Latin America: Look Out For Capital Controls!
Massive capital inflows across South America raise the spectre that authorities throughout the region are about to impose capital controls. Support for exporters appears to be the main reason for such intervention, but fears over a rapid withdrawal of ‘hot money’ in the event of another ‘double-dip’ also appear to be a factor.
Risk Watchdog believes such concerns are not without grounding, with recent trading seeing the Chilean IGPA and Colombian IGBC equity indices hitting all-time highs, while the Peruvian and Brazilian central banks have been forced to intervene in foreign exchange markets on a near-daily basis in an attempt to stem the ongoing appreciation of their respective currencies. With regional growth set to significantly outperform a host of other emerging and developed markets in 2010 and 2011, and the normalisation of monetary policy likely to boost the carry on offer in many Latin American markets, risks that short-term capital inflows will lead to an even more pronounced appreciation of local currencies loom large.
In my view, there are four key factors which might cause authorities to impose more pronounced capital controls going forward:
1. Recent History/Statements: Risks of capital controls being instituted is greater within those states that have either pursued such measures in the past, or where key policy makers have made recent statements indicating that such policies cannot be ruled out.
On this metric, Brazil, Colombia and Peru stand out as particularly at risk, given Brazil’s recent (October 2009) history and comments by both politicians and central banks in Colombia and Chile.
2. Political Pressures: The risks of capital controls being imposed increases if exporters possess significant political power, particularly when an election is approaching.
Here Peru and Brazil stand out, with authorities in both states set to come under significant political pressure from domestic exporters who are concerned about losing competitiveness over the coming quarters. That the export sectors in both of these states are likely to see a marked deterioration in export revenues through 2011 concomitant with slowing demand from China (a scenario which I do not believe authorities throughout Latin America have adequately considered), will only increase such demands.
3. Composition of Financial Account: The greater the proportion of portfolio inflows (i.e. ‘hot money’) in the financial account, the greater the risk of capital controls being introduced.
As FDI accounts for the lion’s share of financial account inflows in Peru, Chile and Colombia, according to latest balance of payments data, the willingness of authorities to stem the rise of currency appreciation through punitive capital controls is significantly lower (and generally a reflection that any appreciation is being driven by long-term growth potential rather than speculative cash inflows). In Brazil, however, portfolio inflows continue to dominate the financial account, with latest data from the Banco Central do Brazil showing net portfolio investment coming in at US$14.7bn in Q210, compared to only US$3.8bn in FDI and US$3.5bn in other investment.
4. Concerns Over Asset Bubbles: Elevated concerns that foreign capital inflows are feeding into unsustainable asset bubbles increases the risks of authorities imposing controls.
While it is often difficult to ascertain the degree to which domestic policy makers are concerned about potential asset bubbles, fears in Chilean and Colombian financial markets seem to have been growing in recent weeks, as their respective FX and fixed income markets have continued to hit new record highs amidst global headwinds. Although the underlying fundamentals of both economies are certainly sound, policy makers are becoming increasingly concerned about what impact a marked leg down in global risk sentiment could have on capital outflows through the medium term. Should authorities in either state begin to see signs that portfolio inflows are feeding into larger asset bubbles throughout the country, the risks of administrative measures to help redirect the flow of foreign capital into the economy would rise precipitously.
Taken together, this analysis implies that the risks of such measures being introduced are greatest in Brazil and Peru, followed by Colombia, with Chile the least likely to embark on such a path.
Mitigating Scenarios
While risks of more drastic capital controls are rising across the region, there are several mitigating factors. Firstly, monetary policy authorities throughout the region have not as of yet adequately factored in the looming slowdown in external demand in H210 and 2011. As the Chinese, U.S. and eurozone economies experience a pronounced leg down in growth through the latter months of 2010 and 2011, and export revenues begin to fall, the majority of South American currencies should begin to weaken, which would in turn ease pressures on central banks to impose capital controls. While this does not preclude the imposition of such measures, it does imply such policies will be short term in nature, and reversed relatively quickly once growth starts to cool.