beyondbrics

Here we go again. As beyondbrics readers know, LatAm currencies have had a blistering start to the year, with most of the region’s currencies hitting their highest levels in about four months against the dollar.

Yet barely six weeks into the rally and it would appear that the pace of FX appreciation has already gotten too hot for comfort for some central bankers.

On Monday, Colombia’s central bank became the latest to intervene in the currency market, snapping up dollars as it looks to curb gains in the peso, which has risen 8.5 per cent since the start of the year. The move comes as Brazil’s central bank bought dollars in the foreign-exchange market for a second straight day. Currency war, anyone?

There is no denying that the sharp rise in the Brazilian real (up 8.3 per cent since the start of the year) and the Colombian peso is heaping pressure on the countries’ exporters.

Brazil posted a trade deficit of $1.3bn in January, the biggest ever recorded for the month, according to figures published by the Trade Ministry last week. The next day, it cranked up protective measures and is rumoured to be looking to scrap a long standing trade agreement with Mexico on auto imports.

Colombia is also getting an earful from its exporters. While the oil and mining industries are booming as military blows against drug-funded insurgent groups have made doing business easier and safer, the peso’s rise has been a headache for flower and banana exporters, two of the biggest employers of rural Colombians.

But we have been here before. Guido Mantega, Brazil’s finance minister, first declared a currency war back in September 2010 as the rising real sapped manufacturers’ competitiveness – only to call it off in last April as inflation became more of a worry. With inflation now in check, Mantega looks ready to do battle again.

The bigger question though is: will the rest of LatAm or other EMs follow?

HSBC, for one, thinks the answer is no. From its note on Monday:

We would expect Brazil’s central bank (BCB) to continue efforts to prevent the BRL from strengthening unchecked, especially given strong M&A flows presently being seen…

Other central banks in the region are not expected to follow a similar policy. In Mexico and Chile, the central banks preferto leave their currencies free from intervention. The MXN remains cheap, even at these levels, and we see no risk of any imminent action from Banxico. Should we see sustained MXN strength in the coming weeks and months, the most likely deviation from a hands off policy would be to reintroduce volatility control options each month, but this seems unlikely at least until we see USD-MXN below 12.00.

For Chile, the criteria to intervene tends to be the central bank’s real effective exchange rate measure, and the degree to which this may be seen as being ‘fundamentally misaligned.’ At present, we do not believe we are close to this level, and therefore would not expect the central bank to intervene. For this to become a possibility, we would expect first we need to see USDCLP below the 460 level.

The problem with currency intervention – at least in the case of Brazil – is that it doesn’t address the structural causes of an overvalued real. To be sure, near-zero interest rates in the US coupled with the uncertain outlook for the eurozone are sending investors to seek higher yields in places like LatAm, pushing up currencies in the process. But the issues also run deeper than that.

Chief among them, as beyondbrics has previously pointed out, is government spending, which is so high that Brazil runs a budget deficit in spite of a tax burden equal to about 35 per cent of GDP – comparable to developed nations but without the services to match. The inflationary impact of that spending is one of the main reasons for Brazil’s chronically high interest rates.

High interest rates in turn continue to make Brazil a magnet for hot money.

As Neil Shearing, chief emerging markets economist, noted:

The huge rally in Latin American currencies from the lows seen in mid-2009 to the record highs seen in mid-2011 was driven by inflows of foreign capital (most countries saw their current account positions deteriorate over this period). Similarly, the latest rally in regional currencies has also been driven by capital inflows. While these partly reflect Latin America’s comparatively bright growth prospects, they have also been exacerbated by the fact that fiscal policy in the region has been kept too loose.

This in turn has required monetary policy to be kept tighter than would otherwise have been the case, thus stoking capital inflows. It is worth noting that Brazil has the highest interest rates of any major economy, while Colombia’s central bank raised its benchmark rate last month.

Shearing added that currency intervention in the region has had little impact in the past.

We estimate that BANREP (of Colombia) bought $5.2bn as part of its last US$ purchase programme, but this didn’t prevent the peso from hitting a fresh high last July. Likewise, a raft of measures tocurb the real’s rise had next to no effect on the currency in late-2010 and early-2011.

There is no reason to think that this time will be any different.

Or as Diego Donadio, a Latin American currency and debt strategist at BNP Paribas, simply put it:

“The appreciation trend is likely to continue.”

Related reading:
Guido Mantega: It’s war (again), beyondbrics
In depth: Currency wars, FT
Foreign flows keep Brazilian real running hot, FT