The Attractive Brazilian Carry Trade

I have previously discussed my own calculations which showed that "carry trade" (investing in countries with high interest rates, and perhaps to some extent with money borrowed in countries with low interest rates) was profitable in the long term. Securities in high interest countries Australia, New Zealand and Britain (Britain now has low interest rates, but until 2007 it was generally higher than in most other rich countries) gave a much higher return after taking both interest rates and exchange rate movements into account than securities in low interest countries Japan, Switzerland and the United States.

Of course, before embarking on carry trade, you must see whether the high nominal interest rates really reflect high real interest rates as opposed to high inflation. If they reflect high inflation, then carry trade will not be profitable (investing in Zimbabwe dollars during the recent hyperinflation there would have been a very bad idea, despite extremely high nominal interest rates).

After reading this Bloomberg news column by Alexandre Marinis about the high interest rate level in Brazil, I decided to look whether this would have worked in Brazil during the latest decade.

Brazil have indeed had higher inflation than most Western countries, with an average inflation rate of 6.8% versus 2.7% in the United States.

But nominal interest rates have been far higher in Brazil than in the U.S., with the differential being at double digit levels. Right now it is relatively low, "only" about 8.6 %, but it has often been much higher with a peak being reached in 2003 of no less than 25 %.

I haven't calculated the exact annual average differential, but it is clearly above 10%, meaning that real interest have on average been at least 6% more per year. Add to that the fact that the real exchange rate of the Brazilian currency, the real, has risen dramatically during the latest decade.

Despite the higher inflation rate, the real has roughly the same nominal exchange rate against the U.S. dollar as a decade ago. This increase in the real exchange rate probably reflects to a large extent a Penn effect (or Balassa-Samuelsson effect from the high growth and improved terms of trade that Brazil has experienced primarily due to the global commodity price boom.

The result is then that the return on investments in Brazilian securities has been more than 10% higher per year, even more impressive than the returns from investments in securities from Australia and New Zealand. Even with the 2% tax on foreign capital inflows Brazil has sometimes (including right now) slapped on foreign investments for the purpose of limiting the strength of its currency, Brazilian securities have been, and probably will continue to be, a lot more profitable than for securities in the United States and most other countries.

With the 10-year yield currently being 12.7% versus 3.9% for the U.S., and with inflation being only about 2.5% higher than in the U.S. this means that even assuming that the 2% tax will be permanent and even assuming no further real appreciation, real return would be on average 4.3% higher.