EM FX Off To The Races After QE2, Boosting Talk Of More Capital Controls
by Win Thin
EM currencies are rallying in the wake of the FOMC decision, with many back to testing or even besting the year’s highs vs. USD from mid-October. We continue to feel that the conditions favoring EM investment will continue well into 2011, and the FOMC statement and decision played into this. No wonder EM policy-makers are back to complaining about currency strength. Today, Korea’s central bank warned about the danger of excessive foreign capital flows, while the Finance Ministry said it would consider implementing capital controls in response to continued foreign inflows after the FOMC decision. Korea President Lee said he expects the G20 to agree on a set of guidelines for FX policy when they meet in Seoul next week. Thailand’s Finance Minister Korn said that Asian central banks are in talks with Thailand’s central bank and that they would consider jointly issuing “measures to prevent excessive speculation.” Malaysian central bank Governor Zeti said that regional policy-makers are willing to act jointly on capital flows if needed.
Despite all this chatter, we still feel that the probability is very low that some sort of coordinated solution to the currency strength issue will be put forth by the G-20. As we’ve noted in the past, G-3 can rarely reach a consensus and so adding a bunch of other countries to the G-20 mix suggests that consensus gets even harder. As a reminder, G-20 consists of Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, Korea, Turkey, the UK, the EU, and the US. As long as the developed world is running loose monetary policy, there is not much that EM policy-makers as a group can do to discourage this fundamental and liquidity-driven trade. As a result, it appears that most countries will continue to take unilateral measures to deal with foreign inflows and that is our base case scenario going forward.
While we acknowledge the possibility that some sort of lip service will be paid to a coordinated G-20 or EM response to currency strength, we fell that there is simply no precedent for such coordination in Asia, with most policy-makers running mercantilist-type policies that favor their own exports via undervalued exchange rates. Talk of some sort of Asian Monetary Fund after the Asian crisis never went anywhere, and the greatest coordination that we’ve seen in terms of exchange rates is the Chiang Mai initiative of 2000, which established a network of bilateral dollar swap arrangements between ASEAN+3 (ASEAN plus China, Japan, and Korea). Those swap lines have never been used, and may never be used given that virtually every country in Asia has unilaterally built up massive war chests of foreign exchange. After the Asian crisis, many EM policy-makers aggressively lowered external vulnerabilities by paring back external debt and increasing foreign reserve holdings.