Currency
appreciation in emerging markets has been particularly strong this year both
because of external conditions, including high liquidity, a weak
US dollar and strong risk appetite, and domestic factors such as strong
fundamentals, high potential growth and wider interest rates differentials.
With portfolio
investments to EM countries also rising, policymakers need to figure out how to
avoid losing international competitiveness while also containing asset
inflation and the emergence of asset bubbles. So far this year, most countries
have opted for or maintained either verbal intervention or reserves
accumulation. Others have kept or chosen more aggressive administrative
measures, including capital
controls mostly targeting portfolio investments rather than FDI.

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 October 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 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 as measured by the US Dollar Index and down
14.3% from its March peak. The EM currency rally this year is even stronger
than that of the US 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 in the World is
Next?

Latin America:

Most of the largest Latin American countries have experienced strong
appreciation pressures on since the end of Q1 2009; some have responded by
intervening aggressively in FX markets. What other Latin American governments
may come to the table with capital controls similar to Brazil? Through October
26, the Chilean
(CLP) and Colombian
(COP) peso appreciated 19% and 17%, respectively, versus the dollar. The
Peruvian new sol
(PEN) 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 FX
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 (US$50 million a day) and
the currency is considered to be near its ten-year moving average, in real
terms. Thus, with the Chilean peso currently trading around 530, we believe
Chile is still considerably above a level that would drive the government to
intervene and/or introduce capital controls. As we highlighted in our regional
outlook, RGE does 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 FX 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 US$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
October 23, the Central Bank of Colombia (Banrep) announced it would spend
roughly US$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.

Asia / Pacific:

Despite a flood of portfolio investments into many of the region’s asset
markets since early 2009, Asia still needs foreign capital to stimulate
investment and finance its current accounts. Therefore, facing a sluggish
export recovery and a pegged Chinese renminbi, most countries have opted to
contain currency
appreciation via verbal and actual interventions to avoid losing
competitiveness. Intervention in the foreign exchange market has led to record
reserve growth of over US$70 billion in Q3 alone in emerging Asia ex-China.
Although most Asian countries are expected to keep intervening amid some
currency appreciation, several countries may impose restrictions on foreign
currency transactions. Given buoyant equity markets, attractive carry trades
and the U.S. dollar weakness, policy measures will not contain the impact of
capital inflows on Asian currencies, meaning that some appreciation from the
least trade-dependent countries is to be expected. Taiwan is the country where
capital controls or new restrictions are most likely to be implemented.

Of developed Asia-Pacific economies, only Japan, Australia and New Zealand have
resorted to verbal intervention so far. Australia views currency strength as a
reflection of its economy’s resilience and is unlikely
to officially intervene, especially after the failed intervention in
October 2008. Monetary
tightening could spark more inflows. Japan will continue
to rely on verbal intervention to dampen yen appreciation, albeit less
frequently than the previous pro-export administration, as a stronger yen will
help rebalance the economy toward domestic demand. Meanwhile, New Zealand
officials are more apprehensive that the kiwi’s
strength may abbreviate the economy’s rebalancing away from debt-fueled
domestic demand. A revival of carry trades that pushes the New Zealand dollar
out of alignment with economic fundamentals could prompt a reprisal of 2007
when the Reserve Bank of New Zealand resorted to currency intervention.

The relatively open Asian Tigers are likewise unlikely to impose capital
controls. Singapore and dollar-pegged Hong
Kong will delay rate hikes and depend on FX intervention to contain
currency appreciation. Taiwan
may take a similar stance, especially since its currency is still competitive
relative to South Korea and Japan. However, the Taiwanese government is
considering the possibility of capital controls in the face of strong portfolio
investment. RGE continues to believe that the Taiwanese government is likely to
stick to intervening in the FX market, further adding to its US$330 billion in
foreign exchange reserves.

Based on the pace of reserve
growth, hot money (short-term portfolio inflows) again began flooding into
China even as domestic
monetary conditions have led to an appreciation of domestic real assets,
especially property. China’s quasi dollar peg suggests inflows will persist.
China never lifted pre-existing capital controls. Rather than impose further
controls on inflows, China is expected to improve enforcement of existing
measures and to continue encouraging capital
outflows, both of government investment vehicles and more recently of
retail investors through the revived Qualified Domestic Institutional
Investment (QDII) program.

Low export dependence, reliance on energy imports, inflation risks and
improving investment will allow South Korea, India and Indonesia to tolerate
some currency appreciation despite continuing with FX intervention. These
countries will be among the first ones in Asia to hike interest rates. But
instead of capital controls per se, South
Korea may use regulatory measures to mediate capital inflows by foreign
investors and domestic borrowers and to check asset bubbles. India
already has capital controls in place but may tighten restrictions on foreign
institutional investors and external borrowings by companies if asset
bubbles become a concern. Indonesia’s
reliance on foreign capital for deficit financing will discourage capital
controls. But in the case of excessive currency appreciation, Indonesia
restrictions on currency transactions are a possibility.

Despite high export dependence, Malaysia and Thailand expect that delayed rate hikes and
less attractive asset markets will allow them to contain currency appreciation
largely by FX intervention. Malaysia maintained most of the capital controls
imposed during the Asian crisis. In Thailand, dampened investor sentiment due
to political instability and past capital controls will keep capital inflows
modest. But Thailand may continue easing
capital outflows to contain currency appreciation.

The Philippines will keep on engaging in competitive
devaluation due to its dependence on remittances to drive economic growth. With
capital controls already in place and a need for foreign capital to finance its
current account deficit and build foreign reserves, the Vietnamese central bank
may instead devalue
and restrict currency transactions to manage its currency.

Europe, the Middle East
& Africa:

The South African Reserve Bank has done little to curb the rand’s
25% gain YTD, resorting only to the occasional verbal intervention. Last week,
the central bank had to issue a statement that it did not plan to “freeze” the
currency. The central bank has allowed the currency to float, resulting in
little change in foreign exchange reserves over the past year, despite an increase
in South Africa’s SDR allocation. With its reliance on foreign capital to
finance the country’s chronic current account deficit, capital controls are
particularly unlikely. In the 2009-10 budget, the finance minister suggested
loosening existing exchange controls. Given the sluggishness of South Africa’s
economic recovery, the South African Reserve Bank will be slower to raise rates
compared to some of its EM counterparts, potentially limiting the rand’s future
climbs.

Russia has been steadily intervening in the FX market, lest the ruble climb too
high. As such, its reserves have grown to US$420 billion by mid-October,
despite the fact that Russia is spending the assets in its sovereign
wealth funds. Prime Minister Putin has insisted that Russia would not
impose controls on capital despite a doubling of Russian equities since the
beginning of the year. In fact, Russian authorities continue to try to lure
back foreign investors to its resource sector to maintain output.

Despite rumors of possible capital controls, the GCC
governments did not impose new restrictions on capital in the wake of the
financial crisis and the domestic credit squeeze. Doing so would have further
impaired the regional
economic union. Instead, government backstopping of the banking system and
fiscal spending helped offset portfolio and direct investment outflows. Many
countries, especially Saudi Arabia, continue to have significant restrictions
on inflows to domestic equities, measures that cushioned asset markets.
However, regulations to encourage direct investment are under consideration in
the UAE, including the possible relaxation of the requirement that Emiratis
maintain a majority stake in any project. As with other less liquid frontier
economies, these countries are still seeking to attract capital, especially
through debt markets, as evidenced by Dubai’s
imminent return to the credit markets.

Nordics:

In contrast with the recent experiences of Brazil and certain Asian countries,
which are taking steps to limit excessive capital inflows, Iceland has been
attempting to stop outflows through strict capital
controls, implemented in the wake of the country’s banking
system collapse in late 2008. Payments related to exports and imports of
goods are allowed, but capital transactions are controlled.
The controls have served a number of purposes. For one, they have allowed the
central bank to lower the policy
rate to 12%, down from the 18% peak in October 2008, without destabilizing
the currency. Two, the controls provided a stable environment to restructure
the island’s failed banks.

The general idea behind the controls was to give the economy time to heal, but
as history has shown, capital controls can at best provide a temporary respite.
Over time, people find ways to circumvent the controls. In August 2009, the
central bank announced plans to gradually remove the controls over the next two
to three years. The danger, of course, is that even when controls are removed,
capital inflows will not return. However, as economist Willem Buiter noted
in February: “The example of Malaysia, which imposed capital controls during
the Asian crisis of 1997 suggests that foreign capital either has a short
memory or can be convinced.”