New Forms of External Vulnerability: Brazil in the Global Financial Crisis

This paper argues that Brazil has become subject to new forms of external vulnerability, which led to one of the largest exchange rate depreciations among emerging markets in the recent global financial crisis. Going beyond traditional external vulnerabilities in the form of creditor-debtor relations and stressing the dialectic relationship between capital flows and domestic financial conditions, it is argued that any exposure to (short-term) foreign investment creates vulnerabilities in the domestic economy, making price dynamics increasingly dependent on conditions in international financial markets. In the case of Brazil this vulnerability manifested itself particularly in a rising share of foreign participation in the domestic stock and derivative markets. The rising liquidity of the Brazilian financial system, characterised by a very short-term nature of financial assets and the willingness of the central bank to provide liquidity to the market at any time, fuelled the share of foreign investment in Brazilian assets. The large stock of accumulated foreign investment in Brazilian assets and the liquidity with which these were traded significantly exacerbated exchange rate volatility in the crisis, as � despite sound fundamentals - the country�s assets were among the first and with the largest volume to be sold. It is further shown that Brazil�s rising external vulnerability was not unrelated to domestic economic conditions. Through its operations in the foreign exchange market and providing liquidity to the market - both before and during the crisis - the central bank significantly contributed to Brazil�s increased vulnerability to international market conditions.