Brazil may well be, as Lex puts it, a “victim of its own economic success”.
But its surprise move to impose a 2 per cent flat one-way tax on all new capital inflows this week has also drawn howls from portfolio investors – and some more warnings about the broader implications.
As FT Alphaville noted on Tuesday, there are a host of good – and not so good – reasons for Brazil’s move, including speculation that it will pave the way for an interest rate increase.
For those who believe the main reason for the tax is, as Brazil claims, to stem the real’s rapid rise, Stephen Jen at BlueGold Capital Management predicts some near-term unwinding of short-dollar/real positions – and conceivably, the imposition of further capital controls. All of which, he says, could benefit other emerging market economies, even as Brazil does some “structural damage” to its own financial markets. He says in his latest note:
While I doubt that such a measure will be effective in the long-run against the global backdrop and the powerful under-currents, it is conceivable that Brazil introduces more capital controls until they arrest the appreciation of the BRL.
Capital flows into emerging markets are expected to rise from $349bn in 2009 to $672bn in 2010 — slightly exceeding the $541bn seen in 2008 but substantially less than the $1,250bn in flows seen in 2007, according to the IIF. These are “big numbers”, notes Jen, adding (our emphasis):
To the extent that EM is seen as the leading edge of the global recovery, and a ‘high-beta’ expression of this view by investors, the capital that is potentially repelled from Brazil should go to other EM economies. In other words, as long as other EM economies don’t also impose capital controls, the broad global trend in capital flows should not be affected by Brazil’s actions. If anything, Brazil could suffer: just look at what happened to Malaysia in the years after the Asian Crisis, relative to its peers.Overall, imposing capital controls on bond flows undermines the development of a full yield curve in EM economies, warns Jen. He explains:
Typically, institutional funds in EM tend to have a skew in their demand for local bonds, in favour of short-term bonds instead of longer-dated papers. This may reflect the preference for liquidity that is found in short-dated local papers. However, there are important advantages to having a full yield curve with liquid long-dated bonds.
First, a full yield curve conveys a more clear signal on the market’s inflation expectations (in fact, the lack of long bonds was one key problem in Asia prior to the Asian crisis of 1997). Second, having access to long-term financing reduces a roll-over risk of a crisis occurs: this is good for both borrowers and lenders.
In Brazil and elsewhere, large bond inflows have gone into the longer-dated segment, as foreign investors have helped liquefy a segment of the yield curve that local investors don’t find attractive. Imposing capital controls, therefore, could lead to structural damages to the financial markets in Brazil.
Related links:
‘Bubble management’, Brazilian-style‘ – FT Alphaville
Stakes soar in Olympics contest, and ETFS know it – FT Alphaville