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The currency war is far from over, it seems – it’s just that the Brazilian government has changed sides.

After more than two years of fighting the appreciation of the real against the dollar, Brazil’s authorities are now pulling out all the stops to strengthen the local currency.

On Tuesday, the central bank said it would raise the threshold for short dollar positions that are exempt from a hefty reserve requirement. Up until now, financial institutions had to put down 60 per cent of their short dollar positions on deposit at the central bank for positions over $1bn. Now the rule only applies to positions over $3bn.

If you take the government at its word, the measure makes little sense. Firstly, finance minister Guido Mantega has frequently spoken out against evil “speculation” in the foreign exchange market. But this measure technically makes it easier to short sell the dollar and make bets on a stronger real.

Secondly, the government says interventions in the market are not designed to target a specific rate, but intended to reduce volatility. However, the real has been stuck in a relatively narrow band for months, so why act now?

The consensus among economists and traders, though, is that the government is determined not to let the real weaken beyond the key R$2.10 per dollar level for fear it will stoke inflation.

What is not so clear is whether Tuesday’s rule change will work. The real barely strengthened 0.5 per cent against the dollar after the measure was announced. A 1 per cent tax on currency derivatives, introduced in July last year, is what has really brought the market to a standstill and crushed the real this year.

Loosening or withdrawing other capital controls may not make much difference at this stage. Furthermore, attracting inflows back to Brazil, especially given the slow pace of growth and rising government intervention in the economy, is probably not going to be as easy as keeping the money out.

This from Tony Volpon at Nomura:

While any unwinding of capital controls is a good thing, we should keep in mind that the only reason the BCB is undoing such “macro prudential” measures (which, we should remember, were justified not as measures to stop BRL appreciation, but to control unwanted credit growth) is because there has been a steady, and rising, level of outflows (negative US$4.2 billion month to date). This outflow, we believe, has a structural characteristic, that will not in any way be reverted by unwinding these measures. Increasing market liquidity will smooth out the depreciation, it will not revert it. Thus we believe that any rally will be short lived and we re-affirm our forecast for further depreciation of BRL into 2013.

Related reading:
Brazil drops a capital control, beyondbrics
Brazil: A different kind of currency warrior, beyondbrics
Downturn shakes Brazil from its dream, FT.com

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