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Empirical Evidence of Multiple Equilibria in International Finance

Brad Setser is amazed by the Brazilians he sees:

RGE - Two things I never expected to see: 1. The spread (over Treasuries) on Brazil’s dollar bonds is now 120 bp. I remember when... 2. Brazil added close to $25b to its reserves in a single quarter ($23.7b if you want to be precise). Reserves rose from a tad over $85b to just under $110b. Back during Brazil's most recent crisis, it often had -- after netting out IMF borrowing -- less than $20b in the bank. At the end of 2004, a little more than than two years ago, Brazil only had $27.5b or so net of its IMF loan.

The IMF’s total commitment to Brazil back in 2002 chalked in at a bit over $30b. It was considered huge at the time. And it wasn’t all disbursed in a quarter either. The biggest quarterly disbursement was “only” $6.3b. Yet without the IMF loan, Brazil would have almost certainly defaulted on its external debt. The big “China” surge in commodity prices wouldn’t have come along quickly enough to save Brazil from default.

A country that needed a huge credit line from the IMF to avoid default five years ago now borrows in US dollars for only a bit more than the US Treasury. Talk about multiple equilibria....

Brazil used to have far more dollar debt than dollar reserves, and, to top it off, Brazil’s central bank sold a lot of insurance against further falls in the real when the real was under pressure. The government was effectively short dollars and long real -- its balance sheet deteriorated when the real fell. Now Brazil's government is long dollars. It borrows from the world in real to buy dollar reserves...

The carry trade, you know. It hasn’t gone away. Who doesn’t want to borrow yen to buy real?... There is nothing like getting a 12% or so spread (see Truman's slide 15) lending to a country that doesn’t need the money. Brazil, remember, runs a current account surplus. It doesn’t need to borrow Japan’s savings...

I would say that this scares me. Brazil's central bank doesn't need to borrow Japan's savings, and it really doesn't need to borrow Japan's savings to invest them in dollar-denominated U.S.-located debt. The longer the Brazilian government tries to keep the real from appreciating, et cetera. I don't see how the world's central banks being so far long dollar-denominated debt can end without tears.