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Currency Risk in South America – Brazil and Argentina Inflation

Currencies / Inflation Mar 08, 2011 - 01:02 PM GMT

By: David_Urban

Currencies

Inflation is beginning to rear its head globally.  Demand for commodities worldwide is on the rise causing shortages and riots as countries attempt to deal with the problems associated with population growth and a rising, educated middle class.  Regime changes across the MENA region are adding additional risk factors to the equation. 


Central banks around the world, with the exception of the US, Japan, and Turkey are have entered the rate rising cycle with the ECB expected to join the crowd shortly. 

In South America, Brazil and Argentina are on two different paths with respect to their economies yet fighting the same inflation risks. 

Brazil’s economy has been on a tear for the past decade.  Once known as a basket case and a huge investment risk, Brazil undertook difficult reforms and renewed an agreement with the IMF in 2001.  Within two years Brazil achieved a primary budget surplus and paid off the IMF 2 years ahead of schedule. 

During this period, Brazilian companies have grown into global leaders and were recently awarded the 2016 Summer Olympics. 

The growth does not come without a price.  Currently, Brazil is in a very touchy situation with respect to their economy.  IPCA inflation rose to 6% in January and economic growth looks to continue its strong pace coming in around 7.5% for 2011.  This has forced the central bank to increase the SELIC rate by 50 basis points to 11.75%.

Brazil’s problem is that it needs FDI ahead of the Rio Olympics and has been trying to stem the hot money inflows with a combination of capital controls, FX intervention, and interest rate increases. 

The problem with increasing interest rates is that it attracts even more hot money in the global fixed income area as investors chase yield.  Capital controls are difficult to implement and not looked upon well by international investors.  FX intervention can be very dangerous as it often backfires.

In Argentina they are having the opposite inflationary problem.  The Kirchner government has embarked on a program creating hyperinflation across the country. 

While issues related to the Argentina’s IMF default in 2001 lie unresolved, Argentina has been cutoff of international capital markets and CDS spreads on Argentine debt are in default territory. 

The government has been raiding Central Bank reserves since former Central Bank President Martin Redrado was let go for not backing a plan that would allow the Argentine government to tap central bank reserves in order to pay debtors.  

The Kirchner government has been giving employees generous raises to the tune of 25% in order to combat inflation and a loss of purchasing power.  The additional salaries then flow back into the consumer markets as consumers look to spend their cash as prices continue to rise further eroding their purchasing power and any gains they have made.  This creates a hyperinflationary cycle which continues to feed upon itself ultimately ending in a government default and economic collapse.

In addition, private sector economists in Argentina are being pressured by the government to stop publishing data regarding inflation under threat of heavy fines if they continue publishing.

Compounding the problems in Argentina are provincial and national elections scheduled for later this year.  As the government tries to maintain its hold on power the promises will become greater as they promise everything to everybody. 

Investors looking at mining companies in Brazil and Argentina need to be aware of the risks forming in South America.  It was only a few short years ago that investors woke up to Bolivian President Evo Morales attempt at nationalization for the mining industry which caused immediate haircuts in those stocks with operations in Bolivia. 

This is not to say that you should avoid every stock with Brazilian and Argentine operations but investors need to be aware of the potential risks.  There is a risk of overheating in Brazil and hyperinflation in Argentina while both countries attempt to deal with inflation attacking their economies in very different ways.

By David Urban

http://dcurb.wordpress.com/

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