By Sujata Rao
LONDON, Nov 4 (Reuters) - Rising relative interest rates next year will likely force many emerging central banks to take more measures to stem relentless currency appreciation caused by yield-chasing investors.
Most analysts say the recent market shakeout that knocked many emerging currencies off multi-month highs last month will provide only a brief respite to central banks that have since March watched currencies soar, in some cases by over 30 percent.
The persistence of near-zero interest rates in some of the biggest developed countries -- the United States, the euro zone, Japan, Britain and Switzerland at least -- are ensuring the hunt for yield across a spectrum of emerging assets will likely continue for some time.
To be sure, appreciation is most prominent in Asia and Latin America, with many emerging European economies held back by banking concerns and current account deficits. But broadly, the trend has impacted established units like the Brazilian real and Korean won as well as frontier assets like the Kenyan shilling.
Alarmed central banks are contemplating a range of measures to hold back the tide -- Brazil last month slapped a 2 percent tax on financial inflows while South Africa loosened exchange controls allowing corporates to hold cash overseas.
Talk of controls has surfaced from Turkey to South Korea either by taxing investments or by curbing lending from overseas, and Brazil is expected to propose a "joint response" to speculative capital inflows at the G20 meeting this weekend.
And the recent retreat of up to 8 percent in some emerging currencies does not mean the end of the story.
"The debate over capital controls will resume to an extent we have not seen in the past decade," says Shahin Vallee, strategist at BNP Paribas in London. Emerging markets "will be on a (rate) hiking path pretty much across the board which will lead to more inflows as G3 will be on hold for a while yet."
"You will have funds looking for yields and going to emerging markets and central banks will be unable to cope, which will be an important theme going into next year."
India, South Korea and China are expected to be the first big emerging markets to raise rates in 2010, followed by Latin America in the second quarter and emerging Europe in the last quarter.
The possible consequences are clearly worrying bankers.
"The resultant larger interest-rate differential may attract larger capital flows," Reserve Bank of India Governor Duvvuri Subbarao said last month. "What will the implications be for the exchange rate?"
FEW OPTIONS
Year-to-date emerging equities have drawn over $50 billion, on course to beat the record set in 2007, while bond funds have taken in over $4 billion, according to fund tracker EPFR Global.
The flows are deepening global imbalances by spurring a huge surge in emerging central bank reserves -- Brazil now holds around $233 billion from $200 billion at end-2008 while Asian reserves are up 13 percent this year to $4.96 trillion, up $111 billion in September alone. Click on.
Central banks can let currencies appreciate or they can dampen them via direct intervention or they can impose controls.
As the first would risk export-led recovery, especially in Asia where they need to compete with the tightly-controlled yuan, most central banks have tended to respond via direct FX market intervention. But they then need to sterilise these flows by issuing bonds -- costly in high-yield markets like Brazil. And the more they issue, the higher the yield, which lures more cash.
These options become more and more untenable as economies recover, inflation picks up, interest rates rise and markets rally, said Bhanu Baweja, head of emerging FX strategy at UBS.
"As a result, we do see a risk that policymakers could turn to controls as a preferred means of battling hot money," Baweja said, highlighting Brazil, Egypt, Colonbia, South Africa and India as potential candidates for such measures as well as the Asian surplus economies such as Taiwan and South Korea.
International Monetary Fund Managing Director Dominique Strauss-Kahn told the Financial Times on Monday the Fund was not opposed in principle to using capital controls to limit inflows of hot money, but said most of the time they did not work. Currency appreciation has another side. While central banks worry about exports, currency strength would help check inflation, possibly capping rates. For instance, Australia, the first to raise rates, this week mentioned exchange rate strength to dampen expectations for a December rate hike. "FX appreciation is one of the factors weighing on the market's expectations of rate hikes in 2010," said Murat Toprak, emerging currency strategist at Societe Generale in London.
At the end of the day, as long as low developed world interest rates keep liquidity levels high, cash will keep making its way to where the yields are and where the growth is.
And with emerging growth forecasts being revised up, firmer currencies may not hit growth to the extent central banks fear.
"All these measures will soften appreciation pressure but I fear that in long run the only solution will be to tolerate some appreciation." said Sebastian Barbe, chief emerging FX strategist at Calyon in Hong Kong.
SOME RESPITE?
Two factors may bring respite. One is expectation that China unshackles its yuan next year as the global economy picks up.
Second, the dollar, after months of losing ground against almost every well-traded currency, could get some relief as chatter about exit strategies cuts risk appetite.
Standard Chartered analyst Manik Narain predicts the factor billed as most supportive for emerging currencies -- rate hikes causing a wider yield gap -- may bring the opposite result as they will shrink liquidity at a time when economies are weak. "As exit strategies begin to be implemented, the sweet spot for global fiscal and monetary conditions is coming to an end, he said, adding upside growth surprises are likely to be fewer from now as the boost from stimulus measures fades.
"That may keep the flight-to-safety alive." (Editing by Stephen Nisbet)