Concerning Capital Inflows

By Manoj Pradhan

China's hike in banks' reserve requirements today served notice to the G20 leaders' meeting later this week that capital inflows remain a major problem for EM policymakers. Brazil Finance Minister Mantega's ‘currency war' tag has continued to stay prominent in the lead-up to the G20 summit and certainly in discussions in the media. If currency tensions are indeed frustrating EM policymakers, then perhaps the blunt tools of interest rate cuts could be called upon in the future. This would represent an important turning point in EM dynamics for growth, inflation and currency movements. However, if a currency ‘war' is not a huge concern for EM policymakers, then the use of only FX interventions and possibly mild capital controls could be enough to alleviate EM concerns. And this is indeed the story that seems to coalesce from the views of our EM economics teams. Rather than aggressively fighting a currency war with every tool available, EM central banks seem to be keeping the blunt tool of policy rate cuts away from the skirmish so far. Rather, they seem to prefer the well-directed tool of FX intervention to soak up capital inflows and consequently increase FX reserves.

But which exchange rate to consider? With QE2 emanating from the US, EM and DM currencies have appreciated vis-à-vis the US dollar. However, the effective appreciation of EM currencies against a broader basket of currencies has been much smaller (see EM Macro Strategy Update: Considerations on Currencies, October 15, 2010).

With AXJ economies tied closely to China through their trade links, and the Chinese currency virtually pegged to the dollar (modest appreciation aside), AXJ economies are effectively tied to the USD/CNY peg. Latin America also has close trade links with the US and growing ties to China. However, the situation is different for some countries in the CEEMEA region. For the CEE economies, the US dollar is secondary in importance to the euro. In fact, since the dollar affects imports (specifically commodity imports) more than exports, some appreciation against the dollar is not unwelcome.

QE blocs: Enhanced capital flows to emerging markets courtesy of QE2 have produced varying degrees of discomfort in the EM world. In a past note, we suggested that QE2 would create two ‘blocs' among EM economies (see "QE20", The Global Monetary Analyst, October 13, 2010). The first bloc, with economies at risk of overheating, would allow currencies to appreciate and dampen domestic growth and inflation. The other, with fewer concerns of overheating, would find currency appreciation unwelcome. This second bloc would likely act to stem the appreciation, and end up stimulating domestic growth. Getting a hands-on perspective from our EM economics teams, we find that this split is indeed borne out. The collective wisdom of our teams suggests that the economies that find currency appreciation unwelcome are also economies where overheating risks are small. On the other hand, economies at risk of overheating do not find the currency appreciation as offensive (with the notable exception of China, as discussed below), as policymakers there welcome the dampening effect that the appreciation has on domestic growth and inflation.

In economies at risk of overheating where domestic demand is strong and the central bank allows currency appreciation, US imports will likely become cheaper. In economies where currency appreciation is resisted, domestic demand is likely to get a boost, and this should increase the demand for all imports, including imports from the US. This is what we called a win-win situation for the US in our QE20 piece.

As always, China is different: China finds the enhanced pressure on its currency highly unwelcome and it will likely allow only a slow and steady appreciation. However, China's highly effective capital and credit controls imply two things: i) there really has been no impact of QE2 on the currency, but FX reserves have probably soaked up a large quantity of capital inflows; and ii) the domestic economy has not received an additional stimulus from QE2. With Chinese growth at 10% for 2010 and 9.5% in 2011, one can hardly say that China should grow faster to generate import demand. In short, China does not fit our dichotomy as it resists currency appreciation on the one hand but maintains firm control over domestic financial conditions and the economy on the other.

The policy response: The policy response from EM economies to the signals about QE2 in the US sent since August is quite varied, but a majority of central banks in the EM world have kept policy unchanged since then. A handful have responded by postponing hikes (the central banks of Peru and Poland have pushed rate hikes further out to keep the currency from strengthening further), while the SARB has actually eased policy outright (and further easing appears to be on the cards - our economists are forecasting a 50bp cut, see South Africa: Rate Call Change - We Expect a 50bp Cut, November 1, 2010). Some central banks that face strong domestic growth have even tightened policy despite the risk that such measures will invite even more capital inflows and put additional pressure on currency values.

Digging deeper: Overheating economies: A large majority of EM economies have shown strong growth. Unsurprisingly, AXJ economies feature prominently here along with Brazil, Chile and Peru from Latin America and Turkey, Israel and Poland from the CEEMEA regions. A smaller number of these strongly growing countries, however, have inflation concerns. This latter group includes India, Indonesia, China, Korea, Brazil, Peru and Poland. Clearly, this bloc would prefer some help in dampening domestic growth, and some currency appreciation might not be unwelcome. We illustrate that these overheating economies are also where central banks are not extremely concerned about currency appreciation (with the important exceptions of China discussed earlier and Brazil discussed below). However, as the cases of Poland and Peru show, even inflation concerns have sometimes been subordinated to keep in check excessive appreciation of the currency. In the case of Poland, inflation concerns are likely to win out fairly shortly, according to our Poland economist, Pasquale Diana.

Brazil clearly dislikes its stronger currency, has been intervening aggressively in FX markets and has quickly raised taxes on foreign investments in local fixed income products. The postponement of rate hikes in Brazil, however, can be traced back to its own slowdown earlier in the year rather than to a growing probability of QE2.

Digging deeper: No overheating: In economies where growth has either not led to inflation and even where growth has been weak with inflationary concerns, the EM emphasis on growth clearly shows because of the desire of these economies to keep their currency from appreciating. Most economies in this category have either intervened in FX markets or have stayed put on monetary policy. Thus, either through accumulating FX reserves leaking into the economy or through the postponement of monetary tightening, economic growth is likely to benefit from a tailwind.

The economies where growth is weak and inflation risks are present (Romania and Hungary) are worth noting. As noted before, these economies are more closely tied to the euro and might actually welcome an appreciation against the dollar, given the asymmetric effects on imports and exports. They do not therefore face the same dilemma as most other EM economies.

FX intervention: Central banks appear to be less reluctant to get involved in FX intervention. The bulk of EM central banks are involved in at least some FX intervention. Further, half of that pack have been intervening quite aggressively in currency markets, but even then with limited results. The difference in the way policymakers seem to have used broad monetary policy and FX intervention to deal with QE-related inflows could be explained in three ways: i) monetary policy is seen as a blunt instrument with broad effects, while FX intervention is seen as a targeted tool best equipped to deal with an FX problem; ii) FX interventions are a less public way of dealing with capital inflows, compared with the public attention that usually accompanies monetary policy changes and capital controls; and iii) EM central banks view FX policy and reserves policy as being distinct, and are accumulating reserves in excess of levels that could ostensibly be used for the defence of the currency.

Different strokes: Different emphases on each of these explanations apply to EM economies. For example, the objectives of FX intervention in Turkey appear to be oriented towards increasing the size of the reserves. Brazilian FX interventions, in line with its aggressive rhetoric and milder capital controls, have probably been aimed at keeping the currency from appreciating. And finally, in Israel, FX interventions have been used to stifle the impact of policy rate hikes on the currency. In all three cases, however, FX interventions have not been entirely successful in keeping the currency from appreciating.

Summary: The extent to which the ‘currency war' debate has been ramped up in the media does not gel with the feedback from our EM economics teams. In general, EM central banks appear to be unwilling to take strong, aggressive action in the form of postponing policy tightening or cutting rates outright (with the notable exceptions of the central banks of Peru and Poland for postponed rate hikes, and the SARB for outright easing). Rather than fighting any such ‘currency war', EM central banks appear to be dealing with the very familiar three-way trade off between capital inflows, exchange rate concerns and monetary policy independence - the trilemma (see "No ‘Currency War'...Yet", The Global Monetary Analyst, October 6, 2010). Central banks seem far less reluctant to use FX intervention. In fact, FX intervention is likely being used as a better directed tool to temper FX appreciation and build up FX reserves (in some cases) at the same time.

The feedback from our EM teams suggests that QE is indeed splitting the EM world into two broad blocs. Economies with strong growth and overheating concerns appear to be more willing to accept currency appreciation in order to dampen domestic growth and inflation. Countries where growth is weak, however, seem to be less tolerant of currency appreciation. The desire there to keep the currency from appreciating is likely to lead to higher domestic growth either through newly accumulated FX reserves leaking into the economy or via inaction (or less tightening, or even easing) on the policy front.

Source: MorganStanley
www.morganstanley.com