* Convertibility would attract even more FX speculation
* Global "currency war" to leave permanent scars
* Offshore NDF trading boosted by intervention measures
By Samantha Pearson
SAO PAULO, Oct 26 (Reuters) - Brazil's battle to slow a recent rally in its currency is jeopardizing plans to open the real to international trading.
With a view to one day becoming a major financial hub with
as much clout as Hong Kong or New York, Brazil has been working
to transform the real into a so-called convertible currency.
That means putting behind it a past of painful currency crises
and lifting heavy restrictions on the real
But in recent months the government has taken a step backward, introducing even more regulation to the market in an effort to curb a currency rally that is hurting exporters and undermining the competitiveness of the Brazilian economy.
"It makes policymakers more reluctant to pursue full convertibility under these circumstances," said Mike Moran, a senior currency strategist at Standard Chartered in New York.
"They will continue to say this is their long term goal, but in the immediate future, the prospect for full convertibility for the likes of Brazil is very weak."
Currently, the central bank permits only a few big banks to trade in the local market, making foreign exchange transactions more costly and time-consuming for everybody else.
But if these restrictions were lifted, Brazil's currency problems would be even worse, some analysts say.
Foreign investors have flocked to Brazil partly due to its high-yielding bonds. The deluge of cash has boosted the real, making it one of the world's most overvalued currencies.
"Convertibility? Forget about it," says Carlos Gandolfo, a partner at Sao Paulo's Pioneer brokerage. A freely tradable real would attract even more hot money, or "motel money" as it is known locally -- thrill-seeking investors who are in and out of the country in hours.
That is exactly the type of investor Brazil has been fending
off with recent intervention measures, such as tax rises on
foreign purchases of bonds.
Graphic on intervention: http://r.reuters.com/kuv79p
Convertibility could also bring more volatility to the market, as has been the case in Mexico, one of the few countries in Latin America to have a convertible currency.
BATTLE SCARS
In March this year, Brazil's trading institutions got together to launch 'Brain' -- the latest project to transform the country into a financial superpower, with one of its goals being to free up the local currency market.
The project has been on hold for the past three to four months because of Brazil's ongoing presidential election, said Alan Gandelman, chief executive officer of the Brazil division of ICAP, the world's biggest interdealer broker.
"The government wouldn't want (convertibility) now with the real at these levels, but maybe four or five years down the road it could be achieved," he said.
However, it could take even longer if the global battle over currency intervention, which dominated a G20 meeting last week, proves to be part of a long-term structural shift.
"There has been a mistrust of what you used to call the Washington Consensus of freely open capital markets, freely convertible, freely floating currencies," said Win Thin, a currency strategist at Brown Brothers Harriman in New York.
But convertibility is not just up to the government: the market also has to want it.
If intervention were done "in a way to lead investors to believe that the risk of that currency had risen because of the force of government intervention, I think it could have an effect," said Gustavo Loyola, a former central bank president.
In contrast, Chile has taken softer measures to deal with its rallying currency, partly for fear that intervention will delay plans to make the peso convertible.
Despite its small size, Chile also dreams of becoming Latin America's financial hub.
Judging by the non-deliverable forward market, investors are souring on trading the real.
NDFs are derivatives that simulate trading in restricted currencies such as the real. The contracts are mostly traded in New York and settled in dollars.
Trading in Brazilian NDFs is facing long-term decline and should eventually die out when the real becomes convertible, as has happened in other developing countries such as Russia.
But after the government's tax rise last week on futures contracts, ICAP saw volumes in Brazilian NDFs soar about 20-30 percent, said Anna Didier, head of NDFs for the broker.
Other investors are weighing costs and contemplating coming back to the market, she said, because even though NDFs are expensive, the rules of the game are more transparent.
"Everyone is going back to the drawing board." (Additional reporting by Silvio Cascione in Sao Paulo, Ana Nicolaci da Costa in Brasilia, and Caroline Stauffer in Mexico City; Editing by Dan Grebler)