Analysis: South America sees new currency wars despite intervention cost

MEXICO CITY Mon Dec 17, 2012 4:40pm IST

A man walks past a board showing the Real-U.S. dollar exchange rates in Rio de Janeiro, in this file photo taken May 16, 2007. REUTERS/Bruno Domingos

A man walks past a board showing the Real-U.S. dollar exchange rates in Rio de Janeiro, in this file photo taken May 16, 2007.

Credit: Reuters/Bruno Domingos

MEXICO CITY (Reuters) - Currency market intervention has cost South America's central banks more than $13 billion in the last 2-1/2 years but they are likely to maintain their defenses against hot money inflows if a fresh rush of cheap money sparks another round of currency wars.

Latin American finance ministers meeting in Chile on Friday said monetary easing in developed countries could hurt their export competitiveness by pushing up currencies in the region - a problem they have been wrestling with since the global financial crisis.

Bank of England Governor Mervyn King warned last week that a 2013 might see a growing number of countries deliberately weakening their currencies to offset the impact of a slow global economy.

Central bank data shows Brazil, Chile, Colombia and Peru have bought $135 billion in dollars to help keep a lid on their currencies since mid-2010, just before the U.S. Federal Reserve announced its last round of monetary easing, dubbed QE2.

The Fed is now well into QE3, and Chilean Finance Minister Felipe Larrain said Wednesday's decision to further bolster U.S. asset purchases was a "source of worry" for all emerging markets with healthy growth and floating exchange rates.

Low interest rates in advanced economies encourage investors to seek higher returns in faster-growing emerging markets such as Latin America, but accelerating capital inflows put unwelcome upward pressure on currencies, making exports more expensive.

"This is the third round of QE and we are starting at a level where the FX rates are a lot stronger," said Jefferies Latin America strategist Siobhan Morden, who sees central bank intervention as the biggest concern for investors in local debt.

"It clearly places more stress on policymakers in how to manage this liquidity."

Low inflation in Peru, Chile and Colombia and healthy budget balances give central banks plenty of leeway to keep buying dollars, adding to already-swollen reserves, analysts said - a contrast to the last round of QE, when many countries were struggling with inflation fanned by a V-shaped recovery.

Most dollar purchases so far have been offset by market operations, such as issuing bonds, to mop up or sterilize excess liquidity - but these operations have a high cost due to the gap between very low U.S. yields and higher local interest rates.

Calculations by Thomson Reuters put the accumulated opportunity cost of currency purchases from mid-2010 to November 2012 at about $13.9 billion, more than $11 billion in Brazil alone, without taking currency fluctuations into account.

Brazil's cost reflects benchmark interest rates which were as high as 12.5 percent in mid-2011, before an aggressive easing cycle which slashed them to a record low 7.25 percent, while U.S. official rates were - and are - close to zero.

Intervention has cost Chile, Peru and Colombia between $500 million and $1 billion each, according to estimates based on central bank data on reserve asset returns, or local and U.S. market interest rates were not.

DIFFERENT STROKES

Officials attending the Community of Latin American and Caribbean States (CELAC) meeting in Chile did not come up with a joint solution on how best to handle hot money flows, but agreed they were a major challenge to the region.

Brazil has slapped strict controls on foreign investment and intervened heavily in markets, while the Andean nations have largely eschewed capital controls and analysts expect they will continue to rely on market intervention in the future.

While Brazil and Chile have scaled back or paused their interventions this year, Peru and Colombia remain very active in the market - despite having an even higher interest rate gap with the United States than they did in mid-2010.

Colombia has picked up the pace of currency interventions, buying 18.5 percent more dollars in the 11 months to November than in all of 2011, and traders are also wary of Chile, where the peso has appreciated 9.5 percent this year.

Peru has bought a record $13 billion so far in 2012 and has also limited banks' ability to make big bets in the currency market with tighter rules on forwards.

Subdued inflation in Peru, Colombia and Chile means those central banks have less reason to worry about the impact of liquidity created by currency market intervention, which depends on demand for local paper to mop up the extra funds.

"Peru will likely increase its intervention and it has the scope to do so," said Nomura Securities economist Benito Berber.

Compared to August 2010, just before the Fed flagged its QE2 easing, the Peruvian sol is up 9 percent, the Chilean peso up 5 percent and the Colombian peso up 1 percent, although Brazil's real is weaker thanks to concerted official efforts.

Brazil confused many by intervening to strengthen the currency in December after a sharp weakening when third quarter growth came in well below expectations.

Policymakers have indicated the central bank wants the currency to stabilize somewhere between 2.0 and 2.1 per dollar, and it is unlikely to tolerate a sharp strengthening.

Economist Intelligence Unit analyst Anna Szterenfeld said Brazil was likely to face less upward currency pressure given recent rate cuts there, compared with rate increases during the Fed's QE2 period. "Some yield-seeking investors - Brazil would call them speculators - won't find Brazil as attractive as they did then," she said.

(Additional reporting by Silvio Cascione in Sao Paulo, Anthony Esposito and Alexandra Ulmer in Santiago, Nelson Bocanegra and Jack Kimball in Bogota, Michael O'Boyle in Mexico City, Terry Wade and Mitra Taj in Lima and Jeoff Hall from IFR; editing by Kieran Murray and Todd Eastham)

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