Capital Controls Roil Latin America Bond Markets by Evoking `80s
Latin American nations from Brazil to Peru are returning to currency and foreign investment controls that marked the 1980s era of hyperinflation.
Since the start of the year, policy makers across the region have increased dollar purchases to record levels, raised reserve requirements and curbed banks’ ability to bet against the dollar in a bid to stem a 29 percent rally in Latin American currencies since March 2009. Controls may stiffen, and other nations could join the “market-unfriendly” drive, said Alberto Ramos, an economist at Goldman Sachs Group Inc.
“In all these countries, if it continues, there will be the temptation to escalate the level of restrictions,” said Ramos, a former economist at the International Monetary Fund, in a phone interview from New York. “We cannot throw into the dustbin four decades of good economic research. Capital controls have serious economic costs.”
Local-currency bonds in Latin America lost 0.5 percent in dollar terms in the past three months, the first decline for the period since October 2008 in the aftermath of the collapse of Lehman Brothers Holdings Inc., according to JPMorgan Chase & Co.’s GBI-EM Global Diversified Index. Yields on Brazilian government notes due in 2017 jumped 111 basis points since the middle of October to 12.55 percent. The higher rates push up the country’s cost to roll over debt that equals 58 percent of gross domestic product, compared with 34 percent in South Korea.
Latin America’s economic turnaround that caused net private inflows to quadruple since 2003 and tamed price increases to record lows comes two decades after defaults spread from Mexico to Venezuela and inflation in Brazil climbed to as high as 6,821 percent in 1990. While governments are taking steps to limit spending, price rises and borrowing costs are picking up and could accelerate should currencies weaken, jeopardizing the nations’ progress, according to Bank of America Corp.
“Central banks view the level of exchange rates as the priority rather than using them to help slow inflation,” said David Beker, chief Latin America strategist at Bank of America. “Once you start targeting multiple objectives, the odds for policy mistakes increase.”
Developing nations outside of Latin America, from Thailand to Turkey, are also taking steps to slow currency appreciation, as near-zero interest rates in the U.S. and Europe, and the Federal Reserve’s buying of $600 billion in U.S. Treasuries attract inflows to higher-yielding assets.
Action to prevent asset bubbles and protect competitiveness has been concentrated in Latin America, where net private inflows surged to $203.4 billion last year from $57.5 billion in 2003, according to the World Bank. The region’s resilience, reflected in 2010 growth of 5.7 percent that was twice of the U.S., means inflows are likely to keep pressuring its currencies, the Washington-based lender said Jan. 12.
Latin American currencies rose 0.3 percent this year, extending its gain since March 2009 to 29 percent, according to a JPMorgan and Bloomberg index tracking six major currencies in the region.
Chile, which hadn’t bought dollars in the foreign-exchange market since 2008, announced Jan. 3 it would purchase a record $12 billion, equal to 43 percent of the country’s currency reserves.
In Colombia, where the peso has gained 10 percent against the dollar since the end of 2009, the central bank is buying at least $20 million a day in the spot market. Peru purchased $9 billion last year, the second-biggest amount ever, as the sol rose to a two-year high in October. The government also increased reserve requirements to lift the cost of short-term, overseas borrowing by local banks.
In Brazil, where a 38 percent rally in the real since the end of 2008 caused the trade deficit in manufactured goods to double to $71 billion in 2010 from the previous year, the government and central bank have been most aggressive in taking measures to curb the advance.
Finance Minister Guido Mantega tripled to 6 percent in October a tax on foreign inflows. After the real strengthened to a two-year high against the dollar on Jan. 3, the central bank set reserve requirements to curb short selling of the dollar by local banks and sold $1 billion of reverse currency swaps on Jan. 13 in a bid to weaken the real. The government also authorized its sovereign wealth fund to place bets in the currency futures market.
The real, which has lost 0.8 percent this year, strengthened 0.4 percent to 1.6744 per U.S. dollar yesterday.
‘Cat and Mouse’
“In these games of cat and mouse, I think policy makers will probably lose,” said Simon Johnson, a professor of finance at Massachusetts Institute of Technology in Cambridge who was chief economist at the IMF from 2007 to 2008. “There is too much unregulated capital in the world, particularly in developed countries. These guys will find ways around various restrictions.”
Nouriel Roubini, the New York University economist who predicted the 2008 global financial crisis, said “intelligent intervention” is preferable to letting currencies gain.
“If you don’t do anything, your currency can appreciate more than is justified by the economic fundamentals,” Roubini said in a phone interview from New York on Jan. 7. “Excessive appreciation is a danger that can lead to loss of competitiveness.”
Latin America’s progress in lowering debt levels has given the region the credibility to implement the appreciation- fighting policies, said Simon Nocera, co-founder of San Francisco-based hedge fund Lumen Advisors LLC.
Policies to stem currency gains are costly. Central bank dollar purchases helped push foreign reserves in six major Latin America nations up 16.5 percent last year to a record $527 billion as Brazil bought $41.4 billion, the most since at least 2008, according to data compiled by Bloomberg.
While the reserves helped cushion the capital flight during the global financial crisis, managing its $290 billion stockpile costs Brazil $20 billion a year since the country must issue debt to pay for the dollars it buys, according to Tendencias, a Sao Paulo-based economic research company.
“The cost of intervention should not be downplayed,” said Bank of America’s Beker. “It’s very expensive.”
Unlike their Asian peers, Latin American nations rely more on foreign investment to finance current account deficits, making their economies vulnerable to restrictions that could limit inflows, said Pierre Yves Bareau, who helps oversee $11 billion in emerging-market assets at JPMorgan Chase & Co. in London.
“There’s always a danger that by having capital controls, you can force some good capital to stay out of the country,” said Bareau, who favors currencies in Asia and Eastern Europe over the real and Chilean peso.
Brazil’s current account shortfall will widen to 3.2 percent of GDP this year, the most since 2001, according to a Bloomberg survey.
The fight against appreciating currencies that Brazil’s Mantega dubbed a “currency war” last year may lead Latin American countries to resist raising interest rates, said Neil Shearing, an emerging markets analyst at Capital Economics in London. Chile unexpectedly left its benchmark interest rate unchanged last week.
While Asian countries including South Korea may allow their currencies to appreciate more to contain inflation, in Latin America “there appears to be a growing focus on shoring up competitiveness,” analysts including New York-based Michael Gavin and Roberto Melzi at Barclays Capital wrote in a note to clients on Jan. 13.
“There is a risk that central banks will allow themselves to become distracted or constrained in their core responsibility to control inflation,” the analysts wrote.
Inflation in Brazil reached a six-year high of 5.91 percent last year, up from a record low of 1.7 percent in 1998, and is forecast to remain above the government’s 4.5 percent target until 2012.
In Chile, one-year inflation expectations have soared to 4.3 percent, a five-month high and compared with almost zero in December 2009, since the dollar-buying plan was announced. The peso declined 4.5 percent this year, the most among 25 emerging market currencies tracked by Bloomberg.
Rather than taking more measures to limit appreciation, Brazil needs to reduce spending to allow the central bank to cut its 10.75 percent benchmark rate, the second-highest in the Group of 20 nations after Argentina’s, said Lumen Advisors’s Nocera. Chile, the world’s biggest producer of copper, should diversify its economy away from exports of the metal, he said.
“Sooner or later you pay the price” for stepped-up controls, said Nocera, a former IMF economist and fund manager with Soros Fund Management LLC. “You pay the price of lower growth or higher inflation.”