Volatility jumped in Brazil’s currency market after the country became one of the first emerging markets to scrap a key capital control in the face of a broadly stronger dollar.

After rallying as much as 2 per cent against the dollar early on Wednesday, the Brazilian real had already erased those gains by midday in São Paulo, raising doubts about the government’s ability to prevent a sharp depreciation of the currency.

The real was quoted around 2.13 per dollar, down 0.1 per cent, in early afternoon trading.

Brazil’s government late on Tuesday cut the financial transactions tax, known as IOF, from 6 per cent to zero on foreign fund flows into the domestic bond market in what analysts said was an attempt to lure back capital and prop up the real.

Brazil has spent much of the past three years fighting for a weaker real to boost domestic industry, attacking the US for creating a “tsunami” of liquidity that flooded emerging markets while putting up a barrage of capital controls at home.

However, as speculation rises that the Fed is preparing to “taper” its third wave of monetary expansion, known as quantitative easing, the real has depreciated rapidly over recent weeks, threatening to exacerbate the country’s inflation problems.

The real sank to a four-year low against the dollar on Friday last week in spite of attempts by the central bank to strengthen the currency by selling currency swaps in the market.

Analysts said Tuesday’s measure would also do little to prevent further depreciation of the real given the prospects of a stronger dollar, as well as Brazil’s economic slowdown.

“Beyond the short-term positive impact we expect the Brazilian real to continue to be negatively impacted by soft macro fundamentals – weak growth, high inflation, deteriorating fiscal and current account balances, and overall weak external competitiveness due in part to the real’s overvaluation,” said Alberto Ramos, economist at Goldman Sachs.

The main impact of the IOF’s withdrawal would likely be increased volatility in the currency market, said analysts at HSBC.

“Foreign investors will be more willing to enter Brazil, but will also be more willing to remove funds from the country at times of greater risk aversion,” they wrote in a report on Wednesday.

However, the move was still largely welcomed by analysts and investors who have long called on Brazil’s authorities to remove controls in the country’s capital markets. While the government also scrapped the IOF tax on foreign inflows into equities in 2011, a particularly strict 1 per cent tax on trading currency derivatives remains in place.

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