competition and change, Vol. 14 No.

34, December, 2010, 296323

Published by Maney Publishing (c) The University of Hertfordshire Business School and W. S. Maney & Son Limited.

International Financialization and Depreciation: The Brazilian Real in the International Financial Crisis
Annina Kaltenbrunner
School of Oriental and African Studies, University of London, UK

Despite sound macroeconomic fundamentals, the Brazilian currency, the real, experienced one of the worlds largest exchange rate depreciations during the recent international financial crisis. This depreciation resulted from Brazils rising international financialization, i.e. the increased participation of foreign investors in short-term domestic Brazilian assets. One important manifestation of this process, in particular, was the increased internationalization of the Brazilian real, which has become one of the most widely traded emerging-market currencies. However, the rising influence of international investors on Brazils domestic currency weakened its exchange rate management during the international financial crisis as rapid international portfolio adjustment led to the reals sharp depreciation. Such exchange rate volatility has important implications for macroeconomic policy, especially exchange rate management, since, in the presence of increased international financialization, the standard prudent macroeconomic management that has been advocated by mainstream economics will prove inadequate and might even undermine efforts to maintain financial stability.
keywords Financialization, Internationalization, Emerging markets, Exchange rates, Financial crisis

Introduction
Despite solid macroeconomic fundamentals and a sound banking system, the Brazilian real was one of the currencies that depreciated most during the international financial crisis. This paper argues that this large depreciation was the result primarily of the rising international financialization of the Brazilian economy, which it defines as the increased participation of foreign investors in short-term domestic Brazilian assets. The depreciation highlights, in particular, one important manifestation of this process: the internationalization of the Brazilian real, i.e. the increased
W. S. Maney & Son Ltd 2010
DOI 10.1179/102452910X12837703615454

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use of the Brazilian currency as an international portfolio asset. This paper argues that, as a result of the increased liquidity provided by the Brazilian economy, the Brazilian currency has become an internationally traded asset and a standard component of the portfolios of international investors. This trend has contributed substantially to the exchange rate volatility experienced by Brazil during the recent crisis. This paper maintains that one important manifestation of financialization is the increased importance of trading as an income-generating and risk-diversification device. The importance of trading, however, makes the liquidity of financial markets and assets a prime concern for investors. Through its specific financial market structure, macroeconomic institutional framework and the very short-term nature of its assets, Brazil has provided such liquidity to international investors. As a result, Brazilian assets have become an integral component of the international trading arena. In contrast to previous experiences with short-term capital flows, which were primarily thought of as investment in emerging countries and were thus driven by considerations about domestic economic conditions, the increased liquidity of Brazils economy has turned its assets into international trading instruments, making portfolio decisions on such assets increasingly independent of domestic economic conditions. This international financialization of Brazilian assets started in 2003 and was substantially exacerbated during the first stage of the international financial crisis between the beginning of 2007 and August 2008, as heightened uncertainty in international financial markets intensified the demand for highly liquid assets. Brazils rising international financialization is also reflected in the increased foreign participation in asset classes for which capital gains are an important part of returns, such as equity and currency trading. The ability to generate returns on capital gains is part and parcel of trading operations. Additionally, the scale of trading in itself in certain assets can create capital gains, further enhancing the attractiveness of these asset classes. In addition to their focus on trading in short-term assets, international investors have also sought increasing exposure to domestic-currency denominated assets. On the one hand, this change has made exchange rate movements an important part of investors concerns for returns. On the other hand, it has made the international tradability of the Brazilian real a pre-condition for continued international financialization, as a basis to hedge currency exposure and/or meet outstanding external obligations. Beyond this factor and as a result of the liquidity of currency trading per se, the Brazilian real has become an international portfolio asset itself. This important manifestation of Brazils international financialization has allowed the potential for huge speculative gains for both domestic and international investors, together with the option of providing them immediate exit from Brazilian assets. The growing internationalization of the Brazilian real, however, had important implications for the countrys exchange rate dynamics as the international financial crisis impacted Brazil in August/September 2008. The large and primarily short-term positions held by foreign investors in Brazils domestic currency and the liquidity with which it was traded led to one of the largest exchange rate depreciations in the world. This precipitous drop in value was independent of domestic economic fundamentals

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and primarily the result of international portfolio adjustment. This depreciation has had, in turn, important repercussions for Brazils macroeconomic policy, especially its exchange rate management, as international reserve management and macroeconomic prudency advocated by mainstream theory have become powerless to contain exchange rate volatility in the face of an increasingly financialized and internationalized domestic financial system. Thus, more radical policy measures including the reversal of Brazils trend towards internationalization might be necessary to regain macroeconomic autonomy. Following this introduction, this paper is divided into four sections. The first section highlights the increased role of trading operations and the demand for liquidity as crucial aspects of financialization. The second section discusses the structural characteristics of Brazils financial and economic system, which provided liquidity to international investors and reinforced Brazils rising integration with international financial markets. The third section presents quantitative and qualitative evidence on a key manifestation of Brazils increased international financialization: the internationalization of the Brazilian real.1 The fourth section discusses the implications that this internationalization of the real has had for Brazils exchange rate dynamics during the international financial crisis. The fifth section concludes with a discussion of the implications for macroeconomic policy, especially exchange rate management.

Financialization and liquidity

In recent decades there has been a substantial increase in the role of financial factors in the world economy. This process, often coined financialization, has implied major structural changes in both the real sector and the financial sector.2 In the financial sector, the increased reliance of companies on open markets and the resulting shifting of banks towards generating profit through intermediating and investing in financial assets, rather than lending, have considerably strengthened the role of market forces in the process of financial intermediation. This development has made the marketability, or tradability, of financial assets a prime concern for banks. Risk management through close relationships between debtors and creditors has been replaced by an approach that breaks down complex risks into elements to which theoretical probability distributions could be assigned. These components could then be repackaged into a one-dimensional structure of spreads above conventional benchmark prices and traded according to the risk preferences of financial investors (Aglietta & Bretton, 2001). The ability to evaluate, homogenize and trade risk has become imperative in order to manage risk in a financial system increasingly dominated by market forces. As a result, the trading of bonds and equities as well as the marketing of hitherto illiquid instruments have become the central functions of the financial sector. Securitization, the transformation of various types of financial assets and debts into marketable instruments, has allowed banks to expand their balance sheets because their exposure to previously illiquid assets could be traded and their risk diversified. For this purpose, the development of derivative markets was essential. By breaking down risks into their generic components, derivatives enable investors to decide which type

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of risk they wish to assume and to what degree (ibid., p. 439). In addition, by allowing investors to hedge their exposure, derivatives have enabled them to expand their balance sheets and increase their trading operations. The rising importance of trading activities is also reflected in the changing nature of the institutions operating in financial markets. In addition to the growing importance of the traditional more trade-oriented institutions, such as investments bank or hedge funds, commercial banks themselves have undergone major structural changes. As pointed out by Ertrk and Solari (2007) and Lapavitsas (2009), commercial banks have increasingly begun to resemble investment banks, generating revenue through proprietary trading, fees and commission, rather than through lending to businesses and profiting from the resultant interest-rate margin. Thus, this paper argues that the increasing importance of trading, as a riskmanagement and income-generating mechanism, is a seminal manifestation of financialization. In doing so, the paper takes a position that is closest to Hardies (2007) work, which defines financialization as the ability to trade risk. This ability is determined, in turn, by the ability of the actors involved to trade risk and the degree of financialization of the market structure itself (i.e. the constraints on the trading of risk in a particular market). However, Hardie does not define theoretically what determines this ability to trade risk, but merely lists possible empirical aspects. In contrast, this paper maintains that, if the ability to trade becomes a defining characteristic of financialization, two determinants of asset demand (in the spirit of Keynes, 1997) become important: the ability to generate capital gains and the degree of liquidity. This paper defines liquidity in Minskyan terms, as the ability to meet outstanding contractual obligations (Minsky, 1975). In the domestic context, this ability implies converting an investment, anytime and without loss of value, into money, the unit of account and denominator of debt contracts. In the international context, liquidity becomes the ability to convert domestic assets into the currency with which positions in these assets have been funded (primarily US dollars under the current financial system) and the transfer of this foreign currency abroad to meet outstanding external obligations. The emphasis on liquidity as the determining factor of asset demand directed towards short-term trading operations and the focus on the liability side in the definition of liquidity not only help to analyse the increased internationalization of the Brazilian currency but also highlight the important role that this internationalization has had for exchange rate dynamics. First, increased exposure of foreign investors to domestic assets funded in international financial markets has tightened the link between international market conditions and movements in domestic asset prices. Any change in international funding conditions or increased demand for the US dollar can lead to an immediate sell-off of domestic assets that is entirely unrelated to domestic conditions. This tendency is exacerbated in a financialized system, where operations are directed primarily towards short-term trading. Second, foreign investment in domestic-currency assets implies an inherent currency mismatch for international investors. As a result, any need to adjust their international portfolios will not only affect domestic asset prices, but will also have an immediate effect on the value of the currency. The focus on the liability side in the description of liquidity also helps explain the definition of an internationalized currency adopted in this paper. This definition

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contrasts with that of McCauley (2006), who stresses a currencys function as an international store of value and a medium of exchange. Thus, he also considers the increased denomination of national bonds in domestic currency as currency internationalization. This paper regards the currency (as international money) as an asset class per se. Even assets denominated in domestic currency have to be initially converted into domestic money, which can then be exchanged for foreign money, in order to meet outstanding external obligations. This condition makes a currency the most liquid domestic asset class per se and thus a prime target for short-term trading operations. Furthermore, for McCauley, the mere increase in the number of non-resident holders of domestic bonds is not a sufficient condition for an internationalized currency; the non-residents also have to become issuers of domestic-currency bonds. In contrast, this paper considers a rising share of domestic currency held by international investors to be a sufficient and defining dimension of internationalization, due to the decisive implications that the resulting funding structure has for exchange rate dynamics. It is also important to distinguish an internationalized currency from a merely liberalized foreign exchange market. While the convertibility offered by such a market is a precondition for an internationalized currency, the latter refers to the widespread and permanent use of domestic currency by international investors for hedging purposes and, especially, speculative purposes. In this vein, while speculative attacks on fixed exchange rate regimes have been an episodic feature of foreign exchange markets, the advent of floating exchange regime regimes in emerging markets combined with ongoing financial liberalization has rendered currency trading and currency speculation a permanent feature of these markets. The increasing importance of trading as a result of the proliferation of increasingly market-driven systems and the importance of liquidity for trading risk are factors that are also highlighted by Aglietta and Breton (2001). Writing on the stock market, the authors argue that, in addition to evaluating risk, financial systems are expected to provide liquidity to economic agents in a market process which can be qualified as speculative and is significantly affected by operators concerns for market liquidity, rather than being the straightforward outcome of the evaluation of the characteristics of the companies in question (p. 438). Indeed, both Hardies definition of financialization as the ability to trade risk as well as Aglietta and Bretons emphasis on risk and liquidity highlight the dual demand on the financial sector to have: (a) the ability to evaluate risk and (b) the ability to trade it, i.e. provide liquidity. In the spirit of Keynes liquidity preference theory, these two demands are not independent from each other, however. For Keynes, agents ability to evaluate risk is limited by fundamental uncertainty (Davidson, 2002). The higher this uncertainty (or the lower the ability to evaluate risk), the more important becomes liquidity (the ability to trade risk). Or, put differently, the more liquid a market, the lower the demand on its ability and/or willingness to assess risk. The increased demand for liquidity in the face of rising uncertainty became particularly evident in the first stage of the international financial crisis. The growing unpredictability of future movements in asset prices increased the attractiveness of

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assets that could be sold any time and at low cost such as the Brazilian real. At the same time, however, the rising liquidity of financial markets had lowered the necessity of risk assessment for financial institutions. However, while greater liquidity i.e. the ability to quickly divest oneself from a risky asset can reduce risk for the individual investor, it cannot have this effect at the macro-level. This became obvious with the failure of Lehman Brothers, which led to a near implosion of the international financial system. The concrete manifestation of liquidity is a multidimensional reality, which is defined by the particular institutional setting. Indeed, recent institutional changes in international financial markets have been aimed primarily at creating greater liquidity for the financial community. Financial liberalization has reduced transaction costs, both through lowered regulation and increased competition. At the same time, financial globalization has substantially increased the number of participants in international financial markets, multiplying the number of possible buyers and sellers and increasing the frequency of quotations. In addition, technical innovations have allowed ever faster and more friction-free transactions between a myriad of geographically separated agents. Finally, financial globalization has led to an everincreasing standardization of financial products and techniques, which has reduced the uncertainty and the costs of private evaluation of risks and increased the access to trading well beyond the individual financial specialist (Orleans, 1999). Table 1 shows two measures of the increased importance of trading and the rising liquidity of international financial markets. One can observe a continuous increase in both market size (e.g. issues outstanding or notional value outstanding) and average daily trading volume (ADTV). Trading volume in stock and derivative markets experienced a substantial surge, in particular, in 2006 and 2007. For example, notional value outstanding on over-the-counter (OTC) derivatives markets surged from just above US$400 trillion in 2006 to nearly US$600 trillion in 2007. In sum, this section has set out one key characteristic of financialization, i.e. the rising importance of short-term trading operations, and it has argued that an assets liquidity is a crucial determinant of its integration into such financialized markets. The next section will show how this liquidity has been provided by the Brazilian economy, laying the basis for its increased international financialization.

Brazils increased liquidity

International trading has gained not only in depth in developed financial markets, but also in breadth as the search for highly liquid assets has extended into the emerging and developing world. This move was driven primarily by developments in international financial markets. Increased competition and abundant liquidity have pushed financial institutions into new areas of investment, while the growing co-movement of financial assets in developed financial markets has increased the attractiveness of emerging-market assets for international portfolio diversification. However, although a global phenomenon, the extent of a countrys integration into these increasingly financialized international markets has been determined fundamentally by its ability and willingness to supply liquid assets to the international investor community. Though a relative late-comer in South America, Brazils

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TABLE 1

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MARKET SIZE AND TRADING VOLUME IN MAIN FINANCIAL MARKETS, US$ BILLION 2000 Bond Markets Issues Outstanding ADTV Stock Markets Market Capitalization ADTV Foreign Exchange Markets Notional Value Outstanding ADTV Derivatives Markets NA NA 1,173 20,435 NA NA NA NA 1,773 31,500 NA NA NA NA 57,597 3,081 NA NA 31,060 199 26,905 152 22,810 132 31,326 133 37,168 169 41,411 204 50,635 280 60,855 32,551 452 454 17,203 358 18,790 509 20,518 630 22,409 752 24,572 819 27,124 919 30,046 893 32,366 33,735 1,015 1,034 2001 2002 2003 2004 2005 2006 2007 2008

Notional Value Outstanding

Exchanges OTC 14,246 23,748 23,826 36,693 46,511 57,242 69,380 79,067 57,715 95,199 111,178 197,167 258,628 258,628 299,261 418,131 595,738 547,371

ADTV
Exchanges OTC 358 NA 653 NA 680 NA 829 NA 1,114 NA 1,370 NA 1,721 NA 2,151 NA 1,515 NA

Source: Bank for International Settlements (BIS); World Federation of Exchanges (WFE); Securities Industry and Financial Markets Association (SIFMA). Notes: Data include all countries for which nancial transactions are reported; bond market data are only for the US; foreign exchange market data are from the BIS triennial survey of foreign exchange market activity.

intensified financial opening and liberalization in the 1990s reduced transaction costs, improved the availability of information and increased the investor base by reducing restrictions on access to its financial markets. The Lula administration reinforced this process in the 2000s, easing restrictions on foreign investors access to local markets and removing any limits on the amount of domestic currency that physical and juridical entities could convert into US dollars. Brazils financial opening was complemented by a highly financialized domestic financial system that provided liquidity to international investors through allowing local institutions to act as counterparties, offering new financial products and lowering the interest-rate spread through heightened competition. As can be seen in Figure 1, total financial-sector assets reached more than 80 per cent of GDP in 2000. After remaining relatively stable at the beginning of the decade, Brazils total financial assets started to expand dramatically at the beginning of 2005 and accelerated further at the end of 2006. Due to accelerated liberalization measures, non-bank financial assets also began to grow in the latter period. These trends coincided with Brazils increasing integration with international financial markets and the surge of shortterm capital inflows. A large share of these financial assets, however, was dedicated to short-term trading operations rather than credit to the private sector (Goldfajn et al., 2003; Hardie, 2007). The developed financial infrastructure and skills established during the times

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figure 1 Size of financial sector (% of GDP). Source: International Monetary Fund (IMF), International Financial Statistics (IFS).

of high inflation supported Brazilian banks ability to engage in sophisticated trading operations and be active players in the financial market. In addition, the rising participation of non-bank financial institutions, such as hedge and pension funds, as well as non-financial institutions, such as companies, contributed significantly to the liquidity of Brazils financial market. Brazils mutual fund industry alone constituted more than 50 per cent of the BRICS total mutual fund assets in 2007 (Varga & Wengert, 2009). Brazilian pension fund assets reached US$288 billion in 2008, much larger by far than those in other emerging economies, and even some major developed countries such as France and Germany (IFSL, 2010). More recently, large Brazilian companies (mainly exporters) have become very active in trading operations in financial markets in order to hedge their export receipts, but also to speculate on future exchange rate changes. As a result, their positions in the foreign exchange market especially on the derivatives exchange have become an important counterpart to the positions of international investors.3 However, the most peculiar characteristic of Brazils financial market, which provided liquidity to international investors, is the existence of a very deep and actively traded derivative market. The BM&FBovespa (the Brazilian Securities, Commodities and Futures Exchange) is the second-largest listed exchange in the Americas and the fourth-largest in the world (BEST, 2009). In 2007, the volume of derivatives that it traded reached 750 billion contracts, the seventh largest volume in the world (see Table 2).

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TABLE 2 RELATIVE SIZE OF DERIVATIVES MARKET 2007 Volume traded (Nber of contracts) 3,277,239,904 2,867,277,263 2,164,766,857 1,167,323,875 1,049,729,652 1,007,661,590 681,937,317 NA NA 624,606,277 31,839,502 170,829,703 70,878,174 50,245,489 166,386,668 30,145,034 692,064,978 NA NA 1,224,687,735 1,122,063,519 Notional value (USD millions) 2008 2007 2008 2007 2008 Open interest (Nber of contracts) 67,711,205 3,390,829 105,980,701 277,416,624 72,076,623 NA 18,666,537 41,371,648 3,262,892 56,249,131 246,184,086 66,251,520 NA 16,387,685

Exchange

Chicago Mercantile Exchange (CME) Group

3,150,460,638

Korea Exchange

2,777,416,445

Eurex

1,899,778,357

Chicago Board Options Exchange (CBOE)

921,046,369

NYSE Liffe (European Markets)

949,025,452

International Securities Exchange (ISE)

804,359,093

BMF&Bovespa

746,261,356

Single Stock Options 166,983,583 87,627,320

367,305,446

350,063,630

1,056,343 9,982,519 4,289,040

855,130 7,886,598 4,322,398

2,705,526 7,903,570 977,281

2,853,694 5,332,632 1,021,356

Short Term Interest Rate Futures

221,627,417

Currency Futures

88,237,446

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Source: WFE.

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Trading was particularly active for single stock options, and short-term interest rate and currency futures. For the latter two, the size of trading volume in the derivative market has assumed such magnitude that it has replaced the underlying cash market as the main market for trading and price formation. This migration from the spot to the derivatives market has been supported partly by regulation, which has continued to restrict access to the spot market to a few assigned dealer banks. The ability to trade on a large, organized derivatives exchange has contributed to the liquidity of the Brazilian market and its attractiveness to foreign investors. The large number of institutions operating on the exchange and the low transaction costs involved have given foreign investors the capability of trading domestic assets with hardly any costs involved and with the attractive option of immediate exit. The standardization of contracts and uniform contract sizes traded on the exchange have further contributed to this liquidity, as little informational effort is required to identify the main characteristics of the asset traded. This is especially important with respect to credit risk: the BM&FBovespa assumes the credit risk for all trades executed on the exchange, making such trading close to risk-free for the individual trader. In addition, derivative operations allow much higher leverage since the only cash transactions involved are the deposits of margins at the exchange. The ability to operate on leverage significantly expands the ability of market participants to trade risk and expand their balance sheets. This aspect is especially attractive to foreign investors, who, being subject to less stringent regulations on balance sheet exposure in their own country of origin, choose their country allocation of resources according to their ability to assume leverage. However, the important role of Brazils highly liquid derivatives market for the internationalization of its currency goes beyond operations on the futures market itself. The possibility to hedge any foreign exchange exposure immediately and at no cost on the local exchange, especially during times of crisis, has contributed significantly to foreign investors demand for domestic-currency denominated assets. In addition, the liquid local derivatives exchange has contributed crucially to the increased trading of Brazilian real on offshore OTC markets. The cost and complexity of depositing margins at the exchange and/or the remaining convertibility risk might deter international investors from operating on the local exchange. The existence of a deep derivatives market made it possible, however, for (international) banks that have an account with the local exchange to sell domestic currency offshore and hedge their exposure to local risk. In addition to the liquidity provided by the specific structure of Brazils financial system, the institutional framework of its inflation targeting regime, with a floating exchange rate, has contributed significantly to the internationalization of the real. By making inflation the primary goal of monetary policy, an inflation targeting regime assures financial markets that any inflationary risk to the real returns on their asset holdings will be minimized. In addition, it offers a predictable and standardized macroeconomic framework, homogenizing the criteria according to which the properties of domestic currencies can be assessed across the globe. The floating exchange rate, in turn, has made exchange rate movements an important part of returns. Brazil introduced an inflation targeting regime on 1 July 1999. As can be seen in Table 3, the Brazilian central bank has repeatedly demonstrated its commitment to

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TABLE 3 BRAZILS MACROECONOMIC INDICATORS, 19992009 2001 2002 2003 2004 2005 2006 2007 2008 2009

1999

2000

Inflation Indicators 7.7 4.0 8.5 NO NO NO YES YES 5.1 YES YES YES YES 3.5 4.0 5.5 4.5 4.5 12.5 9.3 7.6 5.7 3.1 4.5 4.5 5.9 4.5 4.3 4.5

Effective Inflation Rate

8.9

6.0

Inflation Target

8.0

6.0

Revised target

Target met (within band of 2%)?

YES

YES

Fiscal Indicators (%GDP) 3.4 4.8 42.3 9.9 16.1 11.5 8.1 44.6 43.5 42.5 9.6 3.8 2.6 3.2 3.3 3.8 3.9 3.2 44.9 3.3 3.2 3.5 48.0 1.1 5.1% 1.8% 52,935 1.1 5.7 5.1% 1.6% 53,799 3.2 4.3% 1.3% 85,839 4.0 3.4 2.6 52.5 7.4 2.9% 0.1% 180,334 6.1 3.5 2.0 49.3 10.9 1.5% 1.7% 0.8% 49,296 206,806 5.1 2.1 3.2 52.0 9.2 1.6% 1.5% 239,054 0.2 2.7

Primary fiscal balance

3.2

3.5

Nominal fiscal balance

10.0

4.5

Net domestic public debt

35.2

36.5

Net foreign public debt

9.4

9.0

External Indicators 0.5% 4.2% 35,866 1.3 37,823 1.5% 2.6% 4.5%

Trade Balance % GDP

0.2%

0.1%

Current Account Balance % GDP

4.3%

3.8%

Foreign Exchange Reserves (US$ mn)

36,342

33,011

GDP Growth

0.3

4.3

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Source: Institute for Applied Economic Research (IPEA), Central Bank of Brazil (BCB), Barbosa-Filho (2008).

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this goal of macroeconomic stability in its attempt to build credibility in international financial markets. Actual inflation has surpassed its target range only three times in the last ten years (20012003) and fiscal indicators have generally improved. This macroeconomic stability contributed significantly to the attractiveness of Brazilian assets for international investors and thus the large portfolio adjustment and ensuing exchange rate depreciation in the crisis. The control of inflation has been achieved at the cost of maintaining one of the highest real interest rates in the world. In addition, due to a lack of other monetary policy instruments, the inflation target regime has created a bias towards an appreciated exchange rate (Barbosa-Filho, 2008; Bogdanski et al., 2000). Figure 2 shows the trajectory of the Selic, Brazils policy interest rate, the equivalent of the US Fed Fund rate, and the nominal exchange rate of the Brazilian real against the US dollar. Although declining, the interest rate differential between Brazils Selic rate and the US Fed Fund rate remained consistently above 10 per cent between 2000 and 2008. In addition, the exchange rate appreciated from nearly 4.0 real to the US dollar in 2002 to close to 1.5 in August 2008. Against the backdrop of low and stable inflation and the ample liquidity provided by Brazils financial market, the combination of a high real interest rate and a strong trend towards exchange rate appreciation offered phenomenal US dollar returns to international investors, making the real one of the most widely traded carry-trade currencies in recent years. Last, but not least, the operations of the Brazilian central bank (BCB) as the keeper of foreign exchange reserves and thus the ultimate provider of international liquidity have contributed significantly to the liquidity provided by the Brazilian market. In order to avoid an excessively rapid appreciation of the real, the BCB

figure 2 Brazilian and US interest rates and exchange rates. Source: Institute for Applied Economic Research (IPEA).

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bought more than US$150 billion from the private sector between the beginning of 2006 and August 2008, leading to a stock of foreign exchange reserves of more than US$200 billion (refer back to Table 3). This large stock of foreign exchange reserves increased Brazils protection against speculative attack on its currency by ensuring investors that sufficient liquidity in foreign currency was available to counteract such a threat. More importantly, however, the perception that the BCB could convert a large amount of domestic currency into foreign currency and thus amply provide liquidity to the market at any time served as a security pillow for international investors and substantially increased the attractiveness of Brazilian assets. The foreign exchange purchases of the BCB have also contributed to the liquidity of the Brazilian market in a more indirect way. Through its active operations in the foreign exchange market, the BCB has acted as counterparty to many of the financial operations, ensuring international investors that they would find a buyer in a market that would be dominated mainly by sellers when strong exchange rate appreciation was expected. In addition, as a result of its attempts to sterilize its US dollar purchases, the BCB has supplied a large amount of very short-term securities (repos) to the domestic banking sector, which has expanded the banks ability to act as counterparty to foreign operations and thus further contribute to Brazils international financialization (Kaltenbrunner & Painceira, 2009). The ability and willingness of the BCB to act as the ultimate provider of liquidity was especially evident when the international financial crisis hit Brazil. As detailed in Painceira (2010), the BCB provided large amounts of liquidity to domestic and international financial investors, allowing nearly immediate exit from domestic financial assets, thus reducing investors losses on Brazilian investments. In summary, through Brazils specific financial market structure, institutional macroeconomic framework and the operations of its central bank, the Brazilian economy has been able to provide highly liquid assets to the international investor community. As will be shown in the next section, this liquidity has been complemented by the very short-term nature of the assets themselves, which has further accelerated the integration of Brazilian assets into international financial markets.

The internationalization of the Brazilian real

One manifestation of Brazils increased international financialization was the internationalization of the Brazilian currency, which became a globally traded portfolio asset. This process started in 2003 and was intensified in the first stage of the international financial crisis as international investors sought high yielding and very liquid assets in the wake of rising uncertainty and falling profitability on international financial markets. Figure 3 shows accumulated portfolio flows, which have an inherently short-term nature, to six major emerging market economies. Flows to all countries picked up in 2003 and further accelerated in 2005, as plentiful liquidity in international financial markets drove international investors to search for alternative asset classes. Portfolio flows to Brazil accelerated further in the beginning of 2006 as the result of its continuing liberalization measures. However, Brazil outperformed the other countries between the beginning of 2007, when falling repayment rates on subprime mortgages

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figure 3 Accumulated stock of foreign portfolio investment in six major emerging market economies (US$ million). Source: IMF-IFS.

in the US signalled the first signs of the crisis, and the third quarter of 2008, when the bankruptcy of Lehman Brothers sent shockwaves throughout the international financial system. As detailed in Kaltenbrunner and Painceira (2009), falling profitability in developed financial markets led to a hunt for yield around the globe, mainly into emerging markets that offered liquid high-yielding assets. Brazil was a prime destination: in addition to the liquidity provided by its financial system and the very short-term nature of its assets, real US dollar returns were among the highest in the world. As was seen in Figure 2 earlier, such returns increased further in the midst of the crisis as the Brazilian central bank hiked interest rates in March 2008. The attractiveness of Brazilian assets during the first stage of the international financial crisis is also confirmed by the semi-structured interviews with currency traders in London. While many traders did not experience a serious reduction in their available trading limits until the collapse of Lehman Brothers, many received orders to reduce all positions except their most liquid ones. For many traders, Brazilian assets, and the real in particular, were such a liquid asset class. Thus, during this time, Brazilian assets became an internationally traded asset class and a standard part of international portfolios. Progressing beyond being the investment target of a few specialized institutions, Brazilian assets became trading instruments, fully integrated into financialized international markets. The increased importance of trading in Brazilian assets was also reflected in the rising participation of alternative investor groups, such as hedge funds and private equity firms, which

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are loosely regulated in the developed countries, are highly leveraged and pursue unconventional, speculative and risky investment strategies (Chandrasekhar, 2008). In addition, Brazils increased international financialization has been mirrored in the rising share of foreign investors in the countrys asset classes for which short-term capital gains are an important part of returns, such as equity and currency trading. Liquidity is especially important for such assets since the ability of investors to quickly buy and sell is crucial to realize profits from a change in an assets value. These asset classes are primarily concentrated, however, on the short-end of the yield curve, making them more sensitive to international market conditions. In addition, the rising focus on trading rather than investment makes portfolio decisions increasingly independent from domestic economic conditions. Even more important for the focus of this paper, foreign investment in Brazilian assets has undergone a structural shift away from foreign-currency to domesticcurrency denominated assets. While the main emerging market instruments traded in the 1990s and early 2000s were US dollar-denominated sovereign bonds, foreign investors have become increasingly exposed to changes in the value of the Brazilian real through their investment in the domestic stock market, local currency debt or most importantly for this paper currency trading. This change implies, however, that currency risk and the exchange-rate return on a currency directly enter the investors calculus. Such a transformation has important implications for the tradability and internationalization of the domestic currency. Securing the immediate convertibility of the domestic currency is a prerequisite for international investors to assume domestic currency risk, especially for those primarily targeted at short-term profits from trading. As an illustration of such trends, Figure 4 gives a detailed picture of the behaviour of net foreign portfolio flows into Brazil between the beginning of 2000 and June

figure 4 Foreign portfolio investments to Brazil (US$ million). Source: BCB.

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2009.4 The figure shows the increasing importance of foreign equity investment in the Brazilian economy and the final pronounced surge of these flows during the first stage of the international financial crisis. Between the beginning of 2003 and July 2008, the country received more than US$50 billion in foreign investment in equities. According to the international data company, Emerging Portfolio Fund Research (EPFR), in September 2008 Brazilian titles accounted for nearly 15 per cent of the holdings of Global Emerging Market funds (topping the league by far, and followed by China and South Korea, which had around 11 and 10 per cent of the total, respectively). The existing theoretical literature points to the long-term character of equity investment, suggesting that investors are interested in the real returns, in the form of dividend payments, of the companies in which they invest (e.g. Levine & Zervos, 1996). However, foreign participation in the Brazilian stock market was targeted primarily at short-term trading profits. According to data from the World Federation of Exchanges (WFE), the total value of shares traded on the Brazilian exchange increased from US$46 billion in 2002 to US$724 billion in 2008. The short-term character of foreign equity investment became especially evident when the international financial crisis struck Brazil: between August and December 2008, more than US$12 billion of foreign equity investment fled the country, more than a fifth of what had entered since the beginning of the boom in 2003. As can be seen in Figure 4, inflows into debt securities also accelerated sharply at the beginning of 2007, reaching nearly US$35 billion by July 2008.5 According to EPFR, for those funds specifically dedicated to emerging markets, Brazilian bonds surpassed by far the share of any other country in September 2008, topping the league with nearly 15 per cent of the total. In contrast to previous episodes, however, these inflows were directed mainly towards domestic-currency denominated debt. Table 4 shows the outstanding stock and annual trading volume of Brazils main debt securities. While international debt has stagnated, domestic debt has experienced a continuous increase, reaching US$1.25 trillion in 2009. According to data from the BCB, nowadays, nearly 100 per cent of this domestic debt is denominated in domestic currency. Similarly, trading volumes
TABLE 4 OUTSTANDING STOCK AND ANNUAL TRADING VOLUME IN DEBT SECURITIES, US$ MILLION 2004 Outstanding Stock International Debt Domestic Debt Trading Volume Souvereign Eurobonds Corporate Bonds Local Bonds Options Total 557,662 37,961 624,873 72,793 1,382,344 925,133 45,191 517,975 64,210 1,554,360 801,231 57,980 432,985 37,551 1,423,660 412,642 70,134 459,134 24,021 1,134,574 192,495 49,938 591,172 7,057 846,972 137,335 58,518 548,251 0 747,202 82,388 384,757 81,673 548,972 77,173 696,114 81,414 952,768 75,664 858,795 90,815 1,250,109 2005 2006 2007 2008 2009

Source: Emerging Markets Traders Association (EMTA); BIS.

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TABLE 5

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REMAINING MATURITY IN YEARS, DOMESTIC CENTRAL GOVERNMENT DEBT OUTSTANDING 2000 Brazil Latin America Asia, larger economies Other Asia Central Europe Other Total Emerging Markets Industrial Countries
Source: BIS.

2001 3.00 3.30 6.50 4.80 3.00 5.60 4.60 5.60

2002 2.90 2.80 7.00 5.70 3.30 5.60 5.10 5.20

2003 2.70 2.50 7.10 6.00 5.10 7.40 8.10 10.00

2004 2.70 2.40 7.30 5.90 3.80 4.40 4.90 4.90

2005 2.30 3.90 7.00 5.50 4.00 4.30 5.00 5.90

2006 2.60 4.00 6.90 5.60 4.30 4.10 5.10 5.00

2007 3.00 4.40 7.10 7.10 4.40 3.40 5.20 5.40

2008 3.30 4.90 7.60 5.10 4.40 4.10 5.50 5.00

2.50 2.70 5.30 5.70 3.00 5.40 4.20 6.50

in Sovereign Eurobonds have fallen continuously, in contrast to local-currency bond trading, which has remained relatively stable. As pointed out above, this rising foreign participation has been prompted by the very short maturity of Brazilian assets. Table 5 shows that, although the maturity of Brazilian bonds has increased slightly, it remains lower than any of the regional averages. The rising short-term domestic-currency and interest rate exposure of foreign investors is even more evident in Brazils highly liquid futures market. According to data from the BM&FBovespa, between the beginning of 2007 and mid-2008, the peak of the weekly average of outstanding contracts in short-term interest rate futures stood at around 8 billion far beyond any hedging needs in the underlying fixedincome sector (Costa et al., 2007). More than 60 per cent of outstanding contracts had maturities of less than one year, while 94 per cent had a maturity of less than two years. Around 20 per cent of these open contracts were held by foreign institutional investors, a big part of which were sold again as the international financial crisis struck Brazil in August/September 2008. The rising integration of short-term domestic-currency denominated assets into international financial markets was fundamental to driving the internationalization of the Brazilian real. On the one hand, currency movements became an important part of investor returns. On the other hand, the currency exposure resulting from foreign positions in the domestic stock and bond markets made the availability and tradability of the domestic currency essential for foreign investors to be able to hedge their exposure and/or meet outstanding external obligations. This need was heightened by the very short-term nature of these assets, which could create an immediate demand for foreign currency.6 As such, the internationalization of the Brazilian currency became a precondition for the continued international financialization of the Brazilian economy. In addition, speculative foreign holdings of domestic currency have become an important manifestation of Brazils increased international financialization. As pointed out above, currency gains are a crucial part of returns for carry-trade strategies. Weekly exchange rate changes in the range of 510 per cent, which are not a rarity

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in emerging-market economies, can add substantial profits in US dollar terms; but they can also quickly wipe out any returns generated on the difference in interest rates. Liquidity, the ability to quickly re-convert investments into the funding currency, is crucial for the success of such carry-trade operations. Thus, the liquidity of the Brazilian market has made the Brazilian real one of the most internationally traded carry-trade currencies, allowing substantial profits for domestic and international investors. This process was facilitated by Brazil extremely liquid derivatives market, which is concentrated in very short-term maturities. As could be seen in Table 2 above, the number of currency futures traded on the BM&F in 2007 and 2008 was second only to those of the Chicago Mercantile Exchange (CME), the worlds largest derivatives exchange. More than 85 per cent of this Brazilian trading had a maturity of up to only one month, while 98 per cent had a maturity up to only two months. Figure 5 shows the increase in open contracts in US dollar futures on the BM&F. While hovering around 200,000 contracts in early 2000, open contracts reached an average of 1,000,000 in August/September 2008. There was a substantial surge in open contracts during the first stage of the international financial crisis as short-term currency speculation became one of the most liquid and profitable operations as risk rose on international financial markets. The average daily trading volume in US dollar futures between May and June 2008 was around US$30 billion, compared to a daily volume of operations of around US$4.4 billion in the spot market. As outlined in more detail below, the derivative markets liquidity became especially important

figure 5 Open interest in US dollar futures on Brazilian derivatives exchange (number of contracts). Source: BM&FBOVESPA.

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figure 6 Average share of market participants in US dollar futures (%). Source: BM&FBOVESPA.

when the full impact of the international crisis hit Brazil: in September 2008 daily trading volume increased to US$41 billion, as both international and domestic investors scurried to cover their huge open-currency positions. Thus, Brazils liquid derivatives market has supplied domestic investors and especially foreign investors with the possibility to trade the Brazilian currency as an international asset on the basis of the option of immediate exit. Figure 6 shows the respective shares of three different investor groups in US dollar futures: domestic financial institutions (banks), domestic institutional investors (basically domestic hedge funds) and foreign institutional investors (international funds). Foreign investors share increased substantially in recent years and reached nearly 25 per cent of the total at the beginning of 2008. As pointed out above, the liquidity of the local derivatives exchange (BM&F) has not only fuelled increased foreign participation on the exchange itself, but has also been crucial in supporting the proliferation of trading in Brazilian real on offshore OTC markets. Table 6 shows foreign exchange turnover on OTC markets in 2007 for selected emerging-market economies. It reflects both the importance of the local derivatives exchange for foreign exchange transactions and the substantial share of off-shore speculative trading in Brazilian real. The daily trading volume of foreign-exchange swap and spot operations is very small in Brazil, as the majority of these operations are conducted on the BM&F. In contrast, the volume of outright forwards traded in Brazil is substantially larger than in the other countries. According to our interviews with currency traders, the majority of forward contracts traded off-shore involving the Brazilian real are Non Deliverable Forwards (NDFs).7 A 2005 BIS survey shows, however, that international banks have limited interest in NDF contracts as a basis to hedge their foreign

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TABLE 6

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DAILY FOREIGN EXCHANGE TURNOVER, US$ MILLION, APRIL 2007 Currency Brazilian Real Local Cross-Border Mexican Peso Local Cross-Border Polish Zloty Local Cross-Border Russian Rouble Local Cross-Border South African Rand Local Cross-Border Turkish Lira Local Cross-Border
Source: BIS (2007)

Total 11,112 7,035 4,077 39,218 15,542 23,676 24,231 10,033 14,198 24,811 17,556 7,256 28,523 12,148 16,374 4,691 1,131 3,560

Spot 5,579 4,754 825 14,666 7,150 7,516 4,851 1,906 2,945 17,533 12,421 5,112 5,668 2,037 3,631 2,881 705 2,176

Outright Forwards 5,259 2,133 3,126 4,594 2,044 2,550 2,644 1,000 1,644 1,253 602 651 3,458 1,405 2,053 535 286 249

Swaps 274 148 126 19,958 6,348 13,610 16,736 7,127 9,609 6,026 4,533 1,493 19,396 8,706 10,690 1,275 140 1,135

investments, preferring, instead, to use these instruments mainly to take directional positions in emerging markets (Lipscomb, 2005). Many market participants who were interviewed estimated that as much as 60 to 80 per cent of NDF volume is generated by speculative interest. The increased liquidity of the Brazilian real and the rising importance of foreign investors in the holdings of the real are also supported by the qualitative results from our interviews with emerging-market currency traders. For all traders interviewed, the Brazilian real is now one of the most liquid emerging-market currencies, and has one of the deepest markets. Indeed, for many traders, the real has become the leading currency among emerging markets and therefore serves as a key indicator for future movements of other emerging-market currencies. Several traders even argued that the Brazilian real had progressed to an intermediate stage between an emerging-market currency and a liquid and widely used carry-trade currency such as the Australian dollar. All traders also stressed the rising importance of foreign investors for exchange-rate operations and movements. A large share of those interviewed declared that foreign institutional investors, primarily hedge funds, have become the most important investor group in driving exchange-rate dynamics in the Brazilian market. This increased integration of the Brazilian real into international financial markets has important implications, however, for exchange rate behaviour. First, the sheer

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size of the positions taken by international investors relative to Brazils market size can exacerbate exchange rate movements, toward both appreciation and depreciation. This effect is due not only to the size of their own positions, but also the fact that their trading decisions are seen as a signal for future currency movements by other market participants. Second, since positions taken by international institutional investors are of a primarily speculative nature, they can potentially increase exchange rate volatility. While the foreign exchange operations of domestic and foreign banks are driven at least partly by the hedging needs of their commercial and financial clients, the positions of international hedge funds are focused exclusively on betting on future exchange rate changes. In addition, foreign financial institutions, primarily but not only institutional investors, work with a higher leverage than domestic institutions. Indeed, while Brazilian institutions face relatively stringent restrictions on capital adequacy and leverage, these limitations do not apply to international institutions assuming positions in domestic assets. Because Brazilian banks rely comparatively little on funding from international wholesale markets, they remain relatively immune to problems on international money markets. However, international investors fund most of their positions in US dollars in international financial markets. This proclivity not only tightens the link between international and domestic market conditions but also introduces an automatic currency mismatch when these investors purchase domestic-currency denominated assets. In summary, the rising internationalization of the Brazilian real has important implications for exchange rate dynamics. The tendencies towards both appreciation and depreciation are significantly heightened. In addition, exchange rate dynamics become increasingly de-linked from domestic economic conditions. They reflect international market conditions and portfolio adjustments rather than traditional economic fundamentals. This effect became evident during the international financial crisis, as will be shown in the next section.

The international financial crisis and exchange rate dynamics

Despite relatively sound macroeconomic fundamentals and a healthy banking system, at the height of the international financial crisis the Brazilian real depreciated more than any other currency in the world. As could be seen in Table 3 above, the commonly accepted indicators of macroeconomic fundamentals were in relatively good shape in Brazil: net external debt was negative, the primary fiscal position had a healthy surplus and, although deteriorating, the current account deficit was very modest. In addition, foreign exchange reserves stood at record levels. Nevertheless, the Brazilian real depreciated more than 60 per cent between August and December 2008, due primarily to international portfolio adjustments and the direct result of Brazils increased international financialization, which was reflected in the large exposure of foreign investors to short-term domestic currency risk. Paradoxically, it was Brazils pursuit of macroeconomic stability targeted at creating financial stability that had contributed, in part, to its rising international financialization and thus the ensuing financial instability experienced during the international financial crisis.

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figure 7 Brazilian real and implied volatility of Standard & Poor 500 index options (VIX). Source: Datastream.

Figure 7 shows the strong co-movement between the Brazilian real and the VIX, a measure of the implied volatility of Standard & Poor 500 index options. The VIX is often used as a gauge of market mood or risk aversion (Franke et al., 2008). The figure illustrates that, as global risk aversion increased, international investors adjusted their portfolios to alternative investments and the real weakened. In addition to the changing preferences of international investors on the asset side, their funding constraints are likely to become particularly important during times of market dislocations when global risk aversion intensifies (Brunnermeier et al., 2009). While this relationship broke down temporarily in the first stage of the international financial crisis, it re-established itself more dramatically than ever in September 2008, as the bankruptcy of Lehman Brothers led to a massive outflow of capital back to the centres of international finance. While most countries were affected by the international deleveraging process, the impact on Brazil was especially severe for two reasons. First, as a result of their high degree of liquidity, the share of Brazilian assets in international portfolios was one of the highest among emerging-market economies. At its peak in the middle of 2008, Brazils total outstanding stock of foreign liabilities reached US$1 trillion, a large part denominated in domestic currency or constituted by investment in the currency itself as a result of previous carry-trade operations. This large exposure led to a huge demand for foreign currency when international investors were forced to sell their Brazilian assets to meet funding requirements in international financial markets.8 In the last quarter of 2008 alone, capital flight through the financial account reached US$22 billion.

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Second, the liquidity of the Brazilian market, characterized by its concentration in very short-term assets (including the domestic currency), and the willingness of the Brazilian central bank to provide foreign currency to the market, meant that the countrys assets were among the first to be sold and in the greatest volume in order to meet outstanding external obligations, such as margin calls and redemptions. In addition, the internationalization and liquidity of Brazils domestic currency meant that foreign investors could quickly hedge their exposure, both to domestic currency assets and to other less liquid but correlated markets on the local derivatives exchange. This dramatic trend was reflected initially in the exchange rates value in the first week of August 2008 and it accelerated markedly in September 2008 with the failure of Lehman Brothers. Table 7 shows the depreciation of selected currencies against the US dollar between the beginning of August 2008 and the first week of December 2008. The second column shows the appreciation of the same currencies thereafter, namely, between January 2009 and the end of October 2009. The volatility of the Brazilian real is striking: not only is it the currency that depreciated by far the most during the height of the international financial crisis in 2008, but it also regained its value more than any other currency during 2009. The claim that it was portfolio adjustment by international investors rather than underlying economic fundamentals that led to the depreciation of the real is supported by the data on open positions of foreign institutional investors in the US dollar futures market. After years of sustained exchange rate appreciation, the exchange rate reached a turning point in the first week of August 2008 and continued to depreciate thereafter. This change in the currencys tendency coincided exactly with the change of position of foreign investors in the US dollar futures market (see Figure 8). Foreign investors had maintained long real positions (indicated by the
TABLE 7 EXCHANGE RATE MOVEMENTS Currency Brazilian real Australian dollar Turkish lira South African rand Russian rouble Hungarian forint Indonesian rupiah Philippine peso Chilean peso Mexican peso South Korean won Polish zloty
Source: Datastream

Depreciation in crisis (%) 66 23 39 44 20 40 30 11 34 38 46 49

Later appreciation (%) 27 8 5 19 5 7 14 1 17 6 6 6

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figure 8 Foreign institutional investor net open interest in US dollar futures (US$ billion). Source: BM&FBOVESPA.

negative positions in the figure) since the beginning of the sustained appreciation trend in the middle of 2004 and kept these positions all the way through the outbreak of the international crisis in August 2007. Although switching to short positions in times of increased market uncertainty, e.g. during the near failure of Bear Sterns in March 2008, international investors generally maintained their long positions even during the first stage of the financial crisis. In the first week of August 2008, however, these investors abruptly changed to short positions, a trend that was further exacerbated as the financial crisis intensified in international financial markets. This switch was due partly to investors attempts to hedge their exposure in domestic asset markets. Moreover, the US dollar futures market was the main market of operations for short-term speculative carry-trade operations in the Brazilian real, and these flows also reverted when the international financial crisis struck. The driving role of positions taken by foreign investors on Brazils futures market is further corroborated by the foreign-exchange flow data of the central bank. Despite the increase in financial outflows in April 2008, the balance on commercial and financial foreign-exchange transactions was still positive in August and September 2008 (with a surplus of US$1.9 and US$2.8 billion, respectively), due to a continued strong trade balance. Nevertheless, the exchange rate started to depreciate at the same time as foreign investors changed their positions in the derivative market. Evidence that this change in position by foreign investors was the result of a general deleveraging process is presented in Figure 9, which shows the trend of five of the most liquid emerging-market currencies since the beginning of 2003. Though their general co-movement is evident, it is important to highlight that all five currencies, from three different emerging-market regions, experienced their turning point in the

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figure 9 Exchange rate dynamics in six major emerging-market economies. Source: Datastream. Notes: For illustrative purposes the value of the Mexican peso has been divided by ten.

first week of August. Although similar macroeconomic characteristics might have contributed to this correlation, their highly synchronized movements tend to support the hypothesis that international portfolio adjustments were the main driving factor of exchange rate movements across these countries. Indeed, probably the main common characteristic of these countries is their relatively high degree of integration into international financial markets and their associated exposure to international capital flows. Although a more detailed analysis of the nature of this financial integration would be necessary, data on exchange-based and OTC currency trading show that these currencies are among the most liquid and widely traded currencies internationally. On the one hand, these characteristics intensified the appreciation trend throughout the first stage of the international financial crisis, as international investors sought liquid and high-yielding assets. On the other hand, these features contributed to the sharp, synchronized depreciation in the second half of 2008, as previously established investment positions had to be unwound due to the meltdown of the international financial market. This deleveraging was carried out first and most markedly with the liquid assets available to investors, including emerging-market currencies.

Conclusion
This paper has maintained that the liquidity provided by the Brazilian economy has made the Brazilian currency one of the most widely traded emerging-market

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currencies. This process started in 2003 and was intensified during the early stages of the international financial crisis, as international investors attempted to compensate falling returns in developed financial markets by pouring capital into Brazils highyielding and very liquid financial assets. However, it was precisely this increased internationalization of the Brazilian real that led later to its large and precipitous depreciation, when the financial crisis finally impacted on Brazil in August/September 2008. In highlighting Brazils increased international financialization, this paper argues that Brazil has entered a new stage of integration into international financial markets. This feature has implied that, beyond being the investment target of a few specialized institutions, Brazilian short-term assets have become a standard part of international trading portfolios. This tendency has been reflected in the increased foreign participation in short-term Brazilian assets, such as equity and currency markets, in which capital gains are an important part of financial returns. In addition, exchange rate movements have become a significant component of returns for international investors. This has made the international tradability of the Brazilian real a precondition for Brazils international financialization. This process had important implications for exchange rate movements. The exposure of foreign investors to short-term domestic currency risk has exacerbated exchange rate movements and tightened the link between international market conditions and exchange rate movements. This trend became evident in the international financial crisis, as international deleveraging resulted in one of the largest exchange rate depreciations in the world, despite Brazils relatively favourable economic fundamentals and an unscathed banking system. This large depreciation underlines the implications that Brazils international financialization has had for macroeconomic management, especially the management of the exchange rate. Rather than stabilizing the exchange rate, the attempts of Brazilian policymakers to maintain sound fundamentals, as promoted by mainstream economics, might have, paradoxically, contributed to greater financial instability through attracting increased foreign inflows of speculative capital. Similarly, the crisis has shown that a large level of foreign exchange reserves, in addition to being very costly, might still not be adequate to stabilize the exchange rate in the face of a rapid and large outflow of speculative capital. These observations raise, however, important questions about the future management of the exchange rate. An important economic variable, the exchange rate is a crucial relative price in the economy that affects the allocation of economic resources and the distribution of income and has historically been an important development tool. In contrast to what is advocated in mainstream economics, our findings suggest that a strict pursuit of macroeconomic stability and sound fundamentals might end up, in fact, undermining rather than enhancing financial stability in the presence of increased financial openness. Hence, taking measures to limit a countrys international financialization might become a priority for avoiding large swings and excessive volatility of exchange rates. Indeed, as was shown in this paper in relation to the case of Brazil, international financialization is not an accidental outcome but the result of a specific institutional setting shaped by policy choices. Alternative policy

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choices that could be made include increased financial regulations and restrictions that could help avoid financial instability while at the same time increasing macroeconomic policy autonomy and freeing valuable foreign exchange reserves for productive investment purposes.

Acknowledgements
An earlier version of this paper was presented at the CRESC Finance in Question/Finance in Crisis conference, April 2010, Manchester. The author is grateful to the participants for relevant discussions and especially Daniela Gabor for organizing the panel and supporting the paper. The author is grateful to Iain Hardie, Juan Pablo Painceira, Daniel Sills and two anonymous referees for their useful comments. Particular thanks go to Terry McKinley for his very helpful observations. The usual disclaimer applies.

Notes
1

Qualitative evidence for this trend is based on 50 semi-structured interviews with currency traders in Brazil and London conducted between April 2009 and March 2010. For authors focusing on the real side, see Krippner (2005) and Lazonick and OSullivan (2000). For an empirical investigation into the negative effects of financialization on the real economy, see Stockhammer (2004). Although very important for exchange rate dynamics especially during the international financial crisis the portfolio decisions of companies shall not be discussed further in this paper as the emphasis is on the positions of foreign investors, which are considered the driving actors in the Brazilian foreign exchange market. Net portfolio flows are essentially driven by inward foreign investment as portfolio investment abroad by Brazilians is still relatively low.

Negative trends in bond data up to then were primarily due to the governments repayment of external debt. This is especially important for equity investment, for which exchange rate changes are an important part of US dollar returns and thus often remain unhedged. An NDF is similar to a regular forward foreignexchange contract, except that at maturity the NDF is settled in another currency most of the time in US dollars because the other currency is considered non-deliverable (i.e. not settled in domestic currency). The exchange rate depreciation was further exacerbated by domestic companies (mainly exporters), which had speculated on a continuous exchange rate appreciation and needed to cover their open foreign exchange positions once the currency started to depreciate.

References
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ANNINA KALTENBRUNNER

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Notes on contributor
Annina Kaltenbrunner is Researcher and Teaching Fellow at the School for Oriental and African Studies (SOAS), Department of Economics. Her research interests include international finance, development economics and monetary theory. Correspondence to: Annina Kaltenbrunner, Department of Economics, School of Oriental and African Studies (SOAS), University of London, Thornhaugh Street, Russell Square, London WC1H 0XG, UK. Email: ak82@soas.ac.uk