buys,
then the bank will lose 10 cents on each purchase. The bank’s assets will fall, and the
real will drop still more.

The second tool the bank has used is interest rates. By raising the rate the bank
charges for lending, they hope to make the real more valuable. Unfortunately, this only
amounts to closing the barn door after the horses have escaped. The real fell in the first
place because the bank’s portfolio of Brazilian government bonds fell in value. That lost
wealth is gone forever, and the bank cannot recover it by charging more for future loans.
In fact, if the bank sets its interest rate above the market rate, then borrowers will
either borrow somewhere else or they will choose not to borrow—leaving the central
bank with fewer customers, and leaving Brazilians facing a credit crunch as the bank
tightens the supply of reals.

So what should the central bank do? There are three things: (1) Don’t try to support
the real, since this will drive it down even more. (2) Diversify the central bank’s assets
into other securities besides Brazilian government bonds. (3) Don’t raise interest rates
above market levels. This strategy will not reverse the loss already suffered by the real,
and it certainly will not end the Brazilian budget deficit that started the whole problem,
but it will at least prevent future budget crises from becoming currency crises as well.

Mike Sproul ( msproul@econ.ucla.edu
) teaches economics at UCLA. Further reading can be found at

comments to

  • Show Comments (0)

Your email address will not be published. Required fields are marked *

comment *

  • name *

  • email *

  • website *

This site uses Akismet to reduce spam. Learn how your comment data is processed.


You May Also Like

Brazil Getting Ready to Build Another Nuclear Plant

The president of the Latin American section of the American Nuclear Energy Society (LAS), ...

The Pink Tide Has Faded in Brazil and Environs. It’s Everyone for Himself

The foreign policies of South American countries reflect the intricacies of national interests rather ...

US, France and Great Britain Debate in Brazil Paulo Freire’s Literacy Method

Experts from Brazil, United States. Angola, Portugal, Colombia, Belgium, France, Germany, and England are ...

Sweets, the Brazilian Way

According to Yahoo! Brasil, the Brazilian creme de leite craze is catching on outside ...

Brazilians emigrants to send US$ 7.4 billion back to Brazil

Latin Americans Send US$ 72 Billion Back Home. Brazil’s Share: US$ 7.4 Billion

In spite of United States efforts by 2010 remittances from migrants will reach US$ ...

By Advertising Reading, Brazil Is Trying to Sell Meat to Vegetarians

Finally, a Brazilian administration has perceived that it must promote reading in Brazil with ...

Brazil participated at Dubai's Gulfood fair

Brazil to Keep Title as Emirates’ Top Beef Supplier

The eleven Brazilian producers of cattle beef that  participated in the Gulfood, the largest ...

Don’t Expect Any Turn to the Left or Right, Warns Brazil’s Finance Minister

Guido Mantega, Brazil’s Finance minister, discarded any “left turn” or leaning towards the left ...

Happy 450th Birthday, São Paulo

São Paulo contains everything that is bad about Brazil, particularly the enormous social division ...

Brazil’s Petrobras Spends US$ 2.5 Billion in 26 Oil Tankers

Transpetro, subsidiary of the Brazilian oil company Petrobras for the logistics and transportation sector, ...