In case you were wondering whether emerging market currencies would keep appreciating into next year, then look no further than the paragraph below from Citi. It sums up the key drivers quite succinctly — Negative real rates in emerging markets whereby inflation is higher than interest rates, easy monetary policy in the U.S., GDP growth differences between emerging markets and developed ones, etc..
Citi’s David Lubin:
A one-paragraph summary of the EM story right now helps to explain why fx appreciation, reserves accumulation and capital controls are the order of the day. Capital flows to EM are being driven by powerful ‘push’ factors, particularly in the form of i) negative real interest rates and ii) the expectation of further increases in US liquidity if the Fed’s balance sheet undergoes further expansion (our abbreviated history of capital flows to EM in Figure 1 makes it clear that investor enthusiasm for EM is generated by low real US rates even during periods of weak US growth). At the same time, powerful ‘pull’ factors are drawing capital flows towards EM in the form of a large and widening differential in GDP growth rates between EM and DM, alongside a widening interest rate differential (Figure 2).
We admit the chart below isn’t exactly sexy, but it shows how the difference between interest rates in emerging markets vs. developed ones (The G4), will only expand as we enter the first half of 2011.
They’ll be even more pressure for developing countries to hold back the torrent of capital with capital controls.
Many countries are struggling against the currency appreciation that results from these push and pull factors, with the result that official fx interventions are accelerating, together with a greater willingness to experiment with controls on capital inflows. The past month has seen a further rise in Brazil’s IOF tax to 6%; a decision by Thailand to impose withholding tax on foreign owners of domestic securities; and plenty of talk that other countries (Korea, Taiwan, Indonesia and Israel for example) are considering similar measures. Meanwhile, central bank purchases of fx remain heavy. In the first 3 weeks of October, for example, the Brazilian central bank bought over US$4bn; the Bank of Israel over US$2.5bn; the Bank of Indonesia over US$2bn.
But ultimately, Citi expects broad-based currency appreciation to continue for developing nations.
(Citi, Capital Flows And Current Account Balances, David Lubin, 28 October 2010)