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Sao Paulo - Brazil's incoming President Dilma Rousseff is planning aggressive measures including targeted tariff increases and tax breaks to address damage caused to manufacturers by the country's overvalued currency.
The strength of the real, which by one measure is the world's most overvalued major currency, has been the main economic issue in Rousseff's recent meetings with advisers ahead of her inauguration on January 1, sources close to the incoming government told Reuters.
"There is acute concern about the exchange rate," said a senior official in Rousseff's government, speaking on condition of anonymity because she has not taken office yet.
"We were hoping the situation would improve before (the inauguration) but there is no sign of that ... and we realize we need to take action quickly."
The real has gained 11% against the dollar since May, and is up more than 100 percent since 2003, as Brazil's booming economy and high interest rates have attracted massive inflows of capital from the developed world.
Overvalued exchange rates have been a problem throughout much of Latin America and the developing world, due in part to imbalances left over from the 2008-09 financial crisis.
Brazilian Finance Minister Guido Mantega has warned of a "currency war" as countries, including the United States and China, attempt to depress their currencies' value and take other measures to boost local production and exports.
Mantega told reporters on Thursday the consequences from the recent rise in the real "will be dealt with from January by the next government, probably (via) measures in the trade sector".
As an example of the kind of steps Rousseff could take, the sources cited this week's decision by the government of outgoing President Luiz Inacio Lula da Silva to raise tariffs on 14 categories of imported toys to 35 percent from 20 percent.
"You'll see more measures like that in coming months ... always while respecting our international obligations (under trade agreements)," the senior official said, without naming specific sectors. "Trade defense is legitimate."
Toy industry emblematic
The toy decision was permissible under international trade rules because of provisions that allow Brazil to protect domestic industry, an official in the trade ministry said.
Brazil's toy makers, like many other local manufacturers, have bled jobs in recent years despite the broader economic boom. The strong real has left local producers unable to compete with cheap imports from China - which now account for a majority of toy sales in the Brazilian market, according to the Brazilian Association of Toy Manufacturers.
China is accused by many other governments, including the United States, of keeping its currency artificially weak.
Brazilian manufacturers have been clamoring for months for the government to increase tariffs in targeted sectors.
Lula has often been hesitant to do so amid a consumer boom in the final year of his presidency and Brazil's growing trade relationship with China. The toy tariff hike coincided with both the end of Lula's term and the passage of Christmas.
The officials said continued heavy dollar inflows and stagnant industrial production levels throughout most of 2010 have led Rousseff's economic team to plan for a more aggressive approach.
Tariff increases, if carried out on a large scale and imitated by other countries, could fan fears of a wave of protectionism that could stifle the incipient global recovery.
Yet the decision to focus in the short-term on attenuating the consequences of the strong real, rather than trying to weaken the currency outright, could have positive secondary consequences for equity and bond markets.
Tax breaks likely, too
Brazil's government has in recent months increased the so-called IO tax on foreign purchases of local bonds and stocks as a way to discourage dollar inflows.
The possibility of a further tax on equity transactions has weighed on Brazil's stock market in recent months, said Oliver Leyland, an equity portfolio manager for Mirae Asset in Sao Paulo.
Leyland said targeted tariff increases "make some sense" as a method to ease the pressure caused by the strong real.
But he said the policy could end up being "market neutral" for equities since higher tariffs in sectors such as steel - which he called an "obvious" candidate - could result in faster inflation for consumer goods, eroding profits.
Rousseff has announced moderate cuts in budget spending for 2011 that should also help ease the pressure on the exchange rate. Lower taxes and policies that encourage greater innovation are other tools that she may employ to help local industries regain competitiveness at home and abroad.
"The best thing (to weaken the real) would be a rapid decline in interest rates, of course," one of the sources said. "But we recognize that's not going to happen (in the near future)."
The sources told Reuters targeted tax breaks were likely to be implemented in the short-term for manufacturers of some intermediate and finished goods, which have been particularly damaged by the strong real.
"We'll look at all parts of the supply chain ... to incentivize exports and reduce the damage," an official said.
