Efforts to stem FX inflows are futile

WHEN Brazil introduced a tax on capital inflows last month, it was a clear sign that governments are becoming increasingly concerned about the impact on their economies and on their currencies of a weakening dollar, and of foreign investors piling into their stock markets and bonds in search of higher yields.<br /><br />Other emerging nations have since followed suit, erecting defences to protect themselves as the dollar&rsquo;s decline erodes their international competitiveness. Taiwan stopped foreign investors from placing money in short-term time deposits, in a bid to prevent speculative hot money inflows. <br /><br />Plenty of other emerging economies are eyeing controls. Indonesia&rsquo;s central bank last week threatened to restrict foreign ownership of short-term debt while Russia is also considering re-introducing capital controls, which were scrapped back in 2006. South Korea announced measures on Monday aimed at tightening control over FX liquidity. <br /><br />It&rsquo;s no surprise that these countries are struggling to maintain their export competitiveness to both the US and also to China, which has pegged its currency to the dollar. And unfortunately, this is not a trend that is likely to disappear overnight, especially given the continued weakness of the dollar. <br /><br />According to the Institute of International Finance, global capital inflows from private and official sources into emerging markets will almost double from $349bn in 2009 to $672bn in 2010. Investors have been engaging in a large-scale carry trade, selling dollars and pouring their money into emerging markets to take advantage of the higher returns offered by assets in these countries. <br /><br />The Hang Seng has risen more than 100 per cent since markets turned in March, during which time the Argentinian Merval index has risen 145 per cent and Brazil&rsquo;s Bovespa 85 per cent. Policymakers fear that the continued inflow of hot money will fuel asset bubbles in these countries and undermine their strength of recovery. <br /><br />Will more emerging countries follow Brazil and Taiwan&rsquo;s lead and impose control on capital inflows? Neil Mellor at the Bank of New York Mellon thinks so. With the engines of liquidity stuck at full throttle in the West, emerging markets are facing a dilemma to either raise interest rates and allow their currencies to appreciate, or follow the examples of Brazil and Taiwan. Mellor reckons: &ldquo;Given the need to maintain a competitive edge in this the post-crisis world, we strongly suspect that authorities will find that the latter option offers the path of least resistance.&rdquo;<br /><br />If capital controls successfully stem these currencies&rsquo; rise against the US dollar, then foreign exchange traders might expect the Korean won, the Brazilian real and the Taiwanese dollar, for example, to weaken against the greenback in the wake of capital controls, and to go short. <br /><br />But how likely is this and would forex traders actually be better off continuing to back the emerging market bulls? Although in the short-term there might well be some pullback in the currencies of countries which have imposed inflow controls, a number of strategists have argued that capital controls are unlikely to have any significant effect on emerging market currencies. <br /><br />Short-term losses are unlikely to be sustained, as investors find alternative methods of trading that avoid capital controls such as derivatives or offshore markets. Even the International Monetary Fund&rsquo;s Dominique Strauss-Kahn warned that the Brazilian controls were unlikely to be effective in the long-term. <br /><br />Emerging economies are widely predicted to have better prospects for growth, as unemployment is running at a lower rate than in Western economies and domestic consumption is growing. Against a backdrop of a weakening dollar and the expectation that Fed rates will remain on hold, these currencies are expected to continue rising. Capital controls will do little to change this and forex traders should be wary of shorting emerging market currencies in the medium term.