Fiscal Policy and the Foreign Exchange Market: Understanding the Impacts and Influences

Fiscal policy, which consists of government decisions on spending and revenue, has a direct impact on the foreign exchange market. It shapes the value of the local currency. This relationship is through a variety of channels and has an impact on investor confidence, inflation and the country’s public debt. Fiscal policy also affects inflation.

Inflation has a direct impact on the foreign exchange market. A high level of public spending can increase demand in the economy and thus put upward pressure on prices.

In response, the central bank may have to raise interest rates to control inflation. This also affects the exchange rate. In Brazil, recent changes in fiscal policy have had an impact on the foreign exchange market.

To delve deeper into this analysis, Felipe Schuckar, Head of Foreign Exchange, and Victor Arduin, Energy and Macroeconomics Analyst, talk about the impact of these policies on the Brazilian foreign exchange market and the types of fiscal policies.

Fiscal Instability

Fiscal policy in Brazil has had a significant impact on the foreign exchange market. According to Felipe Schuckar, the instability and lack of predictability of fiscal policy creates an environment of uncertainty for foreign investors. The impending change in the leadership of the Central Bank has increased risk aversion, resulting in dollar flight and the consequent depreciation of the exchange rate. Schuckar says that “actions that demonstrate a firm commitment to the fiscal framework are essential to stabilize the currency market”.

Impact on foreign trade

Tax policy also has a direct impact on foreign trade, especially for companies that rely on imported inputs. Schuckar notes that “in the long run, this can create inflationary pressures due to the scarcity of products in the domestic market.

Public debt challenges

Victor Arduin points out that stabilizing the upward trajectory of Brazil’s public debt is one of the country’s biggest challenges, under pressure from rising spending. “The government has been trying to increase revenues, but the high tax burden is creating resistance to these policies,” he says.

Arduin explains that the measures were initially well received by the market, with expectations that public debt would be stabilized by increasing revenues, mainly through tax increases. Recently, however, there has been growing uncertainty about the country’s ability to balance its books in the short term.

The impact of fiscal discipline on the exchange rate

According to Arduin, the exchange rate reflects expectations about economic growth, inflation, the evolution of public debt and risk perceptions. “Fiscal discipline, with spending lower than revenues, creates an attractive environment for investment and contributes to the appreciation of the real. A lack of confidence in the economy, on the other hand, leads to a decrease in the flow of foreign capital and a depreciation of the currency,” he points out.

Macroeconomic indicators

To assess the impact of fiscal policy on the exchange rate, the analysis should be based on macroeconomic indicators such as the evolution of the public debt, the primary result, the level of expenditures and the volume of revenues. Monetary policy also affects the exchange rate.

Moreover, monetary policy is under suspicion. There will be a change in the presidency next year, which will lead to more uncertainty about the country’s inflation in the future.

Forecast for the exchange rate

The current expectation is that the exchange rate will remain between 5.35 and 5.45 and could fall to 5.20 by the end of the year in a more favorable scenario. However, if the fiscal scenario worsens, the dollar could again exceed 5.60 in the first quarter of 2025.

Recently, the Ministry of Finance announced a R$25.9 billion cut in the budget, which may help to reduce fiscal policy uncertainty, but additional efforts will be needed to ensure the stability of Brazil’s public debt.

Effects of expansionary and contractionary fiscal policies

Expansionary fiscal policies, which increase public spending or reduce taxes, can lead to higher budget deficits and growth in public debt. This situation creates uncertainty among investors about the country’s fiscal sustainability and can devalue the local currency.

On the other hand, contractionary fiscal policies that reduce spending or increase taxes to balance the public accounts can increase investor confidence in the government’s ability to manage its finances. This can attract foreign capital, increase demand for the local currency, and lead to its appreciation.

Hedging Strategies and Risk Management

The volatility of foreign exchange rates requires companies engaged in foreign trade to implement more effective hedging and risk management strategies. Schuckar explains that an exchange rate fluctuation of more than 18% can jeopardize a company’s financial results and make operations unprofitable.

At Hedgepoint, our market intelligence team works with fast, up-to-date information on tax policies, hedging strategies, and risk management. As discussed in this article, these factors are critical to understanding currency fluctuations and their impact on business.

Through this work, the team is able to predict movements in the foreign exchange market and manage financial risks for companies engaged in foreign trade. To access this data and in-depth reports, visit the Hedgepoint HUB: a digital platform of up-to-date materials produced by our Market Intelligence team.