The risk on/risk off switch has been stuck in the “off” position since the beginning of the month. In other words, the “Sell in May and Go Away” crowd has been looking pretty smart in 2012. This has been especially true in emerging markets such as Brazil, which last week entered bear market territory, having fallen over 20 percent from its most recent highs. While the Bovespa surged over three percent on Monday, the slide in the real kicked into high gear, with USD/BRZ spiking nearly five big-figures to nearly 2.05 from 1.99 last Friday.

Seven months ago I wrote about how hot money was still flowing into emerging markets despite the coming storm in the eurozone (Beware of Falling BRICs, JLN FX, September 6, 2011). At the time, I argued that given the state of globalization, emerging markets could not soldier on unscathed if the developed world fell into recession. It was around that time that the Banco Central do Brazil (BCB) did an abrupt about-face and lowered its benchmark SELIC rate by 50 basis points a mere six weeks after years of systematic, inflation-fighting rate hikes. Apparently the BCB saw capital flight amid global uncertainty as a greater threat than domestic inflation.

Since last fall, the BCB has continued its dovish policy, having lowered the SELIC from 12.5 percent down to 9 percent; a mere 25 basis points from its all time low. Last week, the BCB lowered its end-of-year rate forecast down to 8 percent. If we see a continuation of the economic malaise that began in Greece and has spread throughout the developed world, it is doubtful the BCB will stop there.

This is the same lesson the ECB and Fed learned a few years back – inflation is the bitterest of enemies, until you need it as an ally against deflationary forces. Then, it is nowhere to be found.

That being said, if Brazil is indeed using the “Western Playbook” – lowering interest rates to weaken its currency to make it competitive in world markets – the country may be flirting with disaster. Some would say Brazil is being forced into these maneuvers by the Federal Reserve Bank’s quantitative easing in recent months. But that too can create problems that Brazil knows well. Capital flight, currency failure and rampant inflation are not-too-distant memories in regard to Brazil. While the nation has moved in recent days to retire the balance of its Brady Bonds and close that particular chapter, it is still widely recognized that the entire Latin American region has a history of instability.

On that note, I have another theory as to why Brazil’s struggles have escalated in recent days – the “spillover” effect from Argentina’s seizure of oil company YPF last month. Yes; Brazil is not Argentina, nor Venezuela. They are not necessarily birds of a feather, nor must they flock together. However, last December, Brazil did help launch the 33-member Community of Latin American and Caribbean States (CELAC), which aims to create a free trade zone that does not take its cues from the U.S. Plus, Brazil has, in the past, been known to nationalize industries after significant foreign investment. While Brazil would like to have the world believe it has turned a corner, this may be a tough sell. As hot money flows in and out of emerging markets, perception tends to become reality.

In order to avoid a repeat of its history, Brazil’s economic leaders must move to stabilize the real. President Dilma Rousseff must publicly renounce Argentina’s nationalization of YPF, to show that Brazil respects international contract law and property rights. Finally, Brazil should either distance itself from CELAC, or take the lead and be a sort of the “United States” of Latin America. Only then will the nation be recognized as having entered the developed world.

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