SCENARIOS-Brazil preps weapons to fight currency war

* Brazil’s real defies government attempts to contain rise

* Incremental moves, warnings may actually boost inflows

* Fiscal tightening seen as the only long-term solution

BRASILIA/SAO PAULO, Oct 14 (Reuters) - Brazilian officials have been fighting at the front line of the global battle over currency intervention, lashing out at world leaders while taking aggressive measures at home to weaken the real BRBY.

But Brazil’s currency has continued to rally. After soaring more than 100 percent since President Luiz Inacio Lula da Silva took office in 2003, the real is now the most overvalued major currency in the world, according to Goldman Sachs.

The central bank has increased its dollar purchases, calling two auctions a day for the past five weeks and buying as much as $1 billion a day.

Last week, the government also doubled a tax on foreign investment in Brazilian bonds -- a measure analysts had previously labeled a “last resort.”

Brazil’s high interest rate makes it a prime target for investors looking for big returns at a time when bonds across much of the developed world are yielding next to nothing.

But these measures have failed to halt the currency’s rise, inflicting even more damage on local companies who are struggling to sell their products abroad.

Following are some measures that could still be used to curb the appreciation of the real:

HIGHER IOF TAX AND/OR TAX RISE ON OTHER ASSETS

The government last week doubled the so-called IOF tax it charges on foreign investment in local bonds to 4 percent from 2 percent. [ID:nN04132890]

But if it is serious about discouraging investors, it would need to raise the IOF much higher to match Brazil’s benchmark interest rate of 10.75 percent, according to some analysts.

The government could also extend the IOF tax increase to other types of investment such as stocks.

But the tax comes at a cost. It distorts markets and is not effective in the long term, some analysts say. It can also make it more expensive for the treasury to finance investments since foreigners could ask for a bigger premium to hold long-term Brazilian bonds to compensate for the tax rise.

BIGGER OR MULTIPLE DOLLAR AUCTIONS

The central bank cut the duration of its regular daily dollar auctions in September, fueling speculation that it was preparing to call even more than two a day. But this has not yet happened. [ID:nN17201349]

It was also expected to intervene in the futures market through so-called reverse currency swap auctions but this has also not yet occurred, surprising some analysts.

The central bank is being careful not to waste its arsenal after the IOF tax did little to curb inflows, some say.

“Intraday volatility has started to move higher with all this and this is precisely something that the central bank does not want,” one analyst said on condition of anonymity.

Meanwhile the board of directors is now mostly made up of central bank public servants who are taking a more cautious line than the market gurus of the past, analysts said.

“The central bank today does not have the outlook of a market trader,” said Carlos Gandolfo, a partner at Pioneer, one of Brazil’s biggest currency brokerages.

SOVEREIGN WEALTH FUND PURCHASES

The government could still resort to using its sovereign wealth fund to buy dollars on the spot market, although local media has said there are still legal obstacles to overcome before that can take place.

Analysts fear that this option could lead to a rise in the country’s debt burden as the treasury seeks to capitalize the fund further by issuing more debt. Finance Minister Guido Mantega has said there is no limit to the fund’s potential intervention in currency markets.

The government also authorized the Treasury last week to speed up dollar purchases. [ID:nN06284208]

VERBAL WARNINGS

Muscle-flexing by Brazilian officials has added volatility to the market but done little to contain the real’s rise. Instead, it has attracted even more capital inflows as investors try to preempt currency measures.

Markets are paying less attention to the verbal warnings since government action has not been as aggressive as its rhetoric. Moreover, measures could be more effective if they caught markets off-guard, analysts said.

“People will try to front-run the measures,” said Tony Volpon, Americas head of emerging markets research at Nomura.

“I do not understand why the government is doing this. It just tells me that they don’t really understand how markets function.”

QUARANTINE ON CAPITAL FLOWS

A measure requiring foreigners to keep investments in Brazil for a set period of time, reminiscent of Chile’s so-called encaje, is unlikely but cannot be ruled out.

It is a clear tinkering with the rules of the game, said Marcelo Carvalho, chief Latin American economist at BNP Paribas in Sao Paulo.

“Encaje would definitely spook the market in Brazil,” said a second analyst who asked not to be named.

“(It) would send a strong signal to the market because it’s not something that the market currently has under its list of options.”

Local media has also speculated that the government could raise margins on trading in currency derivatives to curb the real’s rise. Day traders would be forced to put up more cash before they could enter some parts of the market, deterring short-term speculators. [ID:nN1499966]

LONG-TERM SOLUTIONS

The only long-term solution? Fiscal tightening.

Rising government spending, exacerbated by the current presidential election campaign, has put a strain on Brazil’s public accounts. But fiscal constraint and the accumulation of domestic savings would allow the central bank to reduce interest rates, giving yield-hungry investors less reason to keep pouring money into the country.

“The long-term interest rate is determined by the balance between savings and investment. So as long as you raise the public sector’s domestic savings, you can have a lower equilibrium rate and this helps reduce the inflows of foreign capital,” said Gustavo Loyola, former central bank president and a partner at Tendencias consultancy in Sao Paulo.

(Additional reporting by Silvio Cascione in Sao Paulo)