By Win Thin

NEW YORK ( BBH FX Strategy) -- After warning of further measures to fight BRL appreciation, Brazil unveiled yet another policy measure in its toolbox. The central bank introduced reserve requirements on local bank dollar short positions this morning in an attempt to reduce the magnitude of those shorts. Central bank official Mendes said that the move has the potential to reduce short positions to $10 billion from $16.8 billion in December.

The two biggest takeaways from this is that 1) the authorities are clearly NOT accepting a stronger real to combat inflation, as some in the market had speculated, and 2) BOTH the central bank and Finance Ministry are committed to battling the strong real. Fin Min Mantega could have announced these measures at his press conference Wednesday, but it now looks like FX policy may be getting a little less centralized.

In light of these developments, we believe that 1.65 is the unofficial "line in the sand" and we fully expect more measures if the real threatens to break below that. Central bank meets January 18/19 and is expected to hike rates by 50 bp from 10.75%, which will only add to BRL appreciation pressures. As such, we think other measures will be rolled out over time as needed to try and prevent that break of 1.65.

BRL is slightly weaker but has not reacted significantly to the measures so far today. Even if BRL remains in the 1.65-1.70 range, investors are happy to collect the high interest income. Moves above 1.70 typically draw out more buyers, and BRL hasn't traded above 1.75 since September 1. The ongoing struggle here highlights the fact that the Brazil central bank faces the same policy dilemma as the Asian central banks that we wrote about yesterday. That is, attempts to target both inflation and the exchange rate are basically impossible and will eventually break down. Inflation targeting warrants higher interest rates, which in turn leads to a stronger currency.

The stronger currency is typically part of the process of fighting inflation, but EM policy-makers worldwide are trying in vain to forestall this part of the adjustment. We have long highlighted risks of capital control as being one of the dominant themes in 2011 for EM, especially as the EM rally remains intact and foreign inflows continue.

Other currencies besides BRL are also bumping up against what we view as threshold levels for official action. We believe that's why the 2011 EM rally, if it continues as expected, won't be as big as it was in 2010. Too much official interference is likely to be seen, but such actions are only likely to slow the moves, not reverse them.
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