Tuesday, October 05, 2010

Brazil Raises Tax On Foreign Investments

With yields in the United States, and certain other countries, falling to increasingly absurd levels (the real 5-year yield is -0.28% when this is written) many investors turn to more attractive destinations, such as Brazil, that I wrote about a few months ago.

The yield differential is even more attractive now than when I wrote that post, with the 10-year yield in Brazil being roughly 9.5 percentage points higher than in the United States and with the differential being more than 10 percentage points at earlier maturities.

In part this can be justified by somewhat higher inflation in Brazil. but on the other hand, Brazil's higher growth means that because of the Penn effect, the exchange rate of the real will not fall that much.

Indeed, the problem for Brazil is that the real, far from falling as the Uncovered Interest Rate Parity would have predicted, has actually appreciated in value. The real is trading at roughly 59 U.S. cents, up by 6% from a year ago, and about 10% compared to a decade ago. Investors that have carry traded with the real as target currency have therefore enjoyed very high profits.

That worries Brazilian politicians, who are now trying to stop this by raising the tax on foreign holders of bonds from 2% to 4%. This is arguably the smartest way to prevent the real from appreciating further. Buying foreign assets, like China and most other countries that intervenes in currency markets, would have made much less sense as this would have meant that Brazil would have borrowed from foreigners at interest rates above 10% in order to lend to other foreigners at interest rates near zero.

Even so, considering how ridiculously low yields are in for example the United States, even this might not be enough to prevent investors from pouring in money to Brazil and therefore raise the value of the real. The after tax yield differential is after all still 5.5% for 10-year securities and more than 6% for securities of shorter maturity.