Brazil launches fresh currency war offensive Brazil will no longer "play the fool" and let its currency appreciate while richer nations gain economic advantage by devaluing theirs, its finance minister Guido Mantega, said this week. It is almost 18 months since Mr Mantega first coined the term "currency war," but it appears there is no ceasefire in sight. On the contrary, Brazil has embarked on a new offensive to suppress gains in the real. On Monday it extended a tax on foreign loans for the second time this month. While analysts still predict a long-term appreciation of Brazil's currency, they believe an arsenal of measures from taxes to interest rate cuts could trap it between R$1.75 and R$1.80 per dollar for most of 2012, diverting investor flows to other Latin American assets. "The market is beginning to understand that the Brazilian government is willing to pay the price of distortive capital controls and that they are willing to take risks with inflation just to get the foreign exchange rate down," says Tony Volpon, head of emerging markets research for the Americas at Nomura. A weaker currency has gone to the top of their priority list. Yet the government's bellicose rhetoric comes at a time when the real is already relatively weak. After hitting a 12-year high against the dollar last July, the real has dropped about 14 per cent, trading at around R$1.80 on Thursday. One of the main factors behind this depreciation has been a gradual reduction in the real-denominated holdings of Japan's "Toshin" retail funds. Their exposure has dropped from a peak of $108.65bn in July last year to $90.57bn this month, a decline which Mr Volpon says has broken a traditional correlation with consumer confidence data and which may prove structural. As such, some suspect Brazil's recent assault on the currency was politically motivated and prompted by the need to explain economic data this month showing the country's once China-like rate of growth had slowed abruptly to 2.7 per cent last year. President Dilma Rousseff has since entered the debate, promising to do the "possible and the impossible" to combat the "monetary tsunami" from richer nations. The introduction of similarly protectionist measures from Chile to Switzerland over the past 18 months, along with tacit approval for capital controls by the International Monetary Fund, has only strengthened Brazil's resolve to take action. "Given the exceptional circumstances, monetary policy became heterodox on a global scale; almost every country is trying to react to measures taken by central banks," says Antonio Manfredini, an economist at Brazil's Fundação Getulio Vargas. The question among traders now is what type of measures could be unleashed next, especially if higher commodity prices push the real towards R$1.70 per dollar, the strongest level the government is expected to tolerate. Brazil's high interest rates mean its fixed income market has long been the target of unwanted "hot money" flows, but these declined after the imposition of a 6 per cent IOF transactions tax on bonds and the beginning of an aggressive easing cycle in August. The problem for the government is that the real now appears to be supported by more desirable flows, mainly foreign direct investment and stock market acquisitions. However, foreign companies may now be funnelling money through their Brazilian subsidiaries as FDI to buy bonds locally without paying the IOF, says Flavia Cattan-Naslausky, foreign exchange strategist at RBS. Data from Brazil's central bank seem to support this theory. In January 2011, foreigners spent $2.65bn on Brazilian bonds, but only $638m in the same month this year. Meanwhile, Brazilians poured $1.19bn more into local bonds this January compared with last year. Brazil's decision to extend the 6 per cent IOF on foreign loans to five-year maturities this week could help block some of these flows, which may be disguised as inter-company loans, but analysts say further extensions would cripple smaller companies. Similarly, a rumoured tax on foreign direct investment is expected to be pushed aside for less-damaging measures such as an increase in the currency derivatives tax. The relative strength of Brazil's economy is expected to support the real. But, if the government continues with its new offensive and succeeds in bringing interest rates down to historic lows, investors have said they may move elsewhere in the region. "I would go back to Mexico where the central bank doesn't really intervene and Colombia, a smaller market but one with a better sense of directional trade and less volatility," says Ms Cattan-Naslausky. There are other more transparent trades you can do with fewer risks.