Worrisome Signs

Fiscal Policy
Fiscal Policy - Public and Welfare Economics

There are serious doubts regarding the Brazilian government’s ability to reverse the expansionary fiscal policy that characterized the final two years of the Lula administration. It is always difficult to prevent an increase in public spending, but this task becomes even more challenging if decisions are taken by almost the exact same policy team that did the opposite during the previous government. However, the Minister of Finance’s first declarations were positive, pointing out the need to reverse the excessive fiscal expansion of the previous two years. 

Unfortunately, recent exercises on creative accounting raise doubts regarding the direction of economic policy (Garcia 2010). Even more worrisome is the recent announcement by the Minister of Finance that the Brazilian Sovereign Fund (BSF). will be able to buy dollars in the futures market using a financial derivative known in Brazil as a reverse currency swap, a policy which is likely to lead to large fiscal losses. 

To see why this is the case, let us assume that the BSF purchases dollar futures contracts today that mature at the end of 2011. Because of covered interest parity, the price of this futures contract is equal to the spot dollar price plus the interest rate differential, computed for the period between the initial trade date and the contract settlement date. As the Brazilian interest rate is higher than the dollar’s, the dollar futures price is higher than the spot dollar price, constituting a situation known as “contango” (Keynes 1930).

In a recent Interview, Minister Mantega (Valor Economico 2011) stated that reverse currency swaps will not generate any fiscal loss if there is no currency appreciation.  That statement is incorrect. Let’s see why. The figure illustrates a similar case that actually happened in the recent past. It shows the converging trajectories of the spot dollar price and dollar futures price for the dollar futures contract that matured at the end of August 2010. The difference between the two prices decreased gradually as the settlement date approached. The graph shows that although at the end of November 2009 the spot dollar quotation was equal to the exchange rate on the futures contract settlement date (08/31/2010), any investors who had purchased dollar futures contracts on 11/30/2009 would have incurred a loss equal to the difference between the price of the futures contract on November 2009 and the spot price on August 2010. There would have been no loss only if the Real had depreciated and the spot price on the settlement date had became equal to the price of the futures contract on November 2009. 

We can now use the spot dollar rate and the price of dollar futures contract in January 2011 to calculate the size of expected losses associated to reverse currency swaps.  If the scenario of exchange rate stability (at 1.691 BRL/USD) proposed by the Minister is in fact confirmed, the BSF, by paying BRL 1.845 for each dollar futures, would incur a loss of BRL 0.154 (1.845 – 1.691) for each futures dollar. That is, for every USD 1 billion of reverse currency swaps, in a scenario of currency stability, the BSF is expected to lose BRL 154 million. The BSF would only avoid a loss if the exchange rate at the end of 2011 were equal to or greater than 1.845 BRL/USD, the present dollar futures price. Given that the current market scenario considered by the Brazilian Central Bank contemplates a year-end exchange rate of 1.75 BRL/USD, the additional depreciation necessary to achieve 1.845 BRL/USD would surely require even higher interest rates to keep inflation at bay.


Garcia, Marcio (2010), “Brazil: Creative Accounting and Fiscal Risk,” Roubini Global Economics, October.  

Keynes, John Maynard (1930), A Treatise on Money, 2 vols. London: Macmillan. 


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