With the U.S. dollar weakness, many investors have turned to currency trading either as an opportunistic trade or a hedge against assets held in U.S. dollars.  Since Brazil recently enacted a 2 percent tax on foreign investments to calm its high-flying currency, the real, other countries may follow suit to weaken their currencies.  RGE Monitor, the economic think-tank headed by economist Nouriel Roubini, has issued a report on potential capital controls identifying countries that may be next to make such a move.

Below is a recap of RGE Monitor’s report:

Currency appreciation in emerging markets has been particularly strong this year both because of external conditions, including high liquidity, a weak US dollar and strong risk appetite, and domestic factors such as strong fundamentals, high potential growth and wider interest rates differentials. With portfolio investments to EM countries also rising, policymakers need to figure out how to avoid losing international competitiveness while also containing asset inflation and the emergence of asset bubbles. So far this year, most countries have opted for or maintained either verbal intervention or reserves accumulation. Others have kept or chosen more aggressive administrative measures, including capital controls mostly targeting portfolio investments rather than FDI.

The imposition of capital controls on capital inflows as well as currency intervention tends to be ineffective in reversing the appreciating trend of the local currencies, especially if the latter are primarily driven by external factors. However, capital controls may be helpful in easing volatility and the pace of the trend itself. The risk is that capital controls are seen as punitive measures against capital markets. They raise uncertainty about future policy actions, hurt the credibility of the central bank, and increase the costs of external funding for local businesses. Overall, policymakers’ actions to contain the appreciating trend of their countries’ currencies depend on how fast capital is flowing in, sterilization costs, and monetary policy flexibility. Consequently, EM countries where currencies and equity markets have surged over the course of the year are the most likely to impose some sort of limitations on capital inflows.

On October 20, Brazil surprised investors with a 2% tax on capital inflows to both equity and bond markets. Likewise, in March 2008, Brazil used a 1.5% tax on fixed income inflows only to contain the Brazilian real’s appreciation at the time. The tax was eventually lifted in October 2008 shortly after the Lehman collapse. This time around, taxation on equity investment was included to contain short-term capital flows, while FDI was exempted. Although emerging market currencies may continue to strengthen against the U.S. dollar, other EM policymakers may be more reluctant than Brazil’s to introduce capital controls in an effort to stem the currency appreciation and protect exporters. Below we examine how countries have been dealing with strong capital inflows and which country, if any, is likely to be the first to follow Brazil.

Capital Controls Alone May Not Be Enough

It is important to recognize that the use of capital controls is not uniform and neither are the results. In addition, their impact can be subdued by global conditions. In today’s economy, EM currencies are up against a weakening dollar. The dollar is down 6.3% YTD as measured by the US Dollar Index and down 14.3% from its March peak. The EM currency rally this year is even stronger than that of the US Dollar Index with five different currencies gaining over 10% YTD. Only the Argentine peso has posted a significant loss against the dollar YTD.

Governments are best served implementing measures aimed at smoothing currency appreciation as opposed to halting or reversing trends. This can be done in part by identifying and targeting areas of volatility and hence vulnerability. By addressing areas of greater volatility, countries can smooth currency flows without endangering macroeconomic stability. The recent tax in Brazil targets volatile portfolio flows as opposed to FDI. Portfolio investments fled Brazil following the Lehman collapse only to flow back this year. Meanwhile, FDI has remained relatively stable.

Given the extraordinary flow into emerging markets, it is unlikely that capital controls or intervention alone will be able to put the brakes on EM currency appreciation. Indeed, the Brazilian real gave up 3% against the dollar following the announcement of the tax before appreciating 3.7% after four days. That said, Brazil and other governments may find themselves in a position where they need to tap a greater arsenal if their desire to stem appreciation is strong. With that in mind, look for central bank intervention to be a greater theme in the coming months.

Who in the World is Next?

Latin America:
Most of the largest Latin American countries have experienced strong appreciation pressures on since the end of Q1 2009; some have responded by intervening aggressively in FX markets. What other Latin American governments may come to the table with capital controls similar to Brazil? Through October 26, the Chilean (CLP) and Colombian (COP) peso appreciated 19% and 17%, respectively, versus the dollar. The Peruvian new sol (PEN) is also a top performing EM currency, gaining nearly 10% this year. Mexico’s peso is one of the laggards in the region and capital inflows there are recovering slowly. Moreover, despite positive external factors, uncertainties around passing the 2010 fiscal budget and reforms in Mexico have kept the local currency without much investor support. Therefore, Mexico is not a candidate for any implementation of capital controls.

Chile is no stranger to capital controls, having imposed a 20% unremunerated reserve requirement on foreign loans from 1991-98. Chile’s foreign exchange regime is free floating; however, policymakers have intervened in the FX markets when the currency moved too far from macroeconomic fundamentals, most recently in 2008. Chilean authorities tend to let the markets know of their intentions well in advance, and their mechanisms are very transparent in length and quantity. For instance, until the end of the year, the central bank is currently selling the U.S. dollar on a daily basis (US$50 million a day) and the currency is considered to be near its ten-year moving average, in real terms. Thus, with the Chilean peso currently trading around 530, we believe Chile is still considerably above a level that would drive the government to intervene and/or introduce capital controls. As we highlighted in our regional outlook, RGE does not anticipate any kind of intervention unless the peso falls well below 500 and closer to the 450 level. Even then, we believe Chile would prefer intervening in FX markets and/or maintaining copper earnings abroad over outright capital controls.

Colombia is more likely to step up its actions against currency appreciation. Already the Colombian government pledged to leave roughly US$500 million in dividends from the state-oil company Ecopetrol overseas and sell local currency bonds domestically to compensate. But the government continues to hold off on implementing capital controls, perhaps acknowledging that such an action should be a last resort, especially since strong FDI rather than portfolio flows are driving the Colombian peso’s appreciation. Instead, after its policy meeting on October 23, the Central Bank of Colombia (Banrep) announced it would spend roughly US$1.6 billion to purchase dollars and peso-denominated government bonds. Given that inflation and interest rates are low and the economic recovery is likely to be slow, sterilizing the intervention is an option rather than a necessity at this point.

In Peru’s case, the central bank has stepped up the intervention over the last couple of months in order to contain currency appreciation rather than reverse it. Similar to Colombia, inflation and interest rates are low in Peru while the economy is growing well below potential. Therefore, sterilization costs are low and outright capital controls are not necessary. Moreover, because Peru is a heavily dollarized economy, managing U.S. dollar flows is key to maintaining macroeconomic stability.

Asia / Pacific:
Despite a flood of portfolio investments into many of the region’s asset markets since early 2009, Asia still needs foreign capital to stimulate investment and finance its current accounts. Therefore, facing a sluggish export recovery and a pegged Chinese renminbi, most countries have opted to contain currency appreciation via verbal and actual interventions to avoid losing competitiveness. Intervention in the foreign exchange market has led to record reserve growth of over US$70 billion in Q3 alone in emerging Asia ex-China. Although most Asian countries are expected to keep intervening amid some currency appreciation, several countries may impose restrictions on foreign currency transactions. Given buoyant equity markets, attractive carry trades and the U.S. dollar weakness, policy measures will not contain the impact of capital inflows on Asian currencies, meaning that some appreciation from the least trade-dependent countries is to be expected. Taiwan is the country where capital controls or new restrictions are most likely to be implemented.

Of developed Asia-Pacific economies, only Japan, Australia and New Zealand have resorted to verbal intervention so far. Australia views currency strength as a reflection of its economy’s resilience and is unlikely to officially intervene, especially after the failed intervention in October 2008. Monetary tightening could spark more inflows. Japan will continue to rely on verbal intervention to dampen yen appreciation, albeit less frequently than the previous pro-export administration, as a stronger yen will help rebalance the economy toward domestic demand. Meanwhile, New Zealand officials are more apprehensive that the kiwi’s strength may abbreviate the economy’s rebalancing away from debt-fueled domestic demand. A revival of carry trades that pushes the New Zealand dollar out of alignment with economic fundamentals could prompt a reprisal of 2007 when the Reserve Bank of New Zealand resorted to currency intervention.

The relatively open Asian Tigers are likewise unlikely to impose capital controls. Singapore and dollar-pegged Hong Kong will delay rate hikes and depend on FX intervention to contain currency appreciation. Taiwan may take a similar stance, especially since its currency is still competitive relative to South Korea and Japan. However, the Taiwanese government is considering the possibility of capital controls in the face of strong portfolio investment. RGE continues to believe that the Taiwanese government is likely to stick to intervening in the FX market, further adding to its US$330 billion in foreign exchange reserves.

Based on the pace of reserve growth, hot money (short-term portfolio inflows) again began flooding into China even as domestic monetary conditions have led to an appreciation of domestic real assets, especially property. China’s quasi dollar peg suggests inflows will persist. China never lifted pre-existing capital controls. Rather than impose further controls on inflows, China is expected to improve enforcement of existing measures and to continue encouraging capital outflows, both of government investment vehicles and more recently of retail investors through the revived Qualified Domestic Institutional Investment (QDII) program.

Low export dependence, reliance on energy imports, inflation risks and improving investment will allow South Korea, India and Indonesia to tolerate some currency appreciation despite continuing with FX intervention. These countries will be among the first ones in Asia to hike interest rates. But instead of capital controls per se, South Korea may use regulatory measures to mediate capital inflows by foreign investors and domestic borrowers and to check asset bubbles. India already has capital controls in place but may tighten restrictions on foreign institutional investors and external borrowings by companies if asset bubbles become a concern. Indonesia’s reliance on foreign capital for deficit financing will discourage capital controls. But in the case of excessive currency appreciation, Indonesia restrictions on currency transactions are a possibility.

Despite high export dependence, Malaysia and Thailand expect that delayed rate hikes and less attractive asset markets will allow them to contain currency appreciation largely by FX intervention. Malaysia maintained most of the capital controls imposed during the Asian crisis. In Thailand, dampened investor sentiment due to political instability and past capital controls will keep capital inflows modest. But Thailand may continue easing capital outflows to contain currency appreciation.

The Philippines will keep on engaging in competitive devaluation due to its dependence on remittances to drive economic growth. With capital controls already in place and a need for foreign capital to finance its current account deficit and build foreign reserves, the Vietnamese central bank may instead devalue and restrict currency transactions to manage its currency.

Europe, the Middle East & Africa:
The South African Reserve Bank has done little to curb the rand’s 25% gain YTD, resorting only to the occasional verbal intervention. Last week, the central bank had to issue a statement that it did not plan to “freeze” the currency. The central bank has allowed the currency to float, resulting in little change in foreign exchange reserves over the past year, despite an increase in South Africa’s SDR allocation. With its reliance on foreign capital to finance the country’s chronic current account deficit, capital controls are particularly unlikely. In the 2009-10 budget, the finance minister suggested loosening existing exchange controls. Given the sluggishness of South Africa’s economic recovery, the South African Reserve Bank will be slower to raise rates compared to some of its EM counterparts, potentially limiting the rand’s future climbs.

Russia has been steadily intervening in the FX market, lest the ruble climb too high. As such, its reserves have grown to US$420 billion by mid-October, despite the fact that Russia is spending the assets in its sovereign wealth funds. Prime Minister Putin has insisted that Russia would not impose controls on capital despite a doubling of Russian equities since the beginning of the year. In fact, Russian authorities continue to try to lure back foreign investors to its resource sector to maintain output.

Despite rumors of possible capital controls, the GCC governments did not impose new restrictions on capital in the wake of the financial crisis and the domestic credit squeeze. Doing so would have further impaired the regional economic union. Instead, government backstopping of the banking system and fiscal spending helped offset portfolio and direct investment outflows. Many countries, especially Saudi Arabia, continue to have significant restrictions on inflows to domestic equities, measures that cushioned asset markets. However, regulations to encourage direct investment are under consideration in the UAE, including the possible relaxation of the requirement that Emiratis maintain a majority stake in any project. As with other less liquid frontier economies, these countries are still seeking to attract capital, especially through debt markets, as evidenced by Dubai’s imminent return to the credit markets.

Nordics:
In contrast with the recent experiences of Brazil and certain Asian countries, which are taking steps to limit excessive capital inflows, Iceland has been attempting to stop outflows through strict capital controls, implemented in the wake of the country’s banking system collapse in late 2008. Payments related to exports and imports of goods are allowed, but capital transactions are controlled.
The controls have served a number of purposes. For one, they have allowed the central bank to lower the policy rate to 12%, down from the 18% peak in October 2008, without destabilizing the currency. Two, the controls provided a stable environment to restructure the island’s failed banks.

The general idea behind the controls was to give the economy time to heal, but as history has shown, capital controls can at best provide a temporary respite. Over time, people find ways to circumvent the controls. In August 2009, the central bank announced plans to gradually remove the controls over the next two to three years. The danger, of course, is that even when controls are removed, capital inflows will not return. However, as economist Willem Buiter noted in February: “The example of Malaysia, which imposed capital controls during the Asian crisis of 1997 suggests that foreign capital either has a short memory or can be convinced.”