Brazilian stocks plummet on tax hike

New tax on foreign investment as Brazil tries to protect exporters

By Anthony Mirhaydari Oct 20, 2009 3:25PM

Anthony MirhaydariBrazil's finance ministry announced late Monday that the country will impose a 2% tax on foreign inflows into the country's stock and bond markets as policymakers try to stem the rise of their currency, the real, which is up 23% this year. Brazilian Finance Minister Guido Mantega said after announcing the measure that "Our aim is to stop speculation, which is undermining the real and threatening local companies." He added: "Long-term foreign investment remains welcome."

 

The tax starts today. The move comes as a surprise. On Friday, Brazilian President Lula da Silva said that the government was not considering such a tax. In his words there was "no plan to create any tax" and he added that when "false reports are published, the entire country loses." The tax is designed to placate exporters whose competitiveness is threatened by a strengthening currency. A similar debate is being waged in Japan and elsewhere in Asia.

 

Part of the reason for the nervousness is the ongoing debasement of the U.S. dollar -- which as you know is attracting the ire of central bankers in export-oriented economies around the world. Another part of the problem is that investable capital in the developed world, and especially here in the United States, is being attracted to the higher returns offered overseas. These two dynamics pressure both ends of the foreign exchange rate equation and are rapidly testing commitments to let the market determine currency rates.

 

BRF Chart

 

While the real gained 1.5% today, breaking a string of three consecutive losses, equity investors pushed the iShares Brazil ETF (EWZ) and the Market Vectors Small-Cap Brazil (BRF) down nearly 4% as I write this. Given the overbought condition of Brazil's Bovespa Stock Index, which is up 79% this year compared to the 21.6% rise in the S&P 500, a violent kneejerk reaction was to be expected. However, over the long-term in a backwards way the new tax could actually encourage investors.

 

If it works, it will protect the real as well as Brazil's incredible economic growth potential. Importantly, the new tax does not affect foreign direct investments, ensuring that those looking to invest for the long haul will still be welcome in this South American gem.

 

Anyone who has followed the development of emerging market economies knows that Brazil was a perennial letdown for years before its recent surge. But years of political scandal and revolution marred Brazil's incipient prosperity. Eventually, Brazil's leaders put in place a series of economic and trade liberalization initiatives that tamed inflation, opened markets, and harnessed the country's potential for the full benefit of its people.

 

Now the country is poised to truly lead as the global economy recovers. Brazil's economy expanded 1.9% in the second quarter, the largest gain in four years. Merrill Lynch economists expect the Brazilian economy to expand another 2.2% in Q3 and 1.8% in Q4. For 2010, they are looking for GDP growth of 5.3% compared to a forecast of 3% growth for the United States.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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