Monday, October 26, 2009

Weekly Hurriyet Column: Wheels in the sand

Below is the unedited version of my column for this week. You can read the final version at the Daily News website. No cheesy title this time around, just a little play on words that caused confusion at the editorial, resulting in a the title "Brazil puts wheels in the sand" in the hardcopy version- the web version is OK, as the editors had to change the title after they submitted the article to the web.

As for the article, a really good commentary appeared on the Financial Times the same day as my column- definitely recommended reading, especially if you liked my pieces on the changing role of the IMF. I had never thought of this way, but as the authors suggest, rather than stating the obvious, that such measures will not work, the Fund should channel its energy into coming up with ways that they will. This fits in IMF's new role as well. It seems the Fund springs underneath every stone these days:)...

Brazil stole all attention last week with its 2 percent tax on portfolio inflows, igniting a discussion on not only whether it will work, but also on whether other countries will follow, with Turkey’s name coming up among the candidates.

On the first question, it is important to note this is not the first time Brazil is trying to put sand in the wheels. It had introduced a 1.5 percent tax in March 2008, only to drop it shortly after the Lehman collapse. Just as the previous attempt had not stemmed the real from rising, it is safe to assume that the measure will not have much effect, as the size of the tax is small compared to the underlying forces of appreciation.

Brazil’s problem is that the real could be strengthening not only because of capital flows, but also because of a permanent shift in the country’s terms of trade. While there is room for policy action for the former, at least theoretically, there is no easy fix to the latter other than a rise in productivity, which is definitely more easily said than done.

Terms of trade improvement or not, capital flows emanating from developed country central banks and looking for a new home with high returns had been with us since March, but have gained considerable pace in the last couple of months. According to Emerging Portfolio Fund Research, which collects data on dedicated emerging market (EM) fund flows, flows to EM bonds and equities have already surpassed 2006 and 2007 highs.

These loose cannons wandering around have, in turn, led to asset price booms in EMs across the globe and reawakened the familiar EM drama “fear of appreciations”, as central banks try to prevent their currencies from appreciating through intervention. With the resulting increase in foreign exchange reserves only partly sterilized, the domestic money supply expands, resulting in credit growth and unsustainable rises in asset prices. Looking at the forest rather than the individual trees, this process is also impeding the global rebalancing act needed to put the world economy back in track.

The Turkish case has been different from this textbook scenario in some small but important aspects. To begin with, the lira has performed worse than peers, having lost around 15-20 percent to comparison currencies such as the real, the South African rand and the Hungarian forint. Moreover, flows into equities and bonds have slowed down considerably in the last few months, with anecdotal evidence and banks’ off-balance sheet activity suggesting that much of the action is now in derivatives such as swaps. As for the Central Bank liquidity injections, they have almost exclusively channeled into bonds, and the resulting rally has been a boon not only for the banks holding the Treasuries but also for the Treasury issuing them.

Highlighting these differences is enough to make the case that Turkey is unlikely to enact a similar tax, but a simple comparison with Brazil yields more insights. For one thing, Brazil’s current and fiscal accounts are in better position than Turkey’s, making the former less in need in of capital inflows. Perhaps more importantly, interest rate differentials are also working in Brazil’s favor. While Brazilian officials have hinted that they are in no hurry to hike rates, with the country set to weather the recession with a slight contraction and inflation worries likely to emerge in 2010, the next direction for rates is up rather than down. The Central Bank of Turkey, on the other hand, has at least 50-75 basis points of cuts in its sleeve.

Brazil put sand in the wheels when it felt those wheels were turning too fast. Turkey cannot put any sand in the wheels because its wheels are stuck in the sand.

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