World financial markets are rattling this week, and the impact on Latin America and its robust currencies is again in the spotlight. Booming commodity prices in South America have actually helped resurrect many economies in recent months by bringing in increased foreign investment. While the rapid expansion of South American economies is undeniably positive, many central banks face an interesting dilemma: How do countries continue to attract foreign investment while keeping inflation low and protecting against appreciation of the local currency?
The tools used by policy makers to protect against inflation run contrary to policies implemented by central banks to protect against currency appreciation. In order to counter inflation, central banks typically raise interest rates, which slow down economic growth and encourage investment. This policy leads to an influx of both foreign and domestic cash. Combine increased investment in South America with the inflow of money from rapidly rising commodity prices, and currency appreciation is one of the most significant issues facing many South American economies.
Local South American producers are being priced out of export markets due to appreciation, especially in the US where in recent years many Latin American currencies have experienced exponential growth compared to the dollar. Also, producers are unable to compete against increasingly cheaper imports. This has led to business closures or massive layoffs.
In Colombia, the 9% appreciation of the peso against the dollar over the last year has significantly hurt exporters. One example is in the flower industry, which has traditionally played a large role in the Colombian economy. With expenses exclusively in the peso and the majority of revenues in dollars, flower producers are increasingly letting go of workers or closing. Rafael Ospina, who has been distributing carnations and roses to the US for two decades, filed for bankruptcy last year due to the peso’s rapid appreciation.
In “Waging the Currency War,” an article published by The Economist in January, René Merino, a representative of the Chilean wine industry, detailed that Chilean wineries need an exchange rate of 530 pesos to the dollar to be profitable. As of July 2, the Chilean peso was being traded at 466.9 pesos per dollar.
Brazilian finance minister Guido Mantega famously proclaimed the world is in an, “international currency war.” Mantega was mainly referring to China’s monetary policy that keeps the renminbi artificially low, giving Chinese exports an inherent advantage, and the recent Quantitative Easing by the United States that decreased the value of the dollar.
In November of 2009 Goldman Sachs said the Brazilian real was the “most overvalued currency” in the world after gaining 32.7% when compared to the dollar in 2009. Even with this warning the real has continued to appreciate against the dollar from 1.73 reals per dollar on Jan. 1, 2010 to 1.55 as of July 30, 2011. The appreciation of the real has made it difficult for local companies to compete against foreign imports. Paulo Skaf, head of the Sao Paulo Industrial Federation, estimates the strong real will cause a $100 billion deficit in the trade of manufactured goods this year, an increase from $71 billion in 2010.
To combat against appreciation, local central banks are employing a variety of measures to contain their respective currencies. Policy makers’ initiatives range from purchasing foreign currencies (mostly US dollars), sterilization, monetary policy tightening and allowing inflation to remain close or just above the upper band of inflation targets. While these policies may have slowed the rate of appreciation, they have, for the most part, not stopped currencies from gaining.
Some economists feel the capital control initiatives by South American central banks could potentially have a negative impact on the economies. These economists believe that placing too much significance on trying to contain appreciation can potentially lead to a rapid increase in inflation. One example is Argentina where the currency has devalued compared to the dollar, however inflation has skyrocketed to an estimated 22% in 2010.
Furthermore, economists believe that trying to place an abundance of controls on the economy leads to policy errors. In the article “Capital Controls Roil Latin America Bond Markets by Evoking 80’s” published by Bloomberg, David Beker, chief Latin American strategist at Bank of America said, “Once you start targeting multiple objectives, the odds for policy mistakes increase.”
Another concern is the possibility of investors shying away from Latin America. In October of 2010, Brazil tripled the tax rate on foreign inflows from 2% to 6%, among other initiatives to slow currency appreciation.
There is also a real cost associated with managing reserves. According to Tendencias, an economic research firm based out of Sao Paolo, it costs Brazil $20 billion per year to manage the country’s reserves. This is largely because Brazil must issue debt to pay for the dollars it buys.
Don’t Do Anything
However, not all economists view the Latin American policies negatively. Nouriel Roubini, a New York University economist believes, “if you don’t do anything, your currency can appreciate more than is justified by the economic fundamentals.” While it’s impossible to know for certain what would happen if preventative measures were not taken, current evidence seems to indicate that the policies by central banks, if anything, are only delaying the inevitable by slowing down appreciation. In many cases this delay is all producers are asking for. Luis Carlos Villegas, the head of Colombia’s business lobbying organization the National Industry Federation (ANDI) told El Colombiano newspaper, “Our entrepreneurs can raise productivity by 2, 3, or even 4 percent a year, but not 10 percent.”
With high interest rates and the influx of cash from high commodity prices, it appears likely many Latin American currencies will remain strong in 2011 and beyond. While this may negatively impact some local businesses, it is also a very positive sign of the strong economic growth of many Latin American countries.
Following is a description of the central bank policies and current issues facing the Argentinean peso, Brazilian real, Chilean peso, Colombian peso, and the Venezuelan bolivar fuerte.
Argentinean peso $1 USD/4.1 ARS – Argentina has managed to prevent the appreciation of its currency over the past few years. In fact, the peso has declined in value since January of 2010 when the exchange rate was 3.78 pesos to a dollar. However, the currency manipulation by the central bank has come at a major price with 2010 inflation estimated at 22%.
Argentina’s main policy initiatives to combat appreciation have been to purchase US dollars on the foreign exchange market and to require investors to deposit 30% of funds brought into the country for at least one year. In 2011 the Central Bank of Argentina plans to buy $12.5 billion to build its reserves.
Brazilian real $1 USD/1.56 BRL – As previously discussed the Brazilian real has made exponential gains compared to the US dollar over the past few years. Ironically, Brazil has also employed more initiatives than any other Latin American country to prevent appreciation. Since May of 2009, Brazil’s central bank has been purchasing dollars at daily spot market auctions to stabilize currency appreciation. As of June 21, Brazil’s foreign reserves stood at $335.9 billion. In October of 2010 Finance minister Guido Mantega tripled (from 2% to 6%) a tax levied on foreign investors purchases of local debt. Furthermore, beginning April 4, 2011, the government introduced reserve requirements for financial institutions with dollar short positions. This legislation is designed to prevent local banks from short selling the dollar and also increase purchases of the dollar to cover the $16 billion of outstanding short positions that were being held in the market.
In all likelihood, the policies by the government will have little effect on the real’s appreciation. The abundance of natural resources, high interest rates offered by the central bank, and fairly low risk (compared to other EM economies) make Brazil a popular location for international investment. With inflation threatening to be over 6% in 2011, forecasters expect the Selic interest rate to reach 13% by the end of the year, which will continue to attract foreign investment.
Chilean peso $1 USD/466.90 CLP – Chile is the largest copper producer and exporter in the world, accounting for a third of global supply. High copper prices have caused the Chilean peso to dramatically rise over the past couple of years from $533.72 USD/CLP in July of 2009. The appreciation of the peso has put added pressure on exporters outside of the copper industry who are unable to compete in foreign markets. Also, a third of all Chilean exports are sent to Europe, which causes the peso to follow a similar path as the euro against the dollar.
The Chilean Central Bank is planning to buy $12 billion in 2011 to protect against appreciation. As of July 1, the government had purchased $6.3 billion this year.
Colombian peso $1 USD/1,753.50 COP – The Colombian peso has gained 9% against the dollar over the last twelve months. Colombia recently achieved investment grade status from Moody’s, Fitch and Standard & Poor’s, which is expected to increase investment into Colombia. With the increased investment, many forecasters believe the Colombian peso will continue to gain against the dollar. Finance Minister Juan Carlos Echeverry likened the Colombian currency to a, “wild horse that throws you off at times, but you have to get back on and try to tame it.”
The Central Bank is in the midst of an aggressive dollar purchasing plan buying at least $20 million daily since September of 2010 to curb appreciation. The bank plans to continue purchasing dollars until at least September 30 of this year. Furthermore the Finance ministry is also buying dollars and this year has purchased $330 million of a planned $1.2 billion fund to prevent further appreciation.
Venezuelan bolivar fuerte $1 USD/4.3 VEF – Venezuela uses a fixed exchange rate. In January of 2010 President Chavez devalued the official rate of the “strong bolivar” from 2.15 per dollar to 4.3 per dollar. The central bank also subsidized a stronger 2.6 per dollar rate for imports of food, medicine, and other essential items. The devaluing of the bolivar fuerte was designed to slow the rapid rise of inflation. Unfortunately, the policy had very little effect with inflation increasing to an estimated 29.8% in 2010. In January of 2011, the government moved the exchange rate of essential items from 2.6 per dollar to the official rate of 4.3 per dollar.
However, the official exchange rate in Venezuela only tells one side of the story. Despite Chavez’s best efforts to crack down on the underground exchange, there still exists a black market for dollars exchanged in Colombia. The website lechugaverde.com uses various metrics to track the black market exchange rate and currently lists the rate at 8.49 bolivar fuerte’s per dollar. With the dollar being traded at almost double the official rate on the underground exchange, it will prove to be very difficult for the Chavez regime to improve the inflation rate.
Brendan Wolters currently lives in Panama City, Panama. He works at The Solace Group, which helps foreign investors identify opportunities and invest in Central America. Contact him at email@example.com.