In the aftermath of the May 2013 Taper Tantrum, when the sudden spike in US interest rates and the rapid rise in the dollar prompted many Emerging Market nations to scramble to avoid a panic capital outflow while at the same time keeping their currency stable, the Brazil Central Bank unveiled a clever solution to intervening in the FX market without being held to immediate account by the market, and by the amount of its FX reserves.
Unlike other central banks which mostly employed sterilised interventions, the BCB implemented the largest intervention program of any emerging market not by selling US dollars to buy Brazilian reals but by selling tens of billions in synthetic US dollars in the form of FX forwards. These FX forwards, or swaps as they are called in Brazil, are different from commonly traded currency forwards because they are not settled in US dollars but in Brazilian reals (BRL).
More importantly, this unsterilized method of intervention allowed the BCB to aggressively step into the FX market synthetically, and without explicit reserve constraints, as the swaps were merely contracts to be settled at some future date.
There were negative aspects, however, too, because as these swaps accumulate, at some point they have to be settled in underlying securities, which in the case of an activist central bank which is engaging in increasingly more intervention, the market may start suspecting is untenable.
Well, as we documented two weeks ago, that's precisely what has been going on in Brazil, whose currency plunged as low as 3.93 against the dollar, before consecutive rounds of swap-based interventions limited the loss, although even then the stabilization was tenuous at best.
As a reminder, this is how we documented the BCB's torrid interventions back on June 7:
Having swapped almost $3 billion to buy reals, the second major intervention in a week by the Brazilian Central Bank has utterly failed again...
The market clearly has its eye on Brazil as after intervening 'successfully' selling its 40,000 FX swaps, the Real is fading back to the lows of the day - in other words: intervention failure #2 for the week...
- *BRAZIL CENTRAL BANK SELLS 9-MONTH REPO WORTH BRL10B ($2.75 Billion)
- *BRAZIL SELLS ALL OF 40,000 FX SWAPS IN ADDITIONAL AUCTION
The good news for the Brazilian Central Bank was that these ongoing interventions managed to stabilize the Brazilian real last week, when the BCB unveiled as much as $10BN in weekly swaps to spook the shorts and halt the capital flight, which succeeded in sending the USDBRL back to 3.70, and stabilizing the BRL in the 3.70-3.80 range.
There was just one problem: as we reminded the market last week, these massive swap interventions would have to be settled at some point, and only then would it emerge just how naked the Brazilian FX reserve emperor truly is.
Brazil CenBank to Offer Around $10B FX Swaps Next Week— zerohedge (@zerohedge) June 14, 2018
At some point these swaps will have to be settled
Just 4 days later, it was none other than Brazil itself which confirmed our warning, because as Bloomberg reports on Monday afternoon, citing an unnamed central bank official with direct knowledge of issue, that the volume of currency swaps the Brazilian central bank is currently offering to reduce volatility is not sustainable through the Oct. general election.
What the above statement means that, as we warned, if and when these swaps are settled into USD, there may simply not be enough USD to satisfy claims, in other words, the central bank may find itself USD insolvent.
Confirming as much, Bloomberg continues that maintaining the pace of currency swap sales would mean the stock would exceed the amount Brazil has in its international reserves.
The good news is that for now, the swap offers have so far been successful in reducing FX volatility, with the BCB official adding that the BCB is ready to use international reserves in FX market if necessary.
But the real message is that should the central bank be forced to maintain intervention at the current pace, it will simply run out of dollars, if only later rather than sooner, courtesy of the unsterilized FX intervention, which is growing at an exponential pace as the following chart shows.
Bloomberg further notes that the BCB was surprised by the degree of FX volatility starting in May with truckers’ strike, and adds that concern over the October election is weighing on FX market, citing the unnamed official.
In official response to this shocking admission that its intervention is on the road to failure, albeit by an unnamed central bank official, the central bank said it does not recognize "off-the-record" statements, especially by supposedly "high-ranking central bank sources." Alas, it may be too late, and if the market start asking questions about just how much reserves are already pledged to "make whole" swaps, then all hell may be about to break loose for Latin America's biggest economy, and one of the world's biggest Emerging Markets.
For now, most FX traders appears to have missed the warning, although the real did weaken with the Real dropping from 3.74 to just under 3.76 in response to the stunning admission.