Brazilian Banks Must Purchase Some US$30 Billion in Foreign Currency by Year-end

RIO DE JANEIRO, BRAZIL – Brazilian banks with investments abroad are experiencing a race for dollars this year. Institutions with branches abroad will spend some US$30 billion to settle exchange protection contracts by 2022.

This event should impact the dollar’s rate. With the Brazilian real devalued, the Central Bank has prepared measures to mitigate the impact of the increase in demand for the currency.

Exchange protection contracts are called hedges. They work as a kind of insurance to protect investors from losses with exchange rate fluctuation. These contracts are taxed in Brazil at 48%.

The avalanche of funds needed by banks is owed to the change in tax rules enforced this year. Prior to the Covid-19 pandemic, all Brazilian investments abroad with exchange protection were tax-exempt in the country, unlike hedge contracts.

To cover the payment of hedge contract taxes in Brazil, banks resorted to over-hedging. With the change in the law, this measure will be fought, otherwise the institution may be fined.

Over-hedging occurs when banks contract almost double the value of their vestments abroad to fully protect them from exchange fluctuations.

To offset this tax cost, Brazilian financial institutions eventually entered into hedge contracts in much higher values, 192% on average, over the investment value. To illustrate, a foreign bank subsidiary with capital of US$500 million, for instance, used to protect itself with another US$960 million in hedges so that this position would be effectively protected.

It is this “fat”, the over-hedge, that banks are being forced to end. To this end, they will have to terminate their hedge contracts and this operation implies the bulk purchase of dollars. As increased demand for foreign currency pushes the rate even higher, the Central Bank decided that it would be better to divide this operation into two stages.

The first, of US$ 15 billion (R$78 billion), must be completed by the end of this year. The latter should be completed by the end of 2021. By January 2022 banks will have zeroed their over-hedge positions.

In practice, banks have already begun to demobilize their positions in these contracts to meet the first stage deadline.

The government issued these rules through a Provisional Measure in mid-March under a Central Bank alert that the crisis caused by the pandemic in the world would create additional pressure on the Brazilian real, which has been depreciating against the dollar, hurting the economy – primarily importers (who now buy more expensive supplies in Brazilian currency).

The monetary authority was also concerned that the trend could reduce banks’ operations, particularly in terms of credit supply.

In mid-March, when President Bolsonaro sent the Provisional Measure to Congress, the dollar exchange rate stood at R$4.30. Less than two months later, it rose to R$5.90. On Wednesday, December 23rd, it closed at R$5.20.

This rise caused the depreciation (in reais) of investments by major banks such as Itaú, Bradesco, Banco do Brasil, Santander, in their foreign subsidiaries.

From the financial standpoint, this depreciation was offset by hedge contracts (protection), mostly in Brazil. The adjustments are made at the B3 (São Paulo Stock Exchange).

However, from the accounting standpoint, the depreciation of dollar investments in itself must be recorded in the banks’ balance as a tax loss.

According to Central Bank rules, tax losses lower the level of the minimum shareholder equity required from institutions in order to operate. The level of equity capital is the main factor considered by the monetary authority in determining how much a bank can offer in loans to clients.

If a bank suffers a reduction in equity capital, clients will have less credit supply and this, for the Central Bank, would be worrying at a time when Brazilians need financing sources to overcome the challenges caused by the pandemic.

Sanctioned in July, the Provisional Measure converted into law authorized the Federal Government to tax protected investments abroad. The new rule does not put an end to hedges, considered a crucial instrument for anyone doing business abroad, such as banks, exporters, and multinationals, but it makes them more expensive.

The rules came in reaction to a bullish dollar trend at the start of the crisis, when banks began to reduce investments abroad (reduction in capital). The exchange pressure caused by this trend was not neglected by the government or the economic team.

According to Central Bank data, in March banks had US$53 billion in over-hedge alone. By late June, this figure stood at US$37.7 billion. Today it is estimated at US$30 billion.

In November, the Central Bank’s Economic Policy Director Fabio Kanczuk, in a live stream signaled a potential intervention in the exchange rate should the race for dollars at the end of this year push the greenback up against the real.

“The market needs to be dense, thick enough to withstand a very large flow to occur at the end of the year, and the Central Bank is considering alternatives on how to prevent this flow from being disruptive,” Kanczuk said. “We doubt whether the market is dense enough for this and we think that we will need to help in order to prevent this from impacting the whole of Brazil.”

Kanczuk’s comment lowered the dollar and the Central Bank disclosed a statement to the press saying that “it does not anticipate eventual decisions on intervention, rejecting any interpretations in this direction.

The Central Bank said it is continuously monitoring the exchange market and its “activities are only intended to preserve its normal operation.”

The FEBRABAN (Brazilian Federation of Banks) advisory office said that the sector considers the law positive because it “gradually removes an asymmetry in the handling of investments abroad that, in certain situations, can have an adverse effect on banks’ regulatory capital.”