One of the toughest challenges faced by Brazil’s government is the protection of its export industry from the impact of an appreciating currency. High interest rates and a growing economy have fuelled demand for Brazilian securities, helping to push up the value of the real from $0.38 in 2004 to $0.54 in 2011. The appreciation of the currency has made it easier for foreign companies to sell their wares on the Brazilian market and more difficult for Brazilian firms to compete overseas.

“Brazil is very competitive when the exchange rate is between BR2.2-2.4 to the dollar,” says Peter Stossel, an adviser to the Development, Industry and Foreign Trade Ministry. “But now it’s BR1.8 to the dollar, so it takes out some of the competitiveness.”

Helpful measures

The government is doing what it can to manage the appreciation of its currency: in February, the central bank bought US dollars on the forwards market for the first time since July 2011. In an effort to curb the influx of private capital from overseas, the central bank has also reduced interest rates from 12.5 per cent in July 2011 to 9 per cent in April this year, and the government has increased financial transaction taxes on capital flows (known locally as imposto sobre de operacoes financieras, or IOF).

“There’s been a lot of intervention from the central bank to restrain the strength of the currency, but it’s not been very successful”

Elisa Machado, Centro Brasileiro de Infra Estrutura

The impact, however, has been limited. The real closed at 1.83 to the dollar at the end of March, down from BR1.71 to the dollar a month earlier, but it is still far stronger than the 2004-08 average of BR2.25. “There’s been a lot of intervention from the central bank to restrain the strength of the currency, but it’s not been very successful,” says Elisa Machado, an economist at the Centro Brasileiro de Infra Estrutura in Rio de Janeiro.

The increase in the real’s value has had a marked effect on the country’s foreign trade. Having enjoyed a surplus of $10bn-15bn in 2004-06, by the end of 2011 the current account was in deficit by $52.6bn. Brazil still has a trade surplus of $26bn, but this is little more than half its 2006 peak of $46.5bn. Although the total value of its exports increased by 59 per cent between 2007-11, imports increased 88 per cent over the same period and the service sector deficit increased from $13.2bn to $37.9bn.

On the plus side, rapid growth in the inflow of capital has contributed to an increase in Brazil’s foreign exchange earnings, from $111.5bn in 2004 to $296.7bn in 2011. Foreign exchange reserves increased from $52.5bn to $350.4bn over the same period, and are higher than the country’s total external debt, which reached $314.4bn in 2011. The services deficit, meanwhile, is more than covered by foreign direct investment (FDI), which increased to $76bn in 2011 from just $8.3bn in 2004.

But the strength of the real is hitting the Brazilian economy hard. “One of the main reasons that the economy is only growing at 3-3.5 per cent is that industrial growth has been very poor in recent months because it is suffering from competition from imported products,” says Machado.

“The internal market is Brazil’s main driver … It’s a very closed economy”

Elisa Machado, Centro Brasileiro de Infra Estrutura

Aware of the limitations of monetary policy, the government has intervened directly to support local companies suffering from overseas competition. “The government has responded by reducing interest rates, and has also introduced measures to provide support for domestic industries,” says Shelly Shetty, head of Latin America sovereign ratings at Fitch Ratings, dual-headquartered in the UK and US. “It provides relatively cheap funding through the Banco Nacional de Desenvolvimento Economico e Social [which is majority-owned by the government] and has adopted a sector-by-sector approach to targeting those industries most in need of support.”

The government insists that its support for local industry and the recent hikes in foreign currency transaction taxes do not add up to a policy of protectionism. But its decision to make the development of the internal market the focus of its 2011-14 economic programme, known as Brasil Maior (A bigger Brasil), does not speak of an entirely open attitude to overseas trade.

Total trade as a proportion of gross domestic product was just 19 per cent in 2011, down from 24 per cent in 2004. “The internal market is Brazil’s main driver,” says Machado. “It’s a very closed economy.”

Cultivating ties

Despite its internal focus, Brazil has sought to cultivate as wide a network of trading partners as possible. It is a full member of the South American trading bloc, Mercado Comun del Sur (Mercosur), which includes Argentina, Uruguay and Paraguay. Venezuela is awaiting ratification of an agreement to join the bloc, which also has several associate members.

In 2003, Brazil joined with India and South Africa to form the G3, a trading alliance designed to act as a counterweight to the US and Europe, and the government has continued to strengthen trade ties with the two countries. It also signed an agreement with the EU in 2007, which, if approved by all member states, would make Brazil the first South American country to have a strategic partnership with the union.

“Brazil always tries to maintain a good relationship with everybody,” says Paula Diosquez-Rice, senior economist for Latin America at US-based IHS Global Insight. “In the past 10 years, it has tried to sign as many trading agreements as possible. The vision is to maintain a business relationship with anyone that could be beneficial to the country.”

Brazil’s most important trading partners are China and the US. China increased its share of Brazil’s trade to 16 per cent in 2011, from 14.7 per cent the previous year. The US is a close second, with 12.4 per cent of the total, up slightly from 12.1 per cent in 2010. Argentina is third, with 8.2 per cent, down from 8.6 per cent the previous year. Brazil’s largest European partner is Germany, which ranks fourth with 5 per cent of total trade, but if the EU were taken as a whole, its share of Brazil’s trade would be greater than that of either China or the US.

For the time being, there is a reasonable balance between Brazil’s trade with Europe, the US and China, but its relationship with Beijing is likely to become increasingly dominant. Trade between the two countries grew fivefold between 2000-03 to $8bn. By 2011, it had reached $77bn, up from $56bn the previous year. China is the largest exporter of goods to Brazil, and in 2012 it is expected to overtake the US to become the largest importer of Brazilian goods.

“Trade with China is very important,” says Machado. “When people look at Brazil they think about China. If China stays in good shape then Brazil will stay in good shape too.” In broad terms, this is likely to be an equation that works well for Brazil. The downside, though, is that China’s commercial appetite is for basic commodities such as soya beans rather than processed goods. “We are exporting more and more commodities rather than higher-value products,” says Stossel.

Brazil’s trade with the Middle East is modest at best. The largest of Brazil’s trading partners in the region, Saudi Arabia, is its 18th biggest, with just 1.36 per cent of total trade in 2011. But there is potential for growth in the relationship.

“The Middle East is an absolute priority for Brazil, especially the GCC,” says Stossel. “There is a very large complementarity between Brazil and the Arab region. The GCC needs to invest in food security. They have money and we have land, so it could be an extremely good opportunity for a win-win relationship. We also want to export infrastructure services to them.”

According to Stossel, the government hopes to improve the regulatory environment for trade with the region. “We want a bilateral double taxation agreement and an investment promotion and protection agreement, which is being negotiated,” he says.

Agreeing such a deal will not be easy, however. “Brazil is open to such an arrangement, but it depends on the conditions,” says Stossel. “We are signatories to the Organisation for Economic Cooperation and Development, which stipulates that any country with taxes of less than 20 per cent is a tax haven, so that’s a problem.”

Stable environment

Perhaps mindful of Argentina’s hugely controversial expropriation of the 51 per cent share owned by Spain’s Repsol in local energy firm Yacimientos Petroliferos Fiscales on 14 April, Brazil is at pains to show that it appreciates the importance of a stable business environment to foreign investors.

“It’s really important that even if we don’t have an investment promotion and protection agreement or a bilateral tax agreement in place, we still provide legal security for investments and provide good returns for investors,” says Stossel. “Money goes where it’s needed and stays where it’s well-treated. This is why Brazil is benefiting from such strong FDI.”

The actions of the Argentinian government have provoked fears of a new wave of nationalism in the oil and gas sector in South America. These were stoked in March when Brazilian prosecutors levelled criminal charges against 17 executives of US oil major Chevron and US drilling company Transocean for a small oil spill off the southeast coast.

But the kind of behaviour witnessed recently in Argentina would be unthinkable in Brazil. Not only does it have a much more stable business environment than its neighbour, but it is also reliant on international companies for the exploitation of its offshore oil and gas fields.

Since 2006, Brazil has made some of the world’s largest offshore hydrocarbons discoveries in decades, including the Lula field (originally the Tipi field) that is estimated to contain up to 8 billion barrels of oil, and the similarly sized Jupiter field. But they are also among the most difficult resources to access. Brazil’s national oil company Petrobras has proved itself to be among the most competent in the world, but the country will need foreign expertise to help it drill though thousands of metres of rock and salt beneath the Atlantic Ocean.

According to the government, Brazil’s total oil and gas reserves could now amount to as much as 50 billion barrels of oil equivalent. When these resources start to come into production by about 2016, they will transform Brasilia’s trading relationship with the rest of the world for many years to come.