beyondbrics

Chile has joined the “currency wars” with a hefty $12bn war chest. Traders, for the moment, are in retreat.

The peso weakened by 4 per cent early on Tuesday after the central bank announced the evening before that it was prepared to spend the equivalent of 6 per cent of Chilean annual economic output to try and stop the peso from appreciating further.

Although Chile has now joined Brazil and Colombia in actively intervening, this was a surprise announcement. After all, Chile’s central bank is better known for its hands-off approach to its floating exchange rate. But then surprise, as they say, is a key element to any successful attack.

Will it continue to work? Currency traders seem to think that the central bank’s intention to sell $50m of dollars a day into a market where daily turnover is around $1bn might just work. After all, Chile has never intervened on this scale before – and the last time it did, in 2008, the policy worked.

Figure 1: Infrequent use of intervention in the decade

Source: Haver Analytics, Barclays Capital

Equity traders are more ambivalent. Chilean exporters have been clamouring for months for a weaker exchange rate, which is now at a three-year high against the US dollar. But on Tuesday, wine exporter Concho y Toro’s share price was up only by whisker, and the same was true for Copec, one of the world’s biggest wood pulp producers.

Meanwhile economists, a two-handed lot, are divided. On the one hand, some point out that in real terms, the trade-weighted peso is only eight per cent above its 20-year average; that commodity prices, especially for copper, are still booming; that quantitative easing policies in the developed world look set to run and run; and intervention can only smooth the rate of appreciation, not stop it. Goldman Sachs is in this camp.

Barclays, on the other hand, believes the opposite – even if this is largely because of technical reasons relating to the way foreign investors are currently positioned in the forward peso market:

On the back of a rather unsupportive technical position of foreign investors, we pencil in about a 10 per cent weakening of the currency in the coming three months to 515, with the trend lingering towards yearend. An overshooting in the near term cannot be discarded.

All agree, though, that Chile’s actions show how difficult it is for fast-growing emerging countries to manage their exchange rate in a world distorted by QE2. At this stage of the economic cycle, for example, Chile should arguably be looking raising its interest rate through the new year, currently at 3.25 per cent.

But raising rates, as the central bank has noted, would only encourage further capital inflows, which would in turn boost the exchange rate further, and so possibly increase domestic demand (especially for imports). That would negate the usual effect of higher rates.

Furthermore, and somewhat perversely, abundant capital inflows could even encourage substitution by local borrowers away from expensive domestic financing to cheaper external financing – so further upsetting the normal rules of economic engagement.

Bottom line? If conventional economic policy doesn’t work in the “currency wars”, expect more guerrilla tactics and surprise attacks in 2011. Chile’s is just the first.