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Currency wars loom as capital flows expose the weak
Will the emerging market rout be different this time? The fear is it won't
The Russian central bank has pledged 'unlimited intervention' to defend the rouble Photo: Getty
By Szu Ping Chan
9:30PM GMT 01 Feb 2014
19 Comments
Defending a currency is a tricky business. Take Thailand in 1997, where massive overspending left it with a huge current account deficit and high interest rate, inflated to protect a currency pegged to the dollar.
But markets are never forgiving and speculators soon attacked the baht, believing poor economic fundamentals left the country vulnerable to shocks. Soon, much of Asia was knocking on the International Monetary Fund’s door and the contagion quickly spread. Russia was next, followed by perennial basket-case Argentina and even Brazil.
More than 15 years later, history could be about to repeat itself. Turkey’s 4.25 percentage point interest-rate hike last week highlighted its dire situation, and with a current account deficit and inflation both running at 7pc, the country also has an uncomfortable dependence on short-term funds.
So-called “hot money” underwrites more than 80pc of its trade deficit, leaving the country painfully exposed to the US Federal Reserve’s tapering of asset purchases.
And the dominos are lining up. Argentina gave up trying to support the peso last week, resulting in a double-digit fall against the dollar, while Russia has stormed into action, pledging “unlimited” intervention to prop up the rouble.
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Talk of capital controls is now increasing, especially in Turkey, which has no more aces up its sleeve.
Even the World Bank is becoming a fan. In its most recent Global Economic Perspectives report, the Bank highlighted the “impossible trinity” of achieving autonomy over monetary policy, stable exchange rates and full capital account openness. In short, it’s better to have some influence over capital movement than none at all.
But Domingo Cavallo, Argentina’s former economy minister, insists capital controls do little to prevent outflows. In the face of massive capital flight, Cavallo introduced capital controls in Argentina in 2001 – known as el corralito, or little fence.
“If you are very strict in trying to implement capital controls, it’s very likely you will be creating a black market for dollars, particularly in countries that have a history of inflation,” he told The Sunday Telegraph.
“People in those countries are accustomed to using foreign currency to protect their savings. That is clearly the case in Argentina. People will find foreign exchange in the informal market, where controls have created a gap of 60pc between the exchange rate in the legal and black market.”
Others describe capital controls as “suicide”. “When you start defending a currency, you put yourself on a slippery slope,” said Marcus Ashworth, head of fixed income at Espirito Santo. “The only way to defend a currency is wait until the market corrects itself, then intervene. You have to go with the tide, not against it. You don’t stand there like King Canute trying to stop it coming in.”
Cavallo also said it is too early to say whether recent pockets of emerging market (EM) stress will spread.
“The situation is different in different countries,” he said. “Some like Turkey have very large current account deficits, and therefore reaction of the central bank in increasing interest rates to dampen the effects of outflows is considerable. In EMs that do not have very large current account deficits, I think the situation will not become that critical.
“In cases like Argentina and Venezuela, we cannot blame the global situation. 99pc of what is happening in these economies relates to the crazy policies implemented in the last 10 years.”
Julian Mayo, chief investment officer at Charlemagne Capital, which specialises in emerging markets, agrees. “The situation is very different to 1997, when currencies were largely pegged, resulting in worsening external balances, and countries had large amounts of foreign currency debt,” he said. “This time, currencies have already adjusted, by 30pc in the case of India and Brazil, and this has started to result in lower trade deficits.”
Others are not so optimistic. “EMs today have a big [chunk] of the world economy,” says Marcelo Ribeiro, a strategist at Pentágono Asset Management. “As they compete to raise rates to defend their currencies, the collective effect will be much worse than Fed tapering.”
For Ribeiro, there is only one ending: devaluation. “The script is always the same,” he said. “Central banks sharply raise interest rates. Governments then cut extensively because markets demand it.
“It doesn’t work, so they put in capital controls. Stock markets fall by double digits and the government relents. Then what happens is a big devaluation and destruction of wealth in EMs and developed countries will take back the money.”
Ribiero believes China, the world’s second-largest economy, is not immune. “What worries me more is that people still think that China is different, that it can maintain strong growth when all around her is imploding. This is impossible.
“The four most dangerous words in financial markets is 'this time is different’. Unfortunately the wealth built in EM in the last 10 years will be shaved by between 50pc and 60pc. That’s how a bubble ends.”
Will the emerging market rout be different this time? The fear is it won't
The Russian central bank has pledged 'unlimited intervention' to defend the rouble Photo: Getty By Szu Ping Chan
9:30PM GMT 01 Feb 2014
19 Comments Defending a currency is a tricky business. Take Thailand in 1997, where massive overspending left it with a huge current account deficit and high interest rate, inflated to protect a currency pegged to the dollar.
But markets are never forgiving and speculators soon attacked the baht, believing poor economic fundamentals left the country vulnerable to shocks. Soon, much of Asia was knocking on the International Monetary Fund’s door and the contagion quickly spread. Russia was next, followed by perennial basket-case Argentina and even Brazil.
More than 15 years later, history could be about to repeat itself. Turkey’s 4.25 percentage point interest-rate hike last week highlighted its dire situation, and with a current account deficit and inflation both running at 7pc, the country also has an uncomfortable dependence on short-term funds.
So-called “hot money” underwrites more than 80pc of its trade deficit, leaving the country painfully exposed to the US Federal Reserve’s tapering of asset purchases.
And the dominos are lining up. Argentina gave up trying to support the peso last week, resulting in a double-digit fall against the dollar, while Russia has stormed into action, pledging “unlimited” intervention to prop up the rouble.
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Talk of capital controls is now increasing, especially in Turkey, which has no more aces up its sleeve.
Even the World Bank is becoming a fan. In its most recent Global Economic Perspectives report, the Bank highlighted the “impossible trinity” of achieving autonomy over monetary policy, stable exchange rates and full capital account openness. In short, it’s better to have some influence over capital movement than none at all.
But Domingo Cavallo, Argentina’s former economy minister, insists capital controls do little to prevent outflows. In the face of massive capital flight, Cavallo introduced capital controls in Argentina in 2001 – known as el corralito, or little fence.
“If you are very strict in trying to implement capital controls, it’s very likely you will be creating a black market for dollars, particularly in countries that have a history of inflation,” he told The Sunday Telegraph.
“People in those countries are accustomed to using foreign currency to protect their savings. That is clearly the case in Argentina. People will find foreign exchange in the informal market, where controls have created a gap of 60pc between the exchange rate in the legal and black market.”
Others describe capital controls as “suicide”. “When you start defending a currency, you put yourself on a slippery slope,” said Marcus Ashworth, head of fixed income at Espirito Santo. “The only way to defend a currency is wait until the market corrects itself, then intervene. You have to go with the tide, not against it. You don’t stand there like King Canute trying to stop it coming in.”
Cavallo also said it is too early to say whether recent pockets of emerging market (EM) stress will spread.
“The situation is different in different countries,” he said. “Some like Turkey have very large current account deficits, and therefore reaction of the central bank in increasing interest rates to dampen the effects of outflows is considerable. In EMs that do not have very large current account deficits, I think the situation will not become that critical.
“In cases like Argentina and Venezuela, we cannot blame the global situation. 99pc of what is happening in these economies relates to the crazy policies implemented in the last 10 years.”
Julian Mayo, chief investment officer at Charlemagne Capital, which specialises in emerging markets, agrees. “The situation is very different to 1997, when currencies were largely pegged, resulting in worsening external balances, and countries had large amounts of foreign currency debt,” he said. “This time, currencies have already adjusted, by 30pc in the case of India and Brazil, and this has started to result in lower trade deficits.”
Others are not so optimistic. “EMs today have a big [chunk] of the world economy,” says Marcelo Ribeiro, a strategist at Pentágono Asset Management. “As they compete to raise rates to defend their currencies, the collective effect will be much worse than Fed tapering.”
For Ribeiro, there is only one ending: devaluation. “The script is always the same,” he said. “Central banks sharply raise interest rates. Governments then cut extensively because markets demand it.
“It doesn’t work, so they put in capital controls. Stock markets fall by double digits and the government relents. Then what happens is a big devaluation and destruction of wealth in EMs and developed countries will take back the money.”
Ribiero believes China, the world’s second-largest economy, is not immune. “What worries me more is that people still think that China is different, that it can maintain strong growth when all around her is imploding. This is impossible.
“The four most dangerous words in financial markets is 'this time is different’. Unfortunately the wealth built in EM in the last 10 years will be shaved by between 50pc and 60pc. That’s how a bubble ends.”
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