Last week saw a sell off in some emerging market currencies and whilst this may simply have been profit taking attributable to some large hedge funds it did coincide with the imposition of a tax on portfolio inflows in Brazil. The tax dented sentiment as it quickly fuelled speculation that it would be followed elsewhere, especially in countries that had seen rapid FX appreciation.
The BRL is one of the best performing currencies this year against the USD whilst the stock market has surged on strong capital inflows. The huge increase in USD liquidity globally and substantial improvement in risk appetite has fuelled strong capital inflows into Brazil especially as the country has proven to be one of the most resilient during the crisis.
Although on the margin the tax will have a negative impact on speculative flows into Brazil it is unlikely to have a lasting impact. Previous such measures have done little to prevent further appreciation. The BRL is clearly overvalued by around 25-30 at present, but the tax in itself will not be sufficient to result in a move back to “fair value”.
At best it may act a temporary break on currency appreciation and could limit the magnitude of further gains in the real but this could be at the cost of distorting resource allocation and market functioning. The longer term solution is to enhance productivity but this will not help in the interim. The tax may make investors a little more reluctant to pile into Brazilian assets, which is what the authorities will desire but already the BRL is back on its appreciation path suggesting a short lived reaction.
Other countries that could follow include South Africa, Turkey or South Korea but South Africa has already denied that it has any plans to move in this direction. In South Korea’s case the central bank has chosen to intervene in currency markets to prevent the further strengthening in the won but that also has implications for sterilizing such flows limiting the extent that intervention can be carried out.
The bottom line is that the broad based improvement in risk appetite is proving to be a strong driver of capital flows into emerging markets and the reality is that many emerging economies such as Brazil and many in Asia have been much more resilient than feared.
Although there is clearly a limit on the extent that these countries want to allow their currencies to strengthen versus USD the upward pressure will continue, leading to more FX intervention and potential imposition of taxes or restrictions such as implemented in Brazil. Despite this the outlook for most emerging currencies remains positive and the authorities will face an uphill struggle.