beyondbrics

If the currency wars really are on, then emerging markets are facing an ever-worsening bout of the “Impossible Trinity” syndrome, according to a report from Morgan Stanley.

The Impossible Trinity are three policies that relate to the currency war: pegged exchange rates, free flows of capital, and independent monetary policy. But they are “impossible” because you can’t have all three at the same time; governments can only choose two. And we’re now seeing these choices play out: on Tuesday Thailand became the latest emerging nation to impose restrictions on capital flows – a tax on foreign bond ownership.

As Reuters reports from Bangkok, the Thai government agreed on Tuesday to impose a 15 percent withholding tax – effective Wednesday – on interest and capital gains earned by foreign investors on bonds issued by the government, the central bank and state enterprises.

The markets took the news in their stride, perhaps expecting that the move will in itself have little effect. The thai baht, a top-performing currency this year, was virtually unchanged against the US dollar at 30.04 while shares in Bangkok slipped 0.3 per cent.

But the arguments won’t go away. As Morgan Stanley says, the US is likely to use QE2 to further weaken the US dollar. Yet the RMB, while strengthening slowly, is still pegged to the dollar, meaning it too could weaken against other, non-pegged currencies. In fact, the RMB has depreciating against the the euro for some months now.

With the US (and thus China), Japan and Switzerland all acting to weaken their currencies, others – i.e. the UK and eurozone – could follow suit.

So, for other emerging markets, there’s a problem, albeit not an entirely new one:

The situation in EM economies is surely a source of currency tensions. That’s because these developments come against the backdrop of favorable EM versus DM growth and inflation differentials that have created differences in the stance of monetary policies.

These factors have contributed to sustained capital inflows to EM economies, and EM policymakers have for some time found themselves in the policy trilemma, or ‘impossible trinity.’ Indeed, these flows pose challenges to policymakers with respect to not only domestic demand management, but also considerations of external competitiveness.

So what to do? Brazil has already adopted capital controls to stem hot money flows. China has kept hot money out of financial markets for years (from foreigners at least). With large capital flows going into India and Indonesia this year, policymakers there are also feeling the pressure. Now Thailand has made its move the prospects of others following suit will increase.

More capital looks to be on its way. With many investors across developed markets still in the process of a long-term asset allocation shift – i.e. putting more money into EM assets – the appetite for investing in EM still looks sustained. This from MS again:

Perhaps less-appreciated by the market are the structural flows, which represent relative portfolio allocation shifts. Here we are talking about portfolio flows alone, which are driven by long-term portfolio allocation decisions that are less sensitive to cyclical factors. A 2.5% increase in allocation of developed-market, cross-border portfolios towards EM asset markets – in our view a realistic expectation over the coming 12-18 months – represents $500 billion.

In all, EM policymakers are likely to face sustained and heavy capital inflows in coming months, and as a result we cannot rule out more assertive attempts at stemming currency appreciation.

The market already seems to be anticipating fresh policy moves, as Bloomberg reports today:

Asian currencies fell for a second straight day, led by South Korea’s won, on concern policy makers around the region will intervene to check appreciation that may hurt exporters…

“Regional currencies have appreciated quite a lot, to a level where investors are concerned about intervention or even introduction of measures to stem gains,” said Minori Uchida, a senior analyst in Tokyo at Bank of Tokyo-Mitsubishi UFJ Ltd. “Still, the longer-term trend is that quantitative easing in some major economies will boost fund inflows into emerging markets.”

Being this year’s ‘must-have’ investment has its benefits, but it also carries risks. If developed economies really are in the race to the bottom, emerging market policymakers will have to act.

Related reading:

The Currency Trilemma – Seeking Alpha

Stiglitz on the Fed’s flood of liquidity – Credit Writedowns

Even more money flows into emerging markets – beyondbrics

Weak rouble keeps Russia out of currency wars – beyondbrics

Fears of bubble grow in Brazil, China, India – Economic Times