The imposition of capital controls on capital inflows as well as currency intervention tends to be ineffective in reversing the appreciating trend of the local currencies, especially if the latter are primarily driven by external factors. However, capital controls may be helpful in easing volatility and the pace of the trend itself. The risk is that capital controls are seen as punitive measures against capital markets. They raise uncertainty about future policy actions, hurt the credibility of the central bank and increase the costs of external funding for local businesses. Overall, policymakers' actions to contain the appreciating trend of their countries' currencies depend on how fast capital is flowing in, sterilization costs, and monetary policy flexibility. Consequently, EM countries where currencies and equity markets have surged over the course of the year are the most likely to impose some sort of limitations on capital inflows.
On Oct. 20, Brazil surprised investors with a 2% tax on capital inflows to both equity and bond markets. Likewise, in March 2008, Brazil used a 1.5% tax on fixed income inflows only to contain the Brazilian real's appreciation at the time. The tax was eventually lifted in October 2008 shortly after the Lehman Brothers ( LEHMQ - news - people ) collapse. This time around, taxation on equity investment was included to contain short-term capital flows, while FDI was exempted. Although emerging-market currencies may continue to strengthen against the U.S. dollar, other EM policymakers may be more reluctant than Brazil's to introduce capital controls in an effort to stem the currency appreciation and protect exporters. Below we examine how countries have been dealing with strong capital inflows and which country, if any, is likely to be the first to follow Brazil.
Capital controls alone may not be enough.
It is important to recognize that the use of capital controls is not uniform and neither are the results. In addition, their impact can be subdued by global conditions. In today's economy, EM currencies are up against a weakening dollar. The dollar is down 6.3% YTD and 14.3% from its March peak. The EM currency rally this year is even stronger than that of the U.S. Dollar Index, with five different currencies gaining over 10% YTD. Only the Argentine peso has posted a significant loss against the dollar YTD.
Governments are best served implementing measures aimed at smoothing currency appreciation as opposed to halting or reversing trends. This can be done in part by identifying and targeting areas of volatility and hence vulnerability. By addressing areas of greater volatility, countries can smooth currency flows without endangering macroeconomic stability. The recent tax in Brazil targets volatile portfolio flows as opposed to FDI. Portfolio investments fled Brazil following the Lehman collapse only to flow back this year. Meanwhile, FDI has remained relatively stable.
Given the extraordinary flow into emerging markets, it is unlikely that capital controls or intervention alone will be able to put the brakes on EM currency appreciation. Indeed, the Brazilian real gave up 3% against the dollar following the announcement of the tax before appreciating 3.7% after four days. That said, Brazil and other governments may find themselves in a position where they need to tap a greater arsenal if their desire to stem appreciation is strong. With that in mind, look for central bank intervention to be a greater theme in the coming months.
Who is next? Latin America:
Most of the largest Latin American countries have experienced strong appreciation pressures on since the end of the first quarter of 2009; some have responded by intervening aggressively in foreign exchange markets. What other Latin American governments may come to the table with capital controls similar to Brazil? Through Oct. 26, the Chilean and Colombian pesos appreciated 19% and 17%, respectively, versus the dollar. The Peruvian new sol is also a top-performing EM currency, gaining nearly 10% this year. Mexico's peso is one of the laggards in the region and capital inflows there are recovering slowly. Moreover, despite positive external factors, uncertainties around passing the 2010 fiscal budget and reforms in Mexico have kept the local currency without much investor support. Therefore, Mexico is not a candidate for any implementation of capital controls.
Chile is no stranger to capital controls, having imposed a 20% unremunerated reserve requirement on foreign loans from 1991-98. Chile's foreign exchange regime is free floating; however, policymakers have intervened in the foreign exchange markets when the currency moved too far from macroeconomic fundamentals, most recently in 2008. Chilean authorities tend to let the markets know of their intentions well in advance, and their mechanisms are very transparent in length and quantity. For instance, until the end of the year, the central bank is currently selling the U.S. dollar on a daily basis ($50 million a day), and the currency is considered to be near its 10-year moving average, in real terms. Thus, with the Chilean peso currently trading around 530, I believe Chile is still considerably above a level that would drive the government to intervene and/or introduce capital controls. I do not anticipate any kind of intervention unless the peso falls well below 500 and closer to the 450 level. Even then, we believe Chile would prefer intervening in foreign exchange markets and/or maintaining copper earnings abroad over outright capital controls.
Colombia is more likely to step up its actions against currency appreciation. Already the Colombian government pledged to leave roughly $500 million in dividends from the state-oil company Ecopetrol overseas and sell local currency bonds domestically to compensate. But the government continues to hold off on implementing capital controls, perhaps acknowledging that such an action should be a last resort, especially since strong FDI rather than portfolio flows are driving the Colombian peso's appreciation. Instead, after its policy meeting on Oct. 23, the Central Bank of Colombia (Banrep) announced it would spend roughly $1.6 billion to purchase dollars and peso-denominated government bonds. Given that inflation and interest rates are low and the economic recovery is likely to be slow, sterilizing the intervention is an option rather than a necessity at this point.
In Peru's case, the central bank has stepped up the intervention over the last couple of months in order to contain currency appreciation rather than reverse it. Similar to Colombia, inflation and interest rates are low in Peru while the economy is growing well below potential. Therefore, sterilization costs are low and outright capital controls are not necessary. Moreover, because Peru is a heavily dollarized economy, managing U.S. dollar flows is key to maintaining macroeconomic stability.
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