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Why the Brazilian real could depreciate further (Part 1)

The foreign exchange depreciation has caused big losses for investors in Brazilian equities (EWZ) through 2013Q2—and the FX slide may continue

The volatility in the emerging market currencies has been through the roof since Bernanke hinted at a slowdown of quantitative easing in the United States. Several currencies across different markets depreciated as the U.S. dollar strengthened based on expectations of both a stronger U.S. economy and improving financials of the U.S. government.

USD vs Brazil Real, Real Weakening 2013-07-30Enlarge Graph

Before going into detail as to why the Brazilian real (BRL) may continue to drop, let’s first review the arguments for a stronger BRL.

The case for a stronger BRL

Several analysts are predicting a stronger real by year end. The target range seems to vary between 2.10 and 2.20 BRL per USD. There are two main reasons why this may be the case, as we’ll see below.

Correction overreaction

While it’s true that the BRL was overvalued for a long time, many argue that the correction overshot for several reasons, including the protests in May. The argument is that now the BRL can stabilize as the economy recovers investors’ confidence.

Removal of IOF tax

The removal of the transaction tax has made Brazilian bond yields literally twice as large as those in Mexico, which had become the Latin America sweethearts. The IOF tax used to bite out a 6% chunk of profits, so now investors are more attracted to Brazil.

The increased demand for Brazilian bonds should drive demand for the currency higher and therefore lead to appreciation.

Read on for the arguments in favor of further depreciation

Continue to Part 2