EM FX fallout: cut spending or be damned
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Emerging Markets

EM FX fallout: cut spending or be damned

Government spending cuts could be one way to stem the currency appreciation tide in Latin America, says Capital Economics, but at a cost. Still, it will do little to reduce potential distortions in the financial sector

In recent days, it's clear that currency intervention has come back with a vengeance, at least in Latin America. And the local currency rally is only just  a couple of weeks old. 

First, the news, via Capital Economics:

• Having seen the peso appreciate by 8% against the US$ this year, Colombia announced on Friday night that it would resume its dollar-purchase programme. Starting from today, BANREP will purchase a minimum of $20mn a day for at least three months – in effect restarting the same programme that ran between September 2010 and September 2011.

• BANREP’s announcement was preceded by news that the Brazilian Central Bank had purchased dollars in the forward market. As in Colombia, the decision came against a backdrop of renewed concerns about the strength of the local currency. The real has also gained 8% against the US$ since the start of the year.  

2012 is already proving a busy year for FX traders. So here's a hawkish timely reminder that emerging market nations that cry foul over FX-appreciation - caused by large-scale capital inflows thanks to G7 stimulus -  can, to some extent, dodge the bullet, via the London-based research shop: 

Domestic policy decisions have contributed to the rapid appreciation of Latin American currencies (and the subsequent squeeze on regional manufacturing) over the past year. 

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. 
There are few proponents of unfettered global capital mobility these days. But, for some, it would be difficult to not conceive of Capital Economics's argument other than through ideologically tinted glasses. The likes of Joseph Stiglitz, former World Bank chief economist, would no doubt cry foul at the suggestion that emerging markets, faced with uncomfortably strong currencies, should slash spending on things like health, education and social benefits. Instead, FX intervention and capital controls might seem more palatable.  

But the problem, according to Capital Economics at any rate,  is that the latter strategy will probably fail, at least in Colombia and Brazil:

It is perhaps not surprising that previous attempts to stem rapid currency appreciation have foundered. We estimate that BANREP 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. (See Chart 1.) Likewise, a raft of measures to curb the real’s rise had next to no effect on the currency in late-2010 and early-2011. (See Chart 2.) 
brazil20exchange20rate20vs.png

colombia20exchange20rate20vs.png

(Of course, all this dollar buying is another boon for the US yield curve, as EM central banks snap up Treasuries.) 

In other words, which cocktail is least palatable (and forgive us for some necessary generalisations here): large-scale government spending, higher interest rates, strong currencies and besieged exporters? Or: a smaller social safety net/lower public investment commitments, lower interest rates and a potentially buoyant manufacturing sector.  Net-net, we are not sure. For policy-makers, the key calculation is how much foreign portfolio investment is needed for growth, the pros and cons of the surplus and what the policy risks are of inaction. 

In recent years, the IMF, it has been said, has experienced a road-to-Damscus conversion away from free market dogma to pragmatism, of sorts, such as advocating capital controls and softening its fiscal austerity stance during a clutch of EM sovereign bailouts, such as in Ukraine and Pakistan. 

It will be interesting to see, therefore, in the coming months - and, indeed, years given the Fed's stated commitment to keep rates near zero-bound till 2014 - just how sympathetic the Fund will be towards Capital Economics's argument that spending should be sacrificed on the altar of FX competitiveness. Just how such Latin American nations can stem the currency appreciation tide will no doubt prove a vexing challenge - if global economic conditions are relatively benign. 

Nevertheless, although fiscal tightening might help to reduce currency appreciation pressures, it will do little to stem the broader risk of large-scale capital inflows: financial sector leverage, volatile short-term capital inflows and financial gearing, orientated towards unproductive sectors. 

Finally, we will leave you with these thoughts from Capital Economics about whether it can be said that we are in the midst of a global currency war, in a definitional sense: 

• the term “Currency War” is, at the very least, a misrepresentation of the various forces that are driving exchange rate movements in Latin America. For a start, it is not entirely clear against whom the “war” is being waged. The US authorities are certainly not targeting a weaker dollar.

• Meanwhile, the rhetoric surrounding the “Currency War” debate deflects attention from the uncomfortable truth that domestic policy decisions have contributed to the rapid appreciation of Latin American currencies (and the subsequent squeeze on regional manufacturing) over the past year. 

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