Tag Archive | "Capital Inflows"

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Emerging Market Currencies Still Look Good for the Long-Term

In my previous update on emerging market currencies, I wrote that in the short-term, it’s important not to lump them all together; high-yielding currencies must be distinguished from low-yielding ones. In this post, I’m going to backpedal a bit and argue that over the medium-term and long-term, emerging market currencies as an asset class are still a good bet.

Most emerging market central banks have already begun to tighten monetary policy in order to mitigate against runaway inflation, overheating economies, and asset bubbles. You can see from the chart above (where a dark shade of green signifies a higher benchmark interest rate) that the overwhelming majority of high-yielding currencies belong to emerging market economies. (In fact, if not for Australia, it would be possible to say all high-yielding currencies).

While industrialized central banks are also expected to begin tightening, the timetable is much less certain, due to slowing growth, high unemployment, and low inflation. If current trends continue, then, interest rate differentials should only widen further between industrialized currencies and emerging currencies. Without taking risk into account, the most profitable carry trade will involve shorting the lowest-yielding currency against the highest-yielding currency(s). Alas, liquidity must also be taken in account, and the Angolan Kwanza – with an interest rate of 20% – is probably not a viable candidate. As one fund manager summarized, “[If] we feel like it’s a country where if we exit we are sort of going to shoot ourselves in the foot [due to lack of liquidity], then we won’t go in the first place.

Over the long-term, meanwhile, emerging market currencies will receive a boost from two related forces: strong fundamentals and capital inflows. With regard to the former, emerging market economies already account for the lion’s share of global GDP growth. The World Bank projects that over the next 15 years, emerging market economies will collectively expand by 4.7%, compared to 2.3% in the developed world. As a result of this strong growth, combined with fiscal prudence, debt levels across the developing world are generally falling. It marks a significant reversal that none of the current sovereign debt crises involves an emerging market country. What is more amazing is that some emerging market economies (Mexico, Russia, and Brazil) that struggled with bankruptcy less than a decade ago now have investment-grade credit ratings!

As a result, capital flows into emerging markets should continue to surge. Even though emerging market equity and bond funds have witnessed record inflows over the last few years, portfolio allocations still remain extremely low. For example, “U.S. defined-contribution pension plans only have 2.1% of their funds allocated to developing economies, which make up nearly 50% of global GDP.” Emerging market bonds, meanwhile, account for an estimated 1% of total assets under management. This trend will be further reinforced by domestic investors, which will probably opt to keep more capital in-country.

Of course, the risks are manifold. First of all, there is a risk that these capital inflows will provoke a backlash. “Emerging countries have adopted a broad range of measures to regulate inflows and stem currency rises, increasingly resorting to capital controls and so-called macro-prudential measures such as credit curbs.” Now that they have the blessing of the IMF, emerging market currencies might conceivably be more audacious in trying to limit currency appreciation. On a related note, there is also the possibility that emerging market central banks will fall behind the curve, perhaps deliberately. Lower-than-expected interest rates and hyperinflation would certainly dent the attractiveness of going long such currencies.

Finally, it is possible that in all of their excitement, investors are bidding up emerging market assets to bubble levels. The Wall Street Journal recently reported, for instance, that commodity prices and emerging market currency returns have become strongly correlated. Given that many of these countries are in fact net importers of energy and raw materials, this shows that emerging market currencies are rising more in proportion to risk appetite than to economic fundamentals. If when this risk appetite ebbs, then, this could send emerging market currencies crashing.

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Swiss Franc at Record Highs

This month, the Swiss Franc touched a record high against not one, but two currencies: the US dollar and the Euro. Having risen by more than 30% against the former and 20% against the latter, the franc might just be the world’s best performing currency over the last twelve months. Let’s look at the prospects for continued appreciation.

As I wrote on Monday, the Swiss Franc has been one of the primary beneficiaries of the safe haven trade. With each spike in volatility, the Swiss Franc has ticked upward. Due to monetary and fiscal stability as well as political conservatism, investors have flocked to the Franc in times of crisis. Of course, the Japanese Yen (and the US dollar, of late) has also received a boost from this phenomenon, but to a lesser extent than the franc, as you can see from the chart above.

Personally, I wonder if this isn’t because the Swiss economy is significantly smaller than that of Japan and the US. In other words, its capacity to absorb risk-averse capital inflows is much smaller than that of Japan and the US. For example, the impact of one million people suddenly rushing out to buy shares in IBM stock would have a much smaller impact on its share price compared to a sudden speculative flood into FXCM. The same can be said about the franc, relative to the dollar and yen.

Ironically, the franc is also rising because of regional proximity to the eurozone. I use the term ironic to denote in order to signify that the franc is not being buoyed by positive association with the euro but rather because of contradistinction. In other words, each time there is another flareup in the eurozone sovereign debt crisis, the franc typically experiences the biggest bounce because it is the easiest currency to compare with the euro. In some ways, it is basically just a more secure version of the euro. This phenomenon has intensified over the last month, as the euro faces perhaps its most uncertain test yet.

It is curious that even as investors have gradually become more inclined to take risk, that not only has the franc held its value, but it has actually surged! Perhaps this is because it is expected that the Swiss National Bank (SNB) will soon hike interest rates, making the franc both high-yielding and secure. To be sure, some analysts think that the SNB will hike as soon as June. The fact the the economy has continued to expand and exports have surged in spite of the strong franc only seems to support this notion.

On the other hand, inflation is still basically nil. And just because the Swiss economy can withstand an interest rate hike hardly provides adequate justification for implementing one. Besides, the SNB hardly wants to give the markets further cause to buy the franc. If anything, it may even need to intervene verbally to make sure that it doesn’t rise any higher. Thus, “The median forecast among economists is for a rate increase in September.”

In short, I think the franc is overbought against the dollar. In fact, you can see from the most recent Commitment of Traders data that speculators have been net long the franc for almost an entire year, and it seems inevitable that this will need to reverse itself. On the other hand, the franc probably has more room to rise against the euro. The takeaway here is that it is less important to know where you stand on the franc in general and more important to understand the cross currency.

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Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.

Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.

Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.

Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.

China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.

Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.

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Asian Currencies Poised to Rise, but for Wrong Reasons

All things considered, Asian currencies have had an okay 2010 (and there’s still another month to go). After a modest first half, they started to rise in unison in June, and several are poised to finish the year 10% higher than where they began. While the last few weeks have seen a slight pullback, there is cause for cautious optimism in 2011.

Asian Currency Chart 2010
At this point, I think the rise in Asian currencies has become somewhat self-fulfilling. Basically, investors expect Asian currencies to rise, and the consequent anticipatory capital inflows cause them to actually rise, thereby reinforcing investor sentiment. For example, the co-head of emerging markets for Pacific Investment Management Company (PIMCO) is “investing in local currency debt and foreign exchange contracts in Asia on the basis that…emerging market currencies are bound to rise for…fundamental reasons.” Upon being asked to elaborate on such fundamentals, he answered lamely that, “One big driver for emerging markets in coming years will come from investors’ relatively low allocations to these fast-growing regions.”

When pressed for actual reasons, investors can glibly rattle off such strengths as high growth and low debt and wax bullish about the emerging market ’story,’ but ultimately they are chasing yield, asset appreciation, and strengthening exchange rates. It doesn’t matter that P/E ratios for (Asian) emerging market stocks are significantly higher than in industrialized economies, or that bond prices are destined to decline as soon as (Asian) emerging market Central Banks begin lifting interest rates, or that Purchase Power Parity (PPP) already suggests that some of these currencies are already fairly valued. In a nutshell, they continue to pour money into Asia because that’s what everyone else seems to be doing.

Personally, I think that kind of mentality should inspire caution in even the most bullish of investors. It suggests that if bubbles haven’t already formed in emerging markets, they probably will soon, since there’s no way that GDP growth will be large enough to absorb the continuous inflow of capital. According to the Financial Times, “Data suggest that emerging market mutual funds, including those invested in Asian markets, have received about 10 per cent of their assets in additional flows over the past four to five months.” Meanwhile, a not-insignificant portion of the $600 Billion Fed QE2 program could find its way into Asia, exacerbating this trend.

US Dollar Asia Index 2010
In addition, emerging markets in general, and Asia in particular, have always been vulnerable to sudden capital outflow caused by flareups in risk aversion. For example, Asian currencies as a whole (see the US Dollar Asian Currency Index chart above) have declined 2% in the month of November alone, due to interest rate hikes in China and a re-emergence of the EU sovereign debt crisis. The former sparked fears of a worldwide economic slowdown, while the latter precipitated a decline in risk appetite.

As a bona fide fundamental analyst, it pains me to say that emerging market Asian currencies can expect some (modest) appreciation over the next year, barring any serious changes to the EU fiscal and global economic situations. It seems that capital will continue to pour into Asia, which – rather than fundamentals – will continue to dictate performance.

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Chinese Yuan Will Not Be Reserve Currency?

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.

The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

China Trade Surplus 2009 - 2010
However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”

For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

China FDI 2009-2010

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.

Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”

So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.

If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.

The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

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Emerging Markets Mull Currency Controls

The rally in emerging markets that I wrote about in April is showing no sign of abating. The MSCI emerging market stocks index is back to its pre-crisis level, while the EMBI+ emerging market bond index has surged to a record high. While no such index (that I know of) exists for emerging market currencies, one can be quite certain that at the very least, it too would also have returned to its pre-crisis level.

MSCI Emerging Markets Index 3 Year Chart
The Greek fiscal crisis, far from discouraging risk-averse investors from emerging markets, appears to instead be spurring them closer. From a comparative standpoint, emerging market governments are in much better shape than their industrialized counterparts, to say nothing of Greece. Credit ratings on a handful of emerging market debt issues are gradually being raised, whereas Greece was downgraded to junk status. Summarized one investor: “This is a group of countries with relatively strong balance sheets offering attractive levels of yield.”

It’s no wonder then that capital inflows into emerging market debt has already set an annual record (for 2010), despite the fact that we are only four months into the year! “The World Bank predicts as much as $800 billion in global capital flows this year, compared with about an annualized $450 billion to developing economies in the second half of 2009.” In addition, whereas institutional investors previously insisted on funding only those issues that were denominated in foreign currency (such as Dollars or Euros), now they seem to have a preference for so-called local currency debt. According to one emerging markets fund manager, “We expect local currency to be our biggest theme going forward.”

Net Private Capital Inflows to Developing Countries

The real story here, however, is less the growing investor interest in emerging markets (which is now well established), and more the growing ambivalence of emerging markets. No doubt grateful to be attracting record sums of capital at lower-than-ever interest rates, emerging market governments are nonetheless unhappy about the resulting currency appreciation.

Taiwan has emerged as the unlikely voice of emerging markets on this issue. Its Central Bank recently “asked 65 banks for details of their foreign-currency lending to make sure exporters and importers aren’t using the loans to speculate on the island’s dollar,” and urged its peers to “adjust their monetary policies to address the disorderly movements of exchange rates.”

It doesn’t need to prod too hard, however, since a handful of Central Banks have either already intervened or are seriously considering intervention. Last month, Poland intervened by selling the Zloty against the Dollar. The Central Bank of South Africa cut interest rates by 50 basis points in March, despite surging inflation. Brazil continues to hold auctions to buy Dollars on the spot market, while India mulls implementing some form of a Tobin tax on currency transactions.

Not long ago, such measures would have been criticized as protectionist and against liberal, free-market principles. Not anymore. The International Monetary Funds (IMF), recently “urged developing nations to consider using taxes and regulation to moderate vast inflows of capital so they don’t produce asset bubbles and other financial calamities.” Private-sector economists agree, with Standard Chartered Bank arguing that “Emerging markets need to take ‘urgent action’ on the surge of liquidity and capital flowing into their economies because they could spur inflation and trigger another crisis,” much like “excess liquidity contributed to problems in the Western developed economies ahead of the financial crisis.”

In short, emerging markets have the green light to go ahead and stop their currencies from appreciating. But will they act on it?

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China’s Forex Reserves Surge to New Record

There are no words to describe the size of China’s foreign exchange reserves. Massive, Mind-Boggling, and Eye-Popping come to mind, but don’t do the $2.447 Trillion justice. What’s more, this figure represents the end of March; the current total has almost certainly surpassed $2.5 Trillion.

Interesting, the rate of reserve accumulation has slowed markedly from 2009. In the first quarter of 2010, the reserves grew by “only” $45 Billion, compared to growth of $125 Billion in the fourth quarter of 2009. There are a couple key explanations for this slowing. First, China’s trade balance has narrowed considerably over the last twelve months, to the point that it in March, it recorded its first trade deficit in six years. Second, China tallies its reserve growth on a net basis – after accounting for changes in valuation. Given that the majority of China’s reserves are still denominated in US Dollars, then, the Dollar’s appreciation over the last quarter may have shaved $40 Billion from the accumulation of new reserves. With this in fact in mind, the actual slowdown is probably much less pronounced than the numbers would suggest.

Breakdown of China's forex reserve buildup 2003 -2009
Besides, exports and foreign direct investment both continue to grow at healthy clips, which means there is nothing (barring a revaluation of the RMB) which could significantly slow reserve accumulation going forward. Even with a revaluation (that many experts believe is imminent), the need to further accumulate reserves will not be impacted, because the RMB will certainly continue to be pegged to the US Dollar. In order to prevent price inflation (which is already creeping up) from reaching dangerously high levels, then, the government will have no choice but to continue to soak up all capital inflows for as long as the RMB remains pegged.
Speaking of revaluation, the unchecked growth of China’s forex reserves would seem to strengthen the case for it. As the WSJ analysis showed, the value of China’s portfolio of reserves has fluctuated wildly over the last five years due both to gyrations on the capital markets and volatility in forex markets. In fact, China has lost a massive $70 Billion due to such volatility since 2003. In short, this program of accumulating reserves is not only a massive headache, but also a losing proposition.

Experts estimate that more than 2/3 is still denominated in USD. Since the Chinese RMB is also pegged to the Dollar, that means that as the RMB appreciates against the Dollar, the value of its reserves will fall in local currency terms. Rectifying this problem is basically impossible, as the EU sovereign debt crisis has demonstrated. It has looked into the possibility of investing in alternative assets such as Gold, Oil, and other commodities but there is simply not enough global supply to soak up more than a small fraction of China’s $2.5 Trillion. For all of the problems with the Dollar, the alternatives are just as bad, if not worse. At this point, the best China can hope for is to “cut its losses” by revaluing sooner rather than later.

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Chinese Yuan Expectations Revised Downwards

Last month, I reported on how anticipation is (was) building towards a revaluation of the Chinese Yuan (RMB), confidently stating that “The only questions are when, how and to what extent.” While I’m not ready to recant that prediction just yet, I may have to temper it somewhat.

On the one hand, the case for RMB revaluation is stronger than ever. Among large economies, China’s economy is by far the strongest in the world, clocking in GDP of close to 2009% while most other economies were lucky to “break even.” Meanwhile, its export sector – supporting which is the primary purpose of the RMB peg – is once again robust, having recovered almost completely from a drop-off in demand in 2008 and the first half of 2009. In fact, exports grew by 30% in January, on a year-over-year basis. China’s share of global exports is now an impressive 9%, up from only 7% in 2006. From an economic standpoint, then, the case for an artificially cheap currency is no longer easy to make.

China exports inflation 2010
At the same time, the RMB peg is contributing to bubbles in property and other asset markets. That’s because the Central Bank of China has been forced to mirror the monetary policy of the Fed, as a significant interest rate differential would stimulate uncontrollable capital inflows from yield-hungry investors. While the US can still handle interest rates of close to 0%, China’s economy clearly can not. Thus, consumer prices are slowly creeping up, and property prices are soaring. The most effective (and perhaps the only) way for China to contain both consumer price and asset price inflation is to hike interest rates, which which in turn, would necessitate a rise in the RMB.

There is also the notion that the peg is becoming increasingly costly to maintain. China’s forex reserves already total $2.4 Trillion, and each Dollar that it adds will be worth less if/when it ultimately allows the RMB to appreciate further. In addition, China’s economic policymakers continue to fret about its exposure to the fiscal problems of the US, with one pointing out that, “China has effectively been kidnapped by U.S. debt.” Of course, they no doubt realize that there isn’t a better option at this point; its attempt to diversify its reserves into other assets proved disastrous. The solution to both of these problems, of course, would simply be to allow the Yuan to fluctuate based on market forces, or at least for it to resume its upward path of appreciation.

Political pressure on China to revalue, meanwhile, is even stronger than it was last month. While not invoking China by name, President Obama has been increasingly blunt about the need to pressure it on the RMB: “One of the challenges that we’ve got to address internationally is currency rates and how they match up to make sure that our goods are not artificially inflated in price and their goods are artificially deflated in price.” In addition, rumor has it that the Treasury Department could finally label China as a “currency manipulator” in its next report, which would allow Congress to impose punitive trade sanctions.

Developing countries, which now account for a majority of China’s exports, are also increasingly unhappy with the status quo. The peg to the Dollar caused many emerging market currencies to appreciate rapidly against the Yuan in 2009, and there is evidence that many of their trade imbalances with China are rapidly worsening, “with exports to India, Brazil, Indonesia and Mexico growing by 30% to 50% in recent months.” As one analyst pointed out, however, the potential backlash from this development could be massive: “It’s one thing to produce job losses in the U.S., but it’s another to produce job losses in Pakistan,’ with which China has close military ties.”

On the other hand, however, is China’s massive reluctance to allow the Yuan to appreciate. Part of this is related to face; with the US and other countries stepping up pressure on a number of fronts, China’s leaders don’t want to be seen as weak, and could act contrary to their own interests if it thinks it can earn political points in the process. “China is unlikely to make significant concessions to U.S. pressure on the yuan, particularly now when the two countries are involved in a range of disputes, including U.S. arms sales to Taiwan,” explained one analyst. More importantly, the leadership is nervous that the nascent economic recovery is not sufficiently grounded for the peg to be loosened. While 9% growth in most other economies would be cause for celebration, in China, it is being interpreted as evidence of fragility.

There you have it. Reason on one side, and politics on the other. Unfortunately, it seems that politics always triumphs in the end. Despite Treasury Secretary Geithner’s recent assertions that the RMB will rise soon, investors know that China ultimately calls the shots: “When it comes to the exchange rate, China’s main consideration is China’s own stable economic growth and the structural adjustment of its economy. Foreign pressure is only a secondary consideration.” In short, the RMB is now projected to appreciate only 2% in 2010, according to currency futures, compared to 3.5% last month.


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How will Foreign Investment Tax Affect the Real?

On October 20, the executive office of the government of Brazil enacted an emergency measure, calling for a 2% tax on on all foreign capital inflows. And with one foul swoop, this year’s 35% rise in the Real had come to an end, right?

The tax certainly took investors by surprise, with the Brazilian stock market falling by 3% and the Real falling by 2%, the largest margins for both in several months. The tax is comprehensive and applies to essentially to all foreign capital deployed in Brazilian capital markets, whether fixed income, equities, or currencies. While the tax doesn’t apply to those currently invested in Brazil, the possibility that it would cause potential investors to stay away was enough to cause a sell-off.

The ostensible reason for the tax levy is to prevent a further rise in the Real. By most measures, the currency’s rise has been excessive, more than erasing the losses incurred during the credit crisis. The concern is that a more expensive currency will derail the Brazilian economic recovery before it has a chance to firmly get off the ground. “Brazil’s currency needs to weaken as much as 19 percent for sustainable economic growth, said Nelson Barbosa, the Brazilian Finance Ministry’s top policy adviser.”

According to cynics, however, the tax is a backhanded effort to raise revenue to fund a growing budget deficit. The government continues to spend money (perhaps to offset the negative impact on exports brought on by the Real’s rise) as part of its stimulus plan, but is increasingly tapping the bond markets to do so. The tax is expected to bring in an impressive $2.3 Billion over the next year, which could go part of the way towards fixing the government’s fiscal problems.

The real question, of course, is how the Real will fare going forward. The initial reaction, as I said, was ‘The Party’s over…‘ But investors with a longer-term horizon aren’t fretting. “In the medium term, the measure will have a limited impact. The fundamentals point to a stronger real, with commodities rising and the dollar weakening globally,” asserted one economist. While investors aren’t happy about paying an arbitrary 2% fee to the government, such pales in comparison to the 10%+ returns that investors still aim to reap from investing in Brazil over the long-term.

Ignoring the possible bubbles forming in Brazilian capital markets (admittedly, a dubious suggestion), Brazil still looks like a good bet, especially on a comparative basis. Interest rate futures point to a benchmark interest rate of 10.3% at this time next year, compared to ~1% in the US. Even after accounting for inflation and the 2% tax levy, the yield spread between Brazil and the US remains impressive. For that reason, the Real has already stalled in its expected fall against the US Dollar, standing only 1.7% below where it was on the day the tax was declared.


It’s unclear how determined the Brazilian government is towards pushing down the Real. The comments by its finance minister suggest that the consensus is that it is not slightly – but extremely overvalued. Thus, it’s likely that the government will enact other aggressive measures to prevent it at least from rising further. It continues to buy Dollars on the spot market, and is trying to make it easier for Brazilians to take money out of Brazil. It is not yet ready to tamper with its floating currency, but by its own admission, the “government was studying additional measures to regulate the heavy inflow of foreign investments and its impact on the country’s currency.”

There are also implications for other (emerging market) currencies. As I wrote earlier this week (”Central Banks Prop Up Dollar“) a number of Central Banks have already intervened or are currently mulling intervention in forex markets, to push down their currencies. You can be sure that other governments will be studying the situation in Brazil closely, with the possibility of implementing such policies themselves.

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Asia (China) Continues to Build Reserves, but Forex Diversification Slows

After a brief pause, the world’s Central Banks (or at least those in Asia) have begun to once again accumulate foreign exchange reserves. I’m not one for hyperbole, but the figures are downright eye-popping: “Reserves held by 11 key Asian central banks totaled $2.625 trillion at the end of August, up from $2.569 trillion at the end of July, according to calculations by Dow Jones Newswires.” Most incredible is that this total doesn’t even include China. whose reserves could exceed $2.3 Trillion by now.

The credit crisis was initially marked by a collapse in trade and an exodus of capital from Asia, as western consumers tightened their wallets and investors flocked to so-called safe havens. As developing countries fought off currency depreciation, forex reserve levels plummeted. Less than a year later, trade has already picked back up, investors have returned en masse to emerging markets, and Central Banks are once again sterilizing capital inflows so as to mitigate upward pressure on their respective currencies. [Chart Below courtesy of Council of Foreign Relations.]

“Taiwan and Thailand, the most aggressive in defending the U.S. currency, have logged record-high reserves every month since December.” Japan, whose reserves are the second highest in the world (after China), is the lone holdout. As the Forex Blog reported yesterday, the newly elected Democratic Party of Japan will pursue an economic policy that depends less on exports, and has pledged to stay out of the forex markets.

The prospects for further reserve accumulation remain reasonably bright, as emerging markets lead the global economy towards recovery. “The outlook for key Asian economies is improving faster than that of developed economies. For the time being, this should accelerate flows into these markets, making it harder for central banks to keep their currencies in check.”

While China’s economy is no exception, its nascent recovery is being driven by capital investment, government spending, and (ultimately?) consumer spending. As a result, it is forecast that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year…that ratio will drop to 24.5%.” If such an outcome obtains, it will almost certainly lead to a slower accumulation of reserves.

China Trade Surplus

While this is all well and good, the more important question for most (forex) analysts is how these reserves are being held. The vast majority of these reserves are still denominated in US Dollar assets, and in fact, the proportion may have risen slightly since the beginning of the credit crisis. Asian Central Banks are particularly biased towards the Dollar, which accounts for 70% of their reserves, compared to the worldwide Central Bank average of 64%.

Moreover, it doesn’t look like plans are afoot to change this trend anytime soon. China has maintained its push (though less vocally) to turn the Chinese Yuan into a global reserve currency, declaring that its capital markets and currency controls will open accordingly to facilitate such. It is in preliminary talks with Thailand for yet another currency swap agreement, to supplement the $95 Billion in such deals signed since December. For its part, the Bank of Thailand has insisted that the Yuan is not even close to challenging the supremacy of the Dollar: “You have to accept that the dollar is going to be a reserve currency for quite some time. You don’t have any alternatives.”

Even China, despite its rhetoric, remains committed to the Dollar. The only talk of diversification in Chinese investment circles is in regards to what kinds of US assets they should invest in, not whether they should be invested in the US or somewhere else. Said the manager of China Investment Corp, which has a mandate to invest nearly $300 Billion of China’s FX reserves, “The risk of a decline in the dollar risks was more of a national issue for China than for CIC because its capital is in dollars.”

This last quote inadvertently confirms that the role of the Dollar as the world’s reserve currency is being treated as a political issue, when in fact it is a financial economic issue. In other words, while many countries want to limit the influence of the US by limiting the power of the Dollar, their Central Banks are stuck with it because it remains the most practical, and advantageous option. Dumping it would be akin to punishing themselves.

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