To the
Rescue

By raising the rate it charges for lending, the Brazilian central bank hopes to make the real more valuable. Unfortunately, this only amounts to closing the barn door after the horses have escaped.

Mike Sproul

Brazil's recent devaluation of its currency exposes a common weakness shared by all modern central banks: While they carefully monitor interest rates and the money supply, they pay little attention to their own assets. Thus the Brazilian central bank, which holds a great deal of its assets in the form of Brazilian government bonds, was badly hurt when those bonds dropped in value. As a result, the bank had fewer resources backing its money, and so the value of the real fell. To make matters worse, the bank chose to support its currency by buying reals on the open market for more than they were worth. This means the bank threw away even more of its assets—inadvertently causing the real to fall still further.

An example will help to illustrate the bank's problem: Suppose the Brazilian central bank has just commenced business. On the day it opens, people deposit 100 U.S. dollars in the bank. The bank gives out paper receipts for the dollars deposited. The bank then promises that each receipt will be redeemable at the bank for one U.S. dollar. Assuming that the bank is trusted, people will begin to use its receipts as a local paper money, equivalent in most respects to genuine U.S. dollars. This, in essence, is how paper money first comes into being. As long as the paper money is redeemable for dollars, people will value the money just as they value dollars. When the bank closes for the weekend and the paper money becomes temporarily irredeemable, people will still value it as long as they know the bank still has its assets. Even when the paper money becomes irredeemable for months or years at a time, people will still value it according to the value of the assets held in the bank.

Once the central bank has established a paper money, it typically begins to acquire government bonds as its chief asset. The Brazilian central bank, for example, uses newly-printed paper reals to buy Brazilian government bonds. In principle there is nothing wrong with this. If the bank prints 100 new reals, and uses them to buy bonds worth $100, then the bank still has one dollar's worth of backing for every real issued, and the value of the real will be stable. But here is the problem: Brazil's treasury has become so stretched that not even an IMF bailout can save it, so Brazilian government bonds drop in value. But those bonds are the backing for the real. When the bonds drop in value, the real must drop too. The central bank has committed the age-old financial error of putting too many eggs in one basket: It owns too many Brazilian government bonds, so when those bonds lose value, the real is pulled down with them.

The Brazilian central bank has tried to stop the fall of the real with two tools—both of them counterproductive. First, it tried to support the real in international markets by using its dollar reserves to buy reals at an artificially high rate. Let's say the fair market value of the real is just $.90. If the bank starts buying those reals at artificially high prices—say if it pays $1 for each real that it buys, then the bank will lose 10 cents on each purchase. The bank's assets will fall, and the real will drop still more.

The second tool the bank has used is interest rates. By raising the rate the bank charges for lending, they hope to make the real more valuable. Unfortunately, this only amounts to closing the barn door after the horses have escaped. The real fell in the first place because the bank's portfolio of Brazilian government bonds fell in value. That lost wealth is gone forever, and the bank cannot recover it by charging more for future loans. In fact, if the bank sets its interest rate above the market rate, then borrowers will either borrow somewhere else or they will choose not to borrow—leaving the central bank with fewer customers, and leaving Brazilians facing a credit crunch as the bank tightens the supply of reals.

So what should the central bank do? There are three things: (1) Don't try to support the real, since this will drive it down even more. (2) Diversify the central bank's assets into other securities besides Brazilian government bonds. (3) Don't raise interest rates above market levels. This strategy will not reverse the loss already suffered by the real, and it certainly will not end the Brazilian budget deficit that started the whole problem, but it will at least prevent future budget crises from becoming currency crises as well.

Mike Sproul ( msproul@econ.ucla.edu ) teaches economics at UCLA. Further reading can be found at http://www.csun.edu/~hceco008/real97.doc

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