Shortcuts – 11/04/2023 – Ana Paula Vescovi

We have read newspaper articles about the government’s intention to implement a guarantee fund to provide exchange rate protection (hedge) for foreign investors, especially in sustainable projects. A more in-depth examination of this mechanism is appropriate here, which would aim to prevent currency fluctuations from interfering with the return expected by those betting on the country in the long term.

It is worth comparing the real costs and benefits of adopting this mechanism, vis-à-vis the merit justifications. And it is necessary to consider the possibility of finding more effective solutions to resolve the need to remove obstacles to the growth of project financing sources, especially direct investments in the country (IDPs).

According to the news, the problem identified would be the reduction in IDPs in the recent period — although, in reality, this is not a macroeconomic problem, as there is slack in external financing and more than sufficient coverage of deficits by IDPs.

The “market failure” highlighted would be the high cost of private foreign exchange hedging in Brazil, basically a reflection of interest rate differentials between countries and the credit risk of the counterparty involved.

High interest rate differentials occur largely due to our high cost of capital and macroeconomic risk premiums. The greater the uncertainty, the greater the perceived risk, the cost of protection and the lower the number of investors willing to take it.

The creation of a guarantee fund, with public resources, would ultimately be financed by the increase in public debt, given the current fiscal deficits. This refers to problems from the recent past, when, for example, the Naval Construction Guarantee Fund (FGCN) was decimated by discontinuities in the industry and the triggering of counterparty guarantees against the Treasury. There is no shortage of cases of Treasury guarantees that ended up in losses for society, effectively becoming non-refundable subsidies. The granting of guarantees presupposes, by definition, a risk of private agents against society.

There are, however, successful examples. Such as the creation, during the pandemic, of the Investment Guarantee Fund (FGI) and the Operations Guarantee Fund (FGO), to provide guarantee and guarantee resources for credit operations, especially for small companies and, thus, sustain their activities during social isolation.

The incentives designed, the management of the operating agents and the very low default rate ensured the sustainability of the funds and guaranteed operations. The benefits have been extended and have been well evaluated*. The creation of these instruments, although transparent, increased public debt in the same proportion. In other words, there is always an opportunity cost for the Treasury.

There is also the argument that exchange rate protection could accelerate investment in decarbonization. But the problem of high hedging costs concerns all IDPs, not just investments in emissions reduction or energy transition.

These sustainable investments tend to be unlocked following the approval of the regulated carbon market law, as well as the definition of the activities that will be classified as such (taxonomy).

Furthermore, a study published by The Royal Society reveals that the potential cost-benefit for climate solutions in Brazil is at least 3.5 times lower than that of other tropical countries, only equal to Indonesia.

We are on the right path to unlocking this value, which has doubled in the last two years and there is much more to multiply. Brazil also has competitive solutions in the energy transition, as it has a renewable and diversified energy matrix.

A second point would be to check the possible appetite of multilateral organizations to provide counterpart guarantees for foreign direct investments. This is not a usual action by these institutions, but it could be tested, when it comes to accelerating agendas with clear externalities — such as “green” investments in emerging industrialized countries.

Brazil’s comparative advantages, very present in the recovery of degraded areas, can attract resources to fulfill global commitments made within the scope of the United Nations Conferences on Climate Change (COP).

For the topic of green investments there is yet another factor. The National Treasury is preparing to issue its first sustainable sovereign bond issue in the foreign market, referenced in dollars.

Funding promises to be close to US$2 billion. But it will serve to guide the cost of future private funding abroad, with the same purpose. The first rounds with foreign investors were very well received and, if such operations manage to reference several points in time, they could leverage future private issues, backed by sustainable projects. Something with promising private returns and very high social returns and global externalities.

There are other investments, however, especially in infrastructure, also dependent on external financing sources, in addition to low domestic savings. There is still a search for relocating production chains after the recent geopolitical conflicts, aiming to bring them closer to the largest consumer markets. Something that can contribute to Brazilian reindustrialization.

Little will happen, however, if we do not continue our efforts to resolve the tax issue, improve the business environment, and increase the legal security of projects. This will always be the main agenda, truly capable of reducing the cost of exchange rate protection for foreign investments and attracting resources, while the others are just shortcuts

*IDB (2022). Brazil: Guarantee Funds as guarantee mechanisms for micro, small and medium-sized companies.

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