Emerging Brazilian Small Caps

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LOS ANGELES (MarketWatch) October 20, 2009 -- Brazilian stocks and the country's currency tumbled Tuesday following the government's decision to impose a tax on foreign fund inflows into securities, a move aimed at tamping down the surge in the markets.

Brazil's Bovespa index fell 2.9% to 65,303.11, its worst percentage decline since late June, but managed to fight its way back from an intraday fall of nearly 5%. The broad-based sell-off saw all of the 65 listed shares languish in the red.

Shares of stock exchange operator BM&F Bovespa were hit the hardest, registering losses of 8.4%.

80,00060,00040,00020,000021Shares of market heavyweight Petrobras /quotes/comstock/13*!pbr/quotes/nls/pbr (PBR 46.29, -0.27, -0.58%) fell 2% and mining company Vale /quotes/comstock/13*!vale/quotes/nls/vale (VALE 27.44, -0.01, -0.04%) fell 2.2%. Outside of the broader tax issue, investors assessed the iron-ore giant's investment plan of $12.9 billion in 2010, representing a 29% climb from investment in the 12 months ending in June of this year.

The Brazilian Finance Ministry late Monday imposed a 2% tax on foreign purchases of fixed-income securities and equities, effective Tuesday. Guido Mantega, Brazil's finance minister, reportedly said that the government wants to reign in "speculative" investment and to "favor production."

The currency took a 2.2% hit on Tuesday, with one U.S. dollar buying 1.749 reals compared with 1.711 reals on Monday.

"This is the usual reaction coming from foreign investors, particularly, when they know that the government is trying to lift barriers on capital inflows," said Alfredo Coutino, director of Latin American research at Moody's Economy.com. "Every time a government imposes capital controls, investors overreact but then they forget about it."

In ETF action, the iShares MSCI Brazil Index /quotes/comstock/13*!ewz/quotes/nls/ewz (EWZ 73.34, -0.03, -0.04%) closed with a 3.8% decline, clawing back from an intraday loss of more than 6%.

Last year, the government levied a 1.5% tax only on investment in fixed-income securities, but it was pulled as part of the government's response to the worldwide financial crisis.

The size and the breadth of the new 2% tax was larger than had been expected by investors, said RBC Capital Markets in a note late Monday, adding that it had cut its position on the real to underweight in its model portfolio.

The currency had been up about 38% against the dollar since the start of this year and the Bovespa was up nearly 80% before new tax was announced.

"The real weakened on the [tax] news, but it's still up for the year so you have to look at any weakness in the context of how strong everything has been," said David Riedel, president of Riedel Research Group, which specializes in emerging-market equity research.

Riedel said the tax move also signals the government's desire to "get away from being just a commodities player. They are willing to sacrifice their exports a little bit by having their currency up so much already, but they don't want it to go up too fast. But this is a reminder that these markets are up a lot, and policymakers are going to start to react."

The impact of the so-called IOF tax is likely to last for a short-term, but evidence from Brazil and other countries "suggests that taxation of inflows is not effective as a tool to permanently alter the exchange rate," wrote Itau Unibanco economists Aurélio Bicalho and Ilan Goldfajn in a note to clients Tuesday.

Itau Unibanco, the largest non-government run bank in Brazil, reiterated its forecast for Brazil's currency to settle around 1.70 at the end of this year, "and stable in real terms thereafter."

Elsewhere in Latin America, Mexico's IPC reversed earlier losses and rose 0.2% Argentina's Merval lost 0.3% and Chile's IPSA shed 0.3%.
Carla Mozee is a reporter for MarketWatch, based in Los Angeles