Currency Wars: Brazil Fires New Salvo To Stop Drop of US Dollar: Requires 60% Withholding

In spite of all the "good news" lately, the US Dollar continues to sink versus the Brazilian real, and Brazilian authorities have stated that theory will not allow it any further, establishing  a floor at 1.60/1.65 (currently 1.67). Today, Brazil's Central Bank reported that it is taking action to resize the exchange positions of financial institutions.

The banks will have to collect and remit to the CB a compulsory deposit worth 60% of the value of the sold foreign exchange position that exceeds the lesser of: $ 3 billion or the banks reference asset value. This compulsory deposit will be collected in kind and will not earn interest.

In the jargon of the financial market, "being sold" signals doing business that require future delivery of dollars or payment of the exchange rate variation. In practice, this represents a bet that the Real will appreciate. Being "bought", therefore, indicates the opposite: expected depreciation of the Brazilian currency.

The director of Central Bank's monetary policy, Aldo Mendez, says that the measure increase the demand for dollar in the financial market and therefore induces dollar purchases by financial institutions, causing a trend of dollar appreciation.

Financial institutions will have 90 days to comply to the new rule. A note of CB published this morning, reports that the CB's board decided to adopt this as a preventive measure. According to the monetary authority, the measure improves the existing regulatory tools and helps maintain the stability of the financial system.

The banks aims to improve the functioning of the spot foreign exchange and reduce the short positions of the system, which in December 2010 reached a value of $ 16.8 billion.

According to Mr. Mendes it is not good for the economy when the system moves to one extreme or the other (purchased or sold in U.S. dollars). That's because, he said, the futures market there is always a risk and uncertainty about the exchange rate. Therefore, it is not good, he insisted, when there is a concentration at one end.

He noted that when a market is in a short position and there is appreciation, there is a run to buy the currency to cover that position.

Mendes also said that ideally the financial system should work with a position closer to the equilibrium exchange rate, instead of focusing on a particular "pole". He noted, however, that the short position does not necessarily mean bet on a certain tendency for the exchange rate, because sometimes it reflects normal operations of financial institutions, such as foreign trade.

In addition, the government is preparing other new measures: a big increase on the IOF (financial tax) or even a "quarentine" of inbound money. It is clear that Brazil has set a floor for the U.S. Dollar. However, there are still very good ways to play this through an ETF. We just need to wait for the measure to be announced and the one-time hit.