Private capital flows to emerging markets will balloon to $833 billion this year from $581 billion in 2009, according to the Washington-based Institute of International Finance. To slow the torrent of so-called hot money, many countries with floating exchange rates have imposed new capital controls. These range from Brazil’s taxes of 6 percent on fixed-income securities and 2 percent on equities to South Korea’s 14 percent withholding tax on government bonds. But such measures have done little to deter investors.
Capital controls usually have a dual purpose: to dampen short-term foreign investment and thus ease upward pressure on domestic currencies so exports stay competitive. Recently, their track record has been mixed. While exchange rates keep rising, in most cases the ascent has slowed. But high local interest rates often trump control efforts, and in many places foreign inflows have picked up.
Despite its country’s punitively steep taxes, the Brazilian real is one of three Latin American currencies favored for 2011 by British bank HSBC Holdings, says emerging-markets currency strategist Clyde Wardle. In a recent report, HSBC noted that “while intervention tends to cap nominal appreciation, it does not impair total returns in high yielding currencies like the real.”
The nominal interest rate for the real is 10.75 percent, with the market pricing in a further 50 to 75 basis points for the first quarter. Japanese investors, who earn less than 1 percent on their savings at home, have poured $60 billion into Brazil since 2008, according to HSBC. In 2010 the real rose 4.6 percent against the U.S. dollar.
Jens Nordvig, global head of foreign exchange strategy at Nomura Securities International, also advises buying the real, but for different reasons. Nomura expects Brazil to tighten its fiscal policy, letting interest rates fall in a rerating of its bond market, Nordvig says: “If you own a bond, you are going to make money by that shift in rates.”
Nordvig is also a fan of the South Korean won, which gained 3.5 percent in 2010. “Capital flows will be allowed to come into Korea, and overall capital restrictions will be fairly moderate, so the won could outperform significantly,” he predicts. Goldman Sachs Group has boosted its 2011 GDP forecast for South Korea from 4.5 percent to 4.7 percent and anticipates a 1 point rise in interest rates.
Deutsche Bank favors the real and the won too, but takes a more nuanced approach. It expects both currencies to gain in the next few months, then for the Brazilian and South Korean central banks to squeeze the dollar higher. “It would be quite beneficial to buy something that would play in this reversal pattern,” says Henrik Gullberg, a foreign exchange strategist at Deutsche’s London office. Deutsche suggests dollar-real and dollar-won three- to six-month straddles, a play that involves buying a call and a put on each currency pair.
In Asia foreigners bought $19.6 billion worth of South Korean stocks in 2010, about $3.4 billion of that in December alone. They also snapped up $3 billion in Taiwanese equities that month, nearly a third of the year’s tally. “The currency component is only one part of the total return,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York.
Most emerging markets beat developed Europe and the U.S. last year, but HSBC’s Wardle says investors must be savvier in 2011. HSBC recommends going long the Mexican peso against the dollar and shorting the Chilean peso in light of Santiago’s plan to devalue it by buying $12 billion worth this year. In 2010 the two currencies gained 5.5 percent and 9 percent, respectively, on the dollar.
HSBC backs the Singaporean, Malaysian and Taiwanese currencies; the latter two have capital controls. One of Nomura’s top Asian picks is the Chinese renminbi, which may have the toughest controls of all. The market calls for the renminbi to appreciate only 2 percent this year, but Nordvig reckons it will rise 6 or 7 percent.
After developing countries with capital controls drew far more investment than their peers in 2010, the International Monetary Fund finally stopped opposing the limits. But Ilan Goldfajn, chief economist of Brazil’s Itaú Unibanco, says controls succeed only if they buy time for government reforms: “If they are imposed for their own good and the government is not willing to change anything, then they won’t work.”
