EMERGING MARKETS: Currency wars and the race to the bottom

Developed economies do all they can to devalue their currencies; Latin American economies fight back

Since the financial crisis erupted in 2007, many have slammed the Federal Reserve's policy of "debasing" the dollar by resorting to zero interest rates and money-printing.

But other central banks have followed suit: Japan has announced open-ended purchases of assets; the Bank of England has been buying government bonds and talks about "flexible" inflation targeting; the Swiss have set a ceiling for how much their currency can appreciate; and even the European Central Bank has bought government bonds from stricken eurozone countries as a means to stabilize soaring yields – true, from secondary markets only and by taking care to sterilize to some extent the liquidity that resulted from the purchases.

As a consequence, emerging markets have been faced with a tsunami of liquidity looking for high yields – and, especially in Latin America, they have been fighting back.

Some Latin American policymakers are resorting to more extreme measures to tackle capital inflows. But the results of these wide-ranging experiments remain uncertain, and the use of surprise as a key element in policy is allowing rumours to swirl.

From late January, small, open Costa Rica imposed a series of drastic measures to slow capital inflows and relieve upward pressure on its currency. Brazil continues to dodge short-term capital inflows through a barrage of measures. Even countries with many more reservations about the effectiveness of such measures, such as Peru and Colombia, are using more tools to turn away short-term capital.

Stealth is now a well-established practice in some countries, with surprise announcements and in some cases retroactive applications even as others are more open about their plans. “Some pre-announce exactly what they intend to do – for example, we will buy $20 million a day – while others attach a lot of value to discretion,” says Alberto Ramos, chief economist, Latin America at Goldman Sachs. The latter clearly has a much stronger deterrent effect, he says.


Abrupt and unexpected shifts in policy have fostered a climate where market rumours spread like wildfire. That has affected even those countries that pursue a policy of transparency and signal their intentions to the market. In early February, it was widely rumoured that Colombia would impose capital controls. But that came just after the country slashed taxation on foreign holders of local bonds, and the rumours made no sense, points out Claudio Irigoyen, head of Latin America foreign exchange and fixed income strategy at Bank of America Merrill Lynch.

At the same time, announcements of changes that are not immediately implemented can cost dear. Costa Rica declared that it might increase taxes on foreign investors in local bonds from 8% to as much as 38%, says Edgar Ayales, minister of finance. Ironically, that may have accelerated inflows in the short term with a spike of between 30% and 40% in foreign purchases of bonds recorded immediately after, as investors sought to beat the implementation of the legislation. Costa Rica made it clear it would not seek to impose the tax on existing bondholders, Ayales tells Emerging Markets.

Discouragement of short-term capital is difficult as it is hard to identify which investments are long and which short term, says Ramos. “Money is fungible, and it’s very difficult to separate out which is which as investors seek ways to circumvent restrictions,” he points out.

All this uncertainty means that economists are busier than ever churning out possible scenarios for intervention. Irigoyen, for example, believes the Chileans are most likely to intervene if the peso reaches 460–465 against the dollar. There are growing worries among investors about what’s next. “The more they intervene, the more trade and currency wars are discussed,” says Ramos.


The issue of controls on inflows has been high or top of the agenda for four years. “It has been at the forefront at half of the meetings we have had,” Julio Velarde, Peru central bank governor, tellsEmerging Markets.

But no cogent positions have emerged on the right way to deal with short-term capital inflows, and there is a cacophony of opinions. “There is no common voice,” says Irigoyen.

Does that matter? If a consensus could be built, it might allow for a region-wide tax on speculative flows, for example based on the idea of the Tobin tax, says Ramos. There would be more attention paid to a common voice from the region.

The issue remains entangled in ideology. Even multilaterals seem reluctant to take a firm stance. “The IMF used to preach to Latin Americans to open their capital markets and integrate into the rest of the world,” says Keith Savard, senior managing economist at the Milken Institute in Santa Monica. “Now they turn around and say: ‘it might not be too bad if you have capital controls,’” he says.

The Fund's advice may come with a series of conditions and caveats for capital controls, but the bottom line is that “most people just jump to the last paragraph and read that in some circumstances capital controls are acceptable. This guidance is no guidance,” says Ramos.


The lack of cohesion on the issue is not only ideological but based on economic fundamentals.

Mexico and Brazil continue to represent either end of the spectrum on policy because their economies have been affected by global factors so differently. Ilan Goldfajn, chief economist at Itaú BBA in São Paulo, points out the Chinese-led commodity boom boosted investments in South America profoundly, pushing up the Brazilian real, while Mexico and its currency continued to be dragged down by the US economy. Inflation is high in Brazil but low in Mexico. It comes as no surprise that Mexico has had little incentive to use restrictions, he says. “What might be successful and appropriate in dealing with inflows in one country might be a total failure in another,” says Ramos.

Of those facing what may be considered disruptive capital inflows, Brazil is the most ready to resort to unorthodox policies. Indeed, finance minister Guido Mantega is widely seen as having coined the phrase "currency wars".

Brazil has adopted macro and micro policies covering tax breaks and stimuli to specific sectors and companies, taxes on inflows, currency intervention and lots of stealth. Getting the balance between inflation and growth is straining institutions, some think. Ramos points to “conceptual confusion with incremental additions to the role of the central bank”. Brazil has tried to rally some support for its position but has not found much sympathy in the region.

In fact, Mexico's central bank governor Agustin Carstens flatly rejects exactly the kind of capital controls Brazil has brought to the table. Goldfajn believes this position may be tested this year if the Mexican peso appreciates substantially: reforms in Mexico and a faster recovery in the US would set the wheels in motion for that to happen, he says. “It’s easier to be relaxed about policy when you don’t face any pressures,” he notes.


In the middle ground stand Chile, Peru and Colombia, which have tended to take a lighter approach to capital inflows. They have generally eschewed capital controls of late but are looking at other measures.

Velarde says he is against the use of capital controls and notes that the Peruvian economy has mostly attracted long-term flows anyway. “We don’t think controls work so effectively, first. Second, inflows have been mostly in foreign direct investments and long-term loans to Peruvian firms.” Portfolio inflow has been smaller, amounting to 2% of GDP, and long-term inflows were 9% of GDP. The 10% currency appreciation last year is leading the country to seek to boost dollar demand in what is a very dollarized economy, says Velarde.

Peru is developing interesting ideas that could have lessons for other countries in the region. Authorities are promoting domestic outflows from the Nuevo sol into the dollar by allowing pension funds to invest more abroad and encouraging companies to lend more overseas, says Velarde. The government is prepaying US dollar debt. The approach is softly-softly. Pension funds were allowed to increase their foreign holdings by 2% in January, and further small rises are planned, says Velarde. Banks can use part of the reserves they leave at the central bank if they take the money abroad.

Moreover – as the number of instruments investors can play with is limited – Peru has choked off short-term capital flows: “We don’t have many instruments for short-term flows to come into,” says Velarde.

Authorities are further restricting access. There are already measures to limit the amount that can be traded in the derivatives and forwards markets, for example. Chile has shown how sovereign funds can help countries adjust to strong capital inflows, notes Goldfajn.

By keeping capital inflows in dollars rather than converting them into local currency, the sovereign wealth fund can offset some of the upward pressure on the domestic currency. That could be a recipe for countries such as Brazil.

Peru’s position on its currency is nuanced. The country is not chasing mercantilist advantage through controlling its currency. “We are not trying to induce depreciation for trade advantage. We are trying not to have too strong a valuation of the currency as then you need to be concerned about rebalancing,” says Velarde.


Today, the scenario is one of capital glut. But many are already looking at what could cause a disruptive reversal in trends. After all, growing economic distortions make Latin American countries more vulnerable to a shift in sentiment. History shows that such sudden reversals have been numerous and painful.

The first area of discussion is US interest rates – and prospects seem benign here. The Federal Reserve is unlikely to raise rates through 2015 or later. Velarde’s baseline scenario is 2015 or the first half of 2016. “Clearly, this will influence capital flows,” he says. But even if rates rise, they are likely to do so at the margin. And stronger economic growth and more robust macroeconomic conditions in Latin America than in the developed world mean the region is likely to continue to attract capital. Ayales believes that any rate rise will be too small to have a large impact. But the US yield curve is relatively steep, with rates of more than 2% at the long end. That suggests there could be a market-led increase in rates.

Another perennial fear is a geopolitical event that could provoke a reversal in capital. North Korea and Iran are possible trigger points, as is a deterioration in the tense relationship between Japan and China, says Savard.

That could cause a huge backlash, he points out. “At the first sign of things going bad, investors run for the hills. When capital starts to leave, things snowball,” he says. Ramos thinks a sharp reversal is unlikely. But “could there be a stampede out? Yes, there is that risk.”

As policymakers in Latin America and the developed world continue their economic experimentation, the stakes become higher. Increasing unpredictability in policymaking in Latin America and macroeconomic instability would amplify the effects of a capital reversal. It would be useful to have some guidance through this minefield. That, however, is in short supply.

About admin

I've been researching and writing on Brazilian financial markets, industry and economy since 2006 for a wide range of specialist media, consultancies and investors. Before that I spent over 10 years in London and New York writing for and editing magazines and journals dedicated to finance, investment and economics in developing markets, mostly for the Euromoney Institutional Investor group and Thomson Financial. Areas of coverage Below are samples of areas that I cover and some of the common themes that I investigate. Capital markets BM&FBovespa markets *capital raising trends: via equities (IPOs and secondary issuance), debt and loans *the asset management industry: legislation and coverage of the key hedge, pension and investment funds * corporate governance: how the regulator is seeking to strengthen best practice and limitations * debt markets: the nascent corporate markets, attempts to boost liquidity and new insturments. * private equity market: why this market has been so successful, who’s involved. *electronic, high frequency trading and alternative trading platforms: what does the future hold? Banking *credit: the growth of consumer and business credit and competition between banks and models *Public versus private: the role and market share of public and private sector banks and the politicization of the industry * internationalization: which Brazilian banks are expanding overseas and where * investment banking: the growth of the domestic market and who’s winning which mandates *regional banks and development banks: what role they play in the industry and how they compete Mining *licensing: the complex process of obtaining environmental, water, land and operating licenses at a state and federal level. * capacity: the feasibility and sustainability of capacity increases * financing: how miners are raising finance in Brazil and abroad *competition: the interplay Vale, MMX and junior miners *logistics: rail, road and port connections Oil and gas: the fund raising issues related to the massive of pre-salt (link) Multilatinas: Who are they and how and where they are expanding Meatpacking: Are debt burdens sustainable, what are the different business models for areas such as branding and distrbution Agriculture: How are farms consolidating, what are environmental risks, how can foreign investors be involved. IT and software: Can Brazil take on India and build a viable long-term IT industry? For more information on clients and work, please see the media and consultancy sections.
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