By Elizaveta Belugina, leading analyst at FBS Markets Inc.,

When Brazilian finance minister Guido Mantega came up with the term “currency war” in 2010,the nation was looking for a way to protect itself from the US monetary aggression. It was the second round of the currency wars: the confrontation between the emerging and advanced economies.

Brazil blames hot money

Elizaveta Belugina
Elizaveta Belugina

In 2008 the US Federal Reserve has cut rates to zero and started printing large amounts of cheap dollars via the quantitative easing program (QE). This hot money has rushed out of America to the places with the highest short-term interest rates – Brazil, South Korea, Peru and Thailand.

Although it might not be evident to the non-economists, the countries in question found these monetary inflows unwelcome. The main reason of such negative reaction was that they made Brazilian real, South Korean won, Peruvian nuevo sol and Thai baht strongly appreciate versus the greenback.

Brazil and others blamed the United States for devaluing the US dollar and, consequently, making their national currencies overvalued. At the picture below you may see Brazilian real making a big advance in 2009-2011. According to the nation’s authorities, this growth didn’t correspond to Brazilian economic fundamentals and was provoked solely by American QE. The negative effects of the higher exchange rate are well-known: export loses price competitiveness landing a blow on the country’s economic growth.

The dynamics

Picture 1. The dynamics of BRL/USD in 2009-2015

These accusations do have some ground behind them. The same chart shows the rapid decline of real in 2014 when the Fed was gradually tapering QE asset purchases. In other emerging nations one could have observed similar dynamics. It confirms that the monetary easing in the US did have a sizeable impact on the developing economies: monetary inflows can affect the exchange rate if they are big enough and can therefore impact the balance of payments.

Advanced economies, on the contrary, assure that the QE is intended to stimulate domestic demand, not to weaken the currency. This process inevitably leads to some spillover effects, but, in their view, they shouldn’t be held accountable for that.

Analysis of the situation shows that the blame for Brazilian troubles is not entirely on the US: even though interest rates in America were lowered almost to zero after the financial crisis, rates and yields in emerging market nations stayed very high. In Brazil, for example, high interest rate was a result of extreme government spending which led to the budget deficit. This provoked inflation and inflation, in its turn, led to high interest rates. Moreover, that time Brazil had good growth prospects and was a titbit for foreign direct investment. All in all, it was natural for big money to leave the United States and pour into Brazil. 


Capital controls become the solution

For a long time economists have advocated the principle of the freely moving capital. However, in case of the emerging nations it became apparent that capital flows can hurt national economy and finance, so they have to be treated with caution. These two ideas represent a contradiction.A question arises: should capital flows be limited and, if so, how?

The answer is that capital flows may be both beneficial and destructive. Positive inflows are investments which create jobs and boost economic activity. Negative flows are unproductive inputs of money into real estate or funding consumer or government spending. Such inflows create financial bubbles. This money may quickly leave the economy once there’s bigger yield elsewhere making the bubble burst.

The big problem is that it’s quite difficult for the government to make a distinction between these two types of flows, especially during the times of economic hardships. One thing is, however, quite certain: the more sound the nation’s macroeconomic and fiscal policy is, the easier it can cope with the volatile monetary flows caused by QE. If countries have economic problems, these problems will be exacerbated by both the loose monetary policy in developed nation and its eventual withdrawal.

Still, whatever the reasons, when its economy was overheating Brazil had to make a move: the leadership just couldn’t remain inactive. The nation chose to introduce capital controls in form of extra taxes on foreign securities purchases. The main goals of such policy were to discourage monetary inflows and to slow down the real’s speedy appreciation.

On the one hand, the idea of capital controls is against the principles of the liberalized economy in which there should be as few barriers as possible. On the other hand, as the currency wars broke out, this measure turned out to be a valuable tool for the emerging market economies suffering from an excessive influx of funds. Now even the International Monetary Fund agreed that short-term controls may be used to ensure financial stability.

Yet, capital controls is a weapon which is yet to be explored in a more comprehensive way. It certainly did a good job for Brazil in terms of stabilizing exchange rate. Yet, the foreign investors’ perception of Brazilian country risk has deteriorated. In addition, it was hard for the nation to control all the flows and, in particular, to distinguish the bad ones, so some industries suffered.

An ethical question

One of the most important question about the currency wars is how far can a nation go to revive its own economy? And if this country is the Unites States, the issuer of the world’s main reserve currency?

As the globalization has made everything interconnected, the actions of one have consequences for the others. The longer we live, the more evident is this relationship. The Hegemonic stability theory tells us that as the economic leader, the US should rule with conscience. The same stands for other countries which generate large capital flows: they should be aware of how their policies may affect global economic and financial stability. At the same time, the nations who claim to be the victims of the capital flows should take care of their national economies in the first place, so they could be more resilient to such challenges.

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