A report by the Inter-American Development Bank suggests that fast-growing Latin American economies will need to implement macro-prudential policies to counter exchange rate appreciation. The use of these tools which include capital controls, liquidity regulations and capital requirements and provisions to combat the currency appreciation caused by high levels of capital inflows is contentious and was the topic of much debate at the IDBs annual meeting in Calgary last month.
"External funding at low cost under the present circumstances, and despite our tight prudential rules, creates incentives to increase risk taking and can end up in asset price distortions vis-à-vis the exchange rate"
Alejandro Izquierdo, co-author of the IDB report, One region, two speeds challenges of the new global economic order for Latin America and the Caribbean, told Euromoney that avoiding "excessive exchange rate appreciation... will require very good macro-economic management to make sure that you dont have overheating". Izquierdo says that monetary policy alone will be ineffective in combating currency appreciation in countries that the report designates as the faster-growing "Brazil cluster" because raising interest rates would increase capital inflows from abroad, thereby putting pressure on the exchange rate.
The reports "Brazil cluster" is essentially the southern, commodity-exporting countries whose exports are aligned to other emerging markets, notably China. They are distinct from the slower-growing "Mexican cluster" of largely central American and Caribbean states that are less commodity-rich and whose exports are aligned with industrial economies, notably the US.
It is not just the sheer volume of recent capital inflows that are the source of the problem, according to Izquierdo. Capital inflows into Latin America were $266 billion in 2010 and the region has doubled its share of global flows to emerging markets from 12% in 2006 to 25% in 2009. There has also been a change in the type of flows: in 2006 63% of total capital flows to the seven biggest Latin American economies were in the form of foreign direct investment, whereas by 2009 FDI was 31% of capital inflows, with 69% being portfolio inflows. Research suggests that FDI causes less appreciation of the host currency and is longer-term in nature.
Juan Carlos Echeverry, finance minister of Colombia, the regions newest investment-grade country, says that while capital inflows are a problem he doesnt believe that capital controls are an effective solution. "When I heard about QE2 back at the September IMF and World Bank [meetings]... I was then afraid because [I realized] we are going to get this inflow of capital that will affect stock prices, housing prices and so on. Thats when we decided to do something to combat inflows to avoid excessive appreciation."
Echeverrys solution was to remove distortion in Colombias financial system. "We introduced a package of measures that avoided capital controls thats the easy way. Instead we solved distortions." For example, Colombia had a withholding tax for domestic borrowing but not one for foreign borrowing: "We were creating an incentive to borrow from abroad, so we evened out those two withholding taxes," he says.
According to Echeverry, solving distortions such as these led to an exchange rate depreciation of between 5% to 7% against the US dollar and the Colombian peso also devalued against its Latin American peers.
Mario Bergara, president of the Bank of Uruguay, thinks there is a need for macro-prudential measures: "We are facing the challenges of successful emerging markets in Latin America. Monetary policy is not enough, a broader set of policies [is needed]."
Bergara expressed support for Brazil, which came under implied criticism for using macro-prudential policies instead of allowing a free-floating exchange rate: "Brazil is attracting a lot of FDI but also a lot of short-term capital that poses serious challenges in the short and medium run. Perhaps [Uruguay] being in the cluster of Brazil is helping us because Brazil attracts so much short-term capital that countries like Uruguay are not that attractive for that kind of capital."
Luiz Pereira da Silva, deputy governor of the Central Bank of Brazil, was unrepentant about recent Brazilian policy, which includes increases in taxes on foreign investments as well as upticks in banks reserve requirements and equity capital ratios. He says that trying to smooth currency appreciation through building up reserves was insufficient (Bradesco predicts Brazils reserves will reach $350 billion this year, the worlds fourth largest). "No matter how much the central bank intensifies the stabilization of its reserve accumulation, there is always a portion of it that remains in the market," he says. "This portion has been increasing in the past few months, leading to a significant expansion of our credit market.
"External funding at low cost under the present circumstances, and despite our tight prudential rules, creates incentives to increase risk taking and can end up in asset price distortions vis-à-vis the exchange rate. This is exactly the context in which macro-prudential measures should be understood. They have been implemented since 2010 precisely with the purpose of ensuring the solvency, robustness and stability of the national financial system."