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Brazil marches on to global greatness - and that is its biggest problem

All new governments grapple with tough decisions. Few face tougher ones than Brazil.

Inflation in Latin America's largest economy is running at a six-year high, with food prices rocketing 10 per cent last year. With memories of painful hyperinflation in prior decades, new President Dilma Rousseff vowed that she wouldn't allow "this plague [to]return to corrode our economic fabric and punish the poorest families."

The most logical move for Brazil's inflation-targeting central bank would be to boost interest rates this month. But Brazil's rates are already among the world's highest, at a choking 10.75 per cent. Raising them further would not only squeeze borrowers - it could give foreign investors yet another reason to buy its currency, the real.

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The real has soared almost 35 per cent since the beginning of 2009, damaging the ability of the country's exporters to compete. Ms. Rousseff has pledged to protect Brazil from "the indiscriminate flow of speculative capital." But the surge is enough that Goldman Sachs recently dubbed it the world's most overvalued currency.

Brazil's predicament illustrates one of the chief threats to growth as economies in South America and Asia remain hot. And the country is far from alone in grappling with a flood of new money: Investment dollars are pouring into many emerging markets, inflation is a growing problem and so too are their galloping currencies. Chile, Peru and Mexico are all publicly fretting over the currency conundrum.

The choices the government and its central bank make matter well beyond Brazil's borders. The country is rapidly becoming a powerhouse in the region and the world. By 2032, Brazil's economy will overtake Germany's in size, PricewaterhouseCoopers predicted last week.

"It is a very challenging, difficult scenario," says André Perfeito, chief economist at Gradual Investimentos in Sao Paulo. "As economists in Brazil, we are very curious about how the central bank will react - to face the inflation challenge, or watch the exchange rate."

The real's rapid appreciation is such that middle-class Brazilian families are flying to Miami or New York to buy cheaper clothes, laptops and shoes, Mr. Perfeito said as an illustration of how "wrong our foreign exchange rate is now."

Last week, Brazil's central bank took more steps to curb the currency's appreciation by raising the reserve requirements on foreign exchange positions. Strategists say the move - the third intervention in recent months - will do little to dent the currency's long-term appeal because Brazil's fundamentals are so good.

Brazil's economy grew an estimated 7.5 per cent last year and is forecast to expand 5 per cent this year thanks to rich oil reserves and a growing middle class.

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The most sensible route, economists say, would be to cut government spending. That, too, is riddled with challenges. Brazil has to boost spending on infrastructure, like roads and airports, as it prepares to host the 2014 World Cup of Soccer and the 2016 Olympic Games. The country is also lagging in education and housing investments, and badly needs to ramp up in both to raise living standards and compete on the world stage.

Ms. Rousseff's new government faces a "policy quagmire. But it's a position of strength, similar to China," said John Price, Miami-based managing director of business intelligence on Latin America at Kroll Inc. Massive infrastructure projects are looming, and he says a key risk will be ensuring funds are spent efficiently.

Protectionism is another risk. Brazil recently raised tariffs on toy imports, such as dolls and tricycles, from China to try to help its flailing manufacturers.

The buoyant economy is a credit to outgoing president Luiz Inacio Lula da Silva, a former shoeshine boy who is leaving office with a record approval rating. Under his tenure, 21 million Brazilians moved out of poverty, with 15 million new jobs created since 2003.

With successes came a flood of foreign interest. The real doubled in value in Mr. Lula's eight-year presidency as investors piled in. Last year, amid mounting concern over the soaring currency, Brazil became the first country to highlight the danger of "currency wars."

Last week, the country's new government made it clear that those wars are still waging. "We're not going to allow our American friends to melt the dollar," Brazil's Finance Minister Guido Mantega said of U.S. plans to inject $600-billion into its economy.

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Even free-market Chile is getting involved in those wars, last week announcing that it is buying U.S. dollars to weaken the peso.

Two factors could help the country weather its challenges, Mr. Perfeito says. One may enfold on its own - the U.S. dollar could regain its strength as the Fed prepares to raise interest rates, and that should take some heat off the real. The other is selective cuts to government spending to take some of the stimulus out of the economy. (Congress might be a place to start - it just approved a 62-per-cent pay raise for itself). Spend - yes, but spend carefully.

"We still need to build a country," he says. "We have problems - our streets in Sao Paulo have a lot of potholes, we need subways, railways. We need to spend, a lot. But we need to spend wisely."

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About the Author

Tavia Grant has worked at The Globe and Mail since early 2005, covering topics from employment and currency markets to trade, microfinance and Latin American economies. She previously worked for Bloomberg News in Toronto and Zurich, writing on mining, stocks, currencies and secret Swiss bank accounts. More

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