Waging the currency war

HAVING quickly shaken off the world recession, many countries in Latin America are prospering again. The region’s economies grew by an average of 6% last year, according to a preliminary estimate from the United Nations Economic Commission for Latin America and the Caribbean. This strong performance, linked in large part to the global commodity boom, has attracted big inflows of foreign cash. With that has come a familiar problem: the region’s currencies have soared in value against the dollar (see chart), making life uncomfortable for Latin American manufacturers. They find themselves priced out of export markets or struggling to compete with cheap imports. Worried governments are launching a battery of measures to try to restrain the value of their currencies. Will they work?

This month alone Chile announced it would buy $12 billion of foreign reserves in 2011 and Brazil began requiring its banks to cover 60% of their bets against the dollar with deposits at the Central Bank that will attract no interest. Peru is buying dollars, too, and similarly extended reserve requirements for banks’ sales of foreign exchange. Central banks in Mexico and Colombia are intervening to buy dollars. Chile’s announcement prompted an immediate fall in the peso, and other currencies have temporarily stabilised, but there is no guarantee that these measures will be effective in the medium term.

In part, stronger currencies reflect Latin America’s stronger economies. The commodity boom plays to the region’s comparative advantage: China and India are gobbling up Brazilian soyabeans and iron ore, Chilean copper and Peruvian silver. Brazil and Colombia have both made big oil discoveries. These countries all have fairly sound economic policies, and their financial systems are deepening. With money cheap and returns poor in the rich world, Latin America has become a tempting destination for investors. Guido Mantega, Brazil’s finance minister, has blamed the real’s strength and his country’s rising import bill both on loose monetary policy in the United States and China’s refusal to allow the yuan to appreciate.

But this is becoming too much of a good thing. The real has appreciated by 38% against the dollar over the past two years, for example. Overall, Latin America posted a current-account surplus of 1.6% of GDP in 2006; this year it is likely to post a deficit of similar magnitude, according to the IMF. There are other signs of overheating: inflation for non-tradable products in Chile is 6.4% and Brazilian wages are increasing at double-digit rates.

Affected businesses are howling. Chile’s wineries need an exchange rate of 530 pesos to the dollar (at the start of this month it was at 464) to be profitable, according to René Merino, who represents the industry. In Brazil, São Paulo’s industrialists’ association claims that “excessive imports” of consumer goods have led to a “dizzying process of deindustrialisation”, costing 46,000 manufacturing jobs and $10 billion in lost output in the first nine months of 2010.

Uncomfortably strong currencies and overheating economies pose an excruciating dilemma for policymakers. If central bankers raise interest rates to curb inflation, they risk driving up the currency further. But if their interventions in the foreign-exchange market drive the currency down, that may boost inflation.

In Brazil overheating has been aggravated by official tardiness in withdrawing the fiscal stimulus applied during the recession. Brazil’s new government has said it will curb its fiscal deficit, though many economists are sceptical as to how deep budget cuts will go. Mr Mantega now accepts that expansionary fiscal policy has helped drive up interest rates and the currency, something he previously denied.

To ease the pressure on currencies, governments are shifting some of their assets abroad. Colombia has urged Ecopetrol, its state oil company, to refrain from repatriating its international profits. Peru’s Congress is considering a bill that would raise the cap on foreign investment by pension funds, from 30% to 50% of their assets. Brazil recently authorised its sovereign-wealth fund to trade currency derivatives.

They are also reaching for less orthodox tools. Brazil introduced a 2% tax on the purchase of bonds by foreigners last year, and then raised it to 6%. Colombia and Peru both tax interest payments to non-residents. Colombia is considering whether to reintroduce a measure to require foreign buyers to deposit 30% of the price of their financial investments in the country for a year at its central bank with no interest.

Measuring the effectiveness of these tools is hard, since nobody can know what the exchange rate would be in their absence. Bankers worry that they might work too well. “Be careful what you wish for,” says Marcelo Carvalho, an economist at BNP Paribas in São Paulo. “If you try too hard to scare investment away, you might succeed.” Reforms, often neglected, of taxes, infrastructure, red tape and labour laws would help manufacturers compete. Nevertheless, trying to scoop the froth from the commodity boom looks justified in the struggle to ensure more balanced long-term growth.