Currency Wars Are Heating Up Across Latin America

Emerging-market countries are gearing up for what could be a potentially damaging round of currency interventions to help keep their economies competitive with other nations, especially China.

"Many countries are increasing the amount of capital controls and direct intervention in order to temper currency inflows and reduce the effect of these flows on currency appreciation," says Mauro Roca, emerging markets currency strategist at Deutsche Bank.

Brazilian Finance Minister Guido Mantega told the Financial Times that his country was preparing additional measures to prevent a further climb in the value of the Brazilian real. He said his government was planning to complain to the World Trade Organization about currency manipulation, naming China and the U.S. as the worst offenders.

"This is a currency war that is turning into a trade war," Mantega said.

Slowing Down the Flow of Capital

Latin America has seen a flurry of recent currency interventions, as neighbors protect themselves against controls being imposed by the countries next door. Chile, for example, announced last week that its central bank would buy $12 billion worth of U.S. currency to keep the Chilean peso from rising further, starting at $50 million a day.

Brazil has already imposed increased taxes on fixed-income investments in the real, to reduce the attractiveness of those inflows. The tax is now at 6%. In Peru, the government is taking an indirect approach, adjusting the reserve requirements for banks to slow the inflow of dollars. Argentina, by contrast, has a totally managed local currency whose exchange rate is set by the central bank.

"If one country takes measures, it make sit easier for other to follow," Roca says.

Some emerging-market countries blame the U.S. Federal Reserve for the problem, saying its program of quantitative easing -- buying $600 billion of Treasury bonds to keep interest rates low and increase liquidity -- is forcing investors to flee the dollar and invest elsewhere. Federal Reserve Chairman Ben Bernanke has been lambasted by the Russians and South Koreans for causing their currencies to appreciate.

Since the Chinese yuan is closely linked to the dollar, when the dollar declines, so does the Chinese currency. This hurts manufacturers in other emerging-market countries that compete with China but where domestic currencies are rising.

Emerging Market Currencies Remain Attractive

But so far, quantitative easing hasn't worked as planned. Interest rates are actually rising sharply in the U.S., and so is the dollar against other major currencies like the euro.

What seems to be happening, according to Roca, is that emerging economies like Brazil have interest rates that are so much higher than those in the developed world that investors, particularly those from Japan, where interest rate are near zero, can make a substantial profit even after paying Brazil's punitive tax.

In addition, Brazil and other developing countries have much higher growth rates than the U.S. and Europe, so the prospect of capital gains on assets is much higher.

"We have very low rates in the developed world, and funds are searching for yield," Roca says. "In most of the emerging market countries, there are good macroeconomic frameworks in terms of fiscal and monetary policies." (Fiscal policy refers to state budgets, while monetary policy applies to interest rates.)

The only nation in the Latin American region so far not to impose currency controls is Mexico, and money has been pouring into the Mexican peso lately.