Capital controls back on the agenda

Governments in Latin America are becoming increasingly concerned about rapid currency appreciation, and for good reason. For a start, most currencies (with the notable exception of the Mexican peso) now look overvalued. More importantly, however, recent appreciation has been driven by a combination of rising commodity exports and increased capital inflows into the natural resource sector. As such, stronger currencies are squeezing the region’s non-resource sector, where productivity and employment growth tends to be strongest. We see three policy options. First, the authorities could step up intervention in the currency markets. But FX purchases carry heavy sterilisation costs – and a failure to sterilise risks generating asset price bubbles. Second, fiscal policy could be tightened, thus allowing interest rates to be lowered and thereby reducing the carry on currencies. But it would be difficult to tighten fiscal policy quickly and, in any case, there are political barriers to such a move. Finally, capital controls could be imposed. This appears to be the most appealing option, although history suggests that modest controls tend to be porous. In the end, the trigger for weaker currencies in the near-term may be a drop in commodity prices. Over the medium-term, however, structural reforms hold the key to mitigating the effects of ‘Dutch Disease’.