In early June, Brazil’s monetary policy committee (COPOM) raised their target for the Selic interest rate to 12.25%.[1]  Media pundits are predicting a huge flow of hot capital into Brazil in pursuit of the high interest rates – currently the country has the highest interest rates among “major economies.”[2]

We’ve heard this story before.  It happened twice during the last 25 years of the 20^th century in Mexico.  “Earn 21% interest in government-guaranteed savings accounts.”  The problem, of course, is that those savings accounts were denominated in pesos.  Mexico’s inflation quickly led to a devaluation of the peso, leaving those who sent their savings south of the border with a serious learning experience, but considerably poorer.

So, once again, it’s time to remind the world that the interest rate that counts is the real interest rate (corrected for inflation) in your local currency.  People who don’t live in Brazil are automatically exposed to exchange rate risk when they send part of their wealth off to Rio.

Let’s look at some data.  As of July 1, 2011, the yield on ten-year Brazil government bonds was 12.39%.[3]  For the U.S. the corresponding yield was 3.18%.  With Brazilian inflation around 6%, the apparent long-term real interest rate in Brazil was 6.39%.  For the U.S. the ten-year real interest rate was 0.69%, implying U.S. expected inflation of 2.49%.[4]

The yield on U.S. five-year notes on the same date was 1.78%.  For Brazil, the yield was 12.56%.  U.S. expected inflation over the next five years is 2.15%.[5]

The principle of uncovered interest parity says the interest rate in one country – say the U.S. – should equal the interest rate in any other country (Brazil) plus the expected depreciation of the U.S. dollar vis-à-vis the Brazilian real.  Using the ten-year bond data above, the implied depreciation of the dollar vis-à-vis the real is
3.18% – 12.39% = -9.21%.  In other words, the dollar is expected to appreciate 9.21% per year vis-à-vis the real over the next ten years.  Over the next five years the rate of appreciation is even higher,
12.56% – 1.78% = 10.78% per year.

Uncovered interest parity has another interesting implication. In the long run the real rate of return on bonds should be about equal in all countries.  This leads to the international version of the Fisher equation which says that the difference between nominal interests between two countries should equal the difference between their inflation rates.  Thus, over the next ten years the market is forecasting Brazil’s inflation will be about 9.21 percentage points higher than U.S. inflation.  With expected U.S. inflation of 2.49%, the implied ten-year inflation rate for Brazil is 11.70% per year.  Over five years the inflation differential is 10.78% per year, implying 12.93% inflation in Brazil.

The implications are straightforward.  The high yields on Brazilian bonds and deposit accounts reflect fear of future inflation.  Those who send their hard-earned dollars to Brazilian banks are betting that COPOM will keep inflation below what the market expects.  Those folks might be right or they might be wrong.  But they should know the gamble.

Brazil Annual Inflation

(Source: OECD)

Brazil Monthly Inflation

(Source: OECD data)