Win Thin: More On Brazil And Korea Currency Controls
No big surprise from Brazil’s decision to boost the IOF tax on fixed income foreign investment to 4% from 2% previously. This is a pretty strong statement from the authorities that 1.70 is the line in the sand, and if USD/BRL continues to grind lower below that level, we would expect further measures (IOF adjustments, FX intervention, possible lock-up period). We are getting increasingly bearish on BRL and believe that as BRL continues to trade below 1.70, there are increasing odds of further capital control measures (see last week’s comment “Is Brazil Considering Encaje-Type Approach To BRL Strength?”) and so we warn that caution is still warranted in BRL at current levels below 1.70. Indeed, we are a bit surprised at the real’s resilience today. When the IOF was first reinstated on October 19 last year, USD/BRL gained about 4% over the first few days afterward to around 1.78 before falling back as time wore on. Post-devaluation low for USD/BRL is around 1.5550 but seems unlikely to be tested given what we see as negative Brazil risks that are developing. Besides the event risks (from politics and more capital controls), we note that the external accounts have turned more BRL-negative, as the current account (CA) deficit widens and FDI flattens out. The so-called basic balance (CA+FDI) turned sharply negative in 2010 and continues to widen. .
And it’s not just Brazil in the news today. Bank of Korea said it will conduct audits of commercial bank FX derivative positions in conjunction with the Financial Supervisory Service. Audits will be conducted between Oct 19 and Nov 5 and are meant to ensure that banks are complying with measures announced June 13 requiring banks to reduce FX derivatives holdings over the next two years (after a 3 month grace period). Those measures were ostensibly taken to reduce KRW volatility but were widely interpreted by the markets as an attempt to limit currency strength. BOK said that as many as 8 banks have breached those limits on derivatives, with 1 domestic and the rest foreign. Official said that the value of FX derivatives held by banks in Korea is about $5.4 bln more than levels allowed under new rules going into effect this month. The won was the worst EM performer today, weakening almost 1% vs. USD as markets are clearly getting jittery about potential for further measures to prevent KRW strength. While the audits don’t really represent a widening or deepening of capital controls, it underscores the risks that policy-makers in Korea will take further measures if the won firms further.
As capital continues to flow into EM, we have highlighted the capital controls/EM FX strength theme as the major driver for EM investing over the next 6-9 months. As we noted last week, EM central banks (not just in Asia) are facing a difficult balancing act between addressing rising price pressures, strong currencies, and risks to the economic recoveries. Higher EM interest rates are likely in the coming months, while developed world interest rates for the most part aren’t going higher. That will help keep a strong bid on EM currencies, as the interest rate divergence with the developed world will only widen in 2011. While currency strength should be seen as a tool to help limit imported price pressures, EM policy-makers still tend to shun strong exchange rates due to the reliance on export-led growth.
Win Thin | Global Head Of Emerging Markets Strategy