Real unappreciative – Brazil pulls out the plug

SINCE last summer, when the Federal Reserve turned back on the liquidity taps, the flow has been largely to developing economies. Rather like financial bathtubs, popular emerging markets in South America, Asia and even Africa have been attracting vast amounts of frothy hot money, and developing world currencies have appreciated immensely.

With the money still pouring in, talk about “currency wars” has heated up again. In Brazil and Chile, governments last week announced measures designed to limit appreciation. Chile plans to spend 6 per cent of its GDP on foreign exchange reserves in an attempt to bid down the peso. Brazil is restricting short selling of the real by domestic banks. In South America at least, might it be time for the long trend of appreciation to reverse?

Certainly it has been an impressive run. Since July, the Brazilian real has appreciated by around 11.8 per cent against the dollar, while the Chilean peso appreciated by closer to 15 per cent. Over the last two years, the real has appreciated by nearly 35 per cent, despite high inflation.

The principal cause has been the higher returns available to investors. The headline interest rate in Brazil is 10.75 per cent, with a real return after inflation of 4.8 per cent. That has drawn in nearly $62bn in hot money inflows last year, up from $46bn in 2009.

According to Flavia Cattan-Naslausky, Latin American currency strategist at RBS, we are entering “an interesting moment for South America”. Until recently, there has been strong demand for risky assets from foreign investors, while governments have broadly welcomed the inflows because currency appreciation has helped to lower inflation.

But Cattan-Naslausky believes that era may now be ending. “At some stage, the benefits of appreciation against inflation are offset by the other implications for the economy”.

As a result, the Brazilian government may now embark on a series on subtle controls to restrict capital inflows. Cattan-Naslausky suggests “that will start to weigh on perceived policy risk and regulatory risk”, deterring many foreign investors.

If that combines with a stronger dollar and a shift back towards developed market assets, then the long appreciation trend may well end. RBS predicts that the dollar could climb back to as high as R$1.90 from its current level of R$1.67.

The same may happen in Chile. The Chilean peso has depreciated by 7.1 per cent since last Monday, when the Chilean central bank announced plans to buy $12bn of currency reserves between now and February in tranches of $50m per day. The peso may also be helped down by copper price falls – Chile is the world’s biggest copper producer.

South American currencies have had an immensely impressive run recently. But though the liquidity taps are still running, the plug may be about to be pulled out. Though it is not possible for retail investors to trade on the real, anyone with an interest in Brazil should watch out.