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“EM FX Never Lies” – BofA Warns As Brazilian Real Is Routed

Mohamed El-Erian warned overnight that Brazilian policy makers are “in quite a tricky position — and there’s little room for error,” and judging buy this morning’s rout in the real, he is dead right.

Crippling nationwide trucker strikes, which prompted the resignation of Petrobras CEO, and forced Brazil and Argentina to roll back their planned fuel-price increases have, according to Bloomberg’s Davison Santana, undermined their already fragile currencies and deter investors eager for signs authorities are serious about putting fiscal accounts in order.

Brazil’s projected budget deficit as a percentage of gross domestic product stands at 7.4 percent, the highest among major emerging-market peers.

The gap, as El-Erian explained succinctly, leave government with a stark choice: keep borrowing or cut spending.

As Santana notes, borrowing more isn’t a healthy option. Higher deficits make currencies less attractive, leading to rising interest rates that reduce growth and erode government revenue in a cycle that ends up, you guessed it, swelling the deficit. Reining in spending typically makes more sense. That’s why it’s all the more remarkable that Brazil recently capitulated in their efforts to remove artificial price controls that kept fuel costs low. After all, it’s much harder to reduce spending while maintaining subsidies.

So where does this leave the real? It means authorities will have to keep intervening in currency markets, a costly use of foreign-exchange reserves that can only stop for good once the nations tackle their underlying fiscal problems. And indeed, after Brazil’s real tumbled to a two-year low on Tuesday, the government effectively tripled its support – which has already failed dismally.

A month ago we explained how critical the Brazilian Real is to identifying just when the Emerging Market turmoil will go viral.

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